After experiencing 15 months of positive growth and despite a healthy economy, the US market experienced some volatility during the first quarter of 2018. The S&P 500 fell about 1%, marking its first negative quarter since 2015. Almost every asset class was down, with a few exceptions.
After dropping a total of 10.16% in February, the S&P 500 has since rebounded, but isn’t fully recovered from the correction, which is defined by any drop of more than 10% off peak value. However, more volatility is likely as the prospect of escalating international trade wars, rising interest rates, and increasing political instability continue to impact investor confidence—even though economic growth shows few signs of slowing in the near term.
2018 Q1 Returns
Sources: Frank Russell Company’s Russell 3000 Index, ©MSCI World ex USA Index [net div.], ©MSCI Emerging Markets Index [net div.], Standard & Poor’s S&P Global REIT Index [net div.], Bloomberg Barclays US Aggregate Bond Index, and Citigroup’s Citi WGBI ex USA 1−30 Years [Hedged to USD].
Top Factors Impacting Markets
Moving into the second quarter of 2018, there are a number of potential opportunities and risk areas to look out for as an investor—including the impacts of wage growth, rising interest rates, and the potential for a trade war.
January’s jobs report was better than expected, with job growth up 200,000 compared to the 180,000 new jobs expected. Year-over-year average hourly earnings increased 2.9% as well, which is the largest wage gain since 2009.
From an economic perspective, higher wages are generally a good thing; however, the first quarter wage-growth metrics have sparked investors’ fears that as the cost of labor increases, inflation will follow. That’s because inflation will cause the cost of doing business to go up and potentially eat into corporate profits, reducing returns on stock investments.
As unemployment remains low, employers will likely continue to be forced to pay more for increasingly scarce workers, which may lead to more volatility in the market moving forward.
Changes at the Federal Reserve
In March, Jerome Powell took his position replacing Janet Yellen as the new Federal Reserve chair. And, as expected, there was another quarter-point increase in the Federal funds rate, or overnight lending rate, to a target range of 1.50%-1.75%.
Powell doesn’t appear to be changing Janet Yellen’s outlook on the economy, which is continuing to grow, so at least two more quarter-point increases are expected before the end of 2018.
However, as interest rates increase, the cost of borrowing goes up, and businesses and consumers may choose to save instead of borrowing to expand or make large purchases—which could slow the current pace of US economic expansion.
Escalating Trade Wars
In addition to the rising inflation and interest rate concerns, equity markets across the globe sold off in latter half of the quarter because of increasing fears of a trade war between China and the United States.
In early March, the Trump administration announced a 25% tariff on steel and a 10% tariff on aluminum imports from China. The Chinese government responded quickly by proposing potential tariffs on more than 120 American products, including pork, wine, and soybeans.
Over the past five years, almost a fifth of all total US imports came from China, and it’s been our largest import location since overtaking Canada in 2007.
Although it is too early to understand the full impact of the steel and aluminum tariffs and any Chinese retaliation, they could help create new US manufacturing jobs and lead to some trade concessions from China, but consumer and production costs here will almost certainly rise.
In an effort to control the rate of inflation, the Fed has communicated their intention to increase the overnight lending rate in quarter-point increments as many as three more times before the end of 2018.
Despite the modest increases to short-term interest rates, the global demand for long-term, US fixed-income investments still remains strong. US government bonds still offer higher yields than most foreign bonds and are viewed as having little credit risk.
However, the intense demand for US government bonds is causing the shape of the US Treasury yield curve to flatten as long-term yields are brought down and the short term rates continue to increase.
A flattening of the yield curve can signal multiple things, including expectations of lower inflation, slower economic growth, or additional Federal Reserve rate increases.
If short-term interest rates rise above long-term rates, the curve is said to be inverted and can be a predictor of an economic recession. Inverted yield curves have preceded the last five recessions by about one to two years.
As the November 2018 US midterm elections approach, uncertainty related to potential policy changes in Congress could also lead to increased volatility in the market.
Democratic candidates are winning most of the special elections leading up to the midterms, and if that trend continues, investors could begin to view potential policy shifts as increasingly likely to occur.
A recession is always possible during periods of increasing inflation, but one doesn’t look likely this year. Global economic growth remains on a steady upward trajectory as almost every global economy is expanding—and is expected to for the rest of 2018.
Whether the first quarter’s market drop is due to rising inflation and interest rate fears or just a regular market correction, it’s not uncommon. On average, 5%-plus pullbacks have occurred three times a year since 1930. Prior to this most recent correction, we hadn’t seen such a drop since mid-2016. Still, it’s prudent for investors to consider the potential impacts of the increasing interest rate environment on their investments.
While passive investing, or buying the market, has been a successful strategy over the past few years as market volatility and interest rates increase, the performance differential between the companies that do well and those that don’t is also likely to increase, highlighting the importance of investment discipline.
Floating rate income securities, which increase their interest rates as rates climb, can help investors diversify their portfolios and mitigate some of the risk associated with rising rates.
Additionally, alternative investments unrelated to the capital markets can also help diversify portfolios and mitigate some of the traditional stock and bond risk.
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To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams advisor.