The eerie calm pervasive in the financial markets for almost two years ended abruptly last week as stock markets around the world reacted to higher inflationary pressures evident in the US labor markets. The release of non-farm payroll data indicated a larger than expected (2.9% year-over-year) pickup in wage growth, something that has been mostly absent in the post financial crisis recovery to date, which spooked the bond market and rattled the stock market as well. The yield on the benchmark 10-year US Treasury Bond that silently crept above 2.4% late last year in recognition of the robust global economy, full employment and a large tax reform package implemented at the end of 2017 now sits at 2.83%. This may not seem like much, but translates into an 18% increase in rates since the end of the year.
Last week ended with a decline of approximately 5% in most of the major stock markets, but is sure felt like more. In fact, before last week’s decline, markets had experienced one of the longest periods of time in history without a 5% decline. In any given year, the average intra-year decline is 13% with an average gain of 8.8% (1980 to present) so a 5% drop is really quite normal and overdue, especially since last year’s 3% intra-year decline was such an anomaly. We had been enjoying a period of relative calm, in an almost Goldilocks-type environment, with the porridge being “just right.” The manic convulsions of the stock market got a boost from the unwinding of many “low-Vol” strategies that relied on a continued low volatility environment. When the selling started, it forced these strategies to unwind their bets, which created more selling. Throw in a heavy dose of leverage through option and futures overlays and you have a classic squeeze where forced selling begets more selling until the books are balanced.
Internally, we have had many discussions about the lack of volatility, but it was in conjunction with a very strong economy, low inflation, easy monetary policy and recent boost from fiscal policy as well. What seemed odd to us was the almost vertical rise of markets in January. Yes, going straight up is a bit strange too, but not unprecedented. In January the S&P 500 finished the month up 5.73%, and at one point was up 7.55%. After last week’s action the year-to-date return is now down in negative territory at -1.84%. So, the market gave up all of January and a little bit more, taking the market price levels back to Thanksgiving. The intra-year decline was 10% at its worst, but finished the week at down 8.72%, which is a normal correction, although the duration of how quickly it happened was not typical. For what it’s worth, according to a study by Factset and LPL Research, big gains in January on average lead to more gains for the rest of the year. However, the study also reveals that on average there is a 10.7% intra-year pullback to go with the gains, which is what we just experienced – this is normal.
The question we ask ourselves is, “Has anything changed?” From a big picture standpoint, the answer is “no.” The fundamental backdrop that supports higher stock prices is still very much in tact:
- Strong Corporate Sales and Earnings
- Accommodative Fiscal and Monetary Policy
- Low Inflation
- Tax Reform
- High Consumer Confidence and Small Business Confidence
If investors were truly concerned about economic fundamentals, then areas like precious metals and government bonds would be increasing in value and high yield bonds would be declining. The declines of last week were centered in the stock market and low volatility based products and strategies. There would also have been a flattening of the yield curve, which is a signal the bond market gives when it is concerned about future economic growth. In fact, we saw the exact opposite, a widening of the curve reflecting the increasing inflationary expectations in the short run, but higher economic growth expectation at the longer end of the curve.
Is there anything to worry about? The simple answer to that question is always “yes,” but the answer to the more important question of the day, “Is there anything to panic about?” that answer would be “no.” At this point in the economic cycle we are watching:
- Monetary Policy
- Trade policy
- Budget Deficits
- Risk Asset Valuations
In 2017 the Federal Reserve commenced a program of quantitative tightening to slowly unwind the historic levels of monetary policy accommodation (“Quantitative Easing”) deemed necessary during the financial crisis. The unwinding includes raising short term interest rates, halting purchases of US Treasury and mortgage-backed securities and now letting the Federal Reserve’s massive bond portfolio worth $4 trillion shrink by $50 billion a month by selling such securities. This may be challenging to navigate without upsetting the financial markets, but certainly is possibly since it is being done at such a measured pace.
Complicating the actions of the Federal Reserve are the recently approved tax reform and budget package. Normally at this point in the economic cycle, a fiscal stimulus program of the magnitude just enacted would not be deemed necessary. The economic recovery off the lows of 2009 is now one of the longest in history with the economy already close to full employment and inflationary pressures bubbling up. Tax reform and the projected fiscal budget deficit will magnify the need for government borrowing at a time when the Federal Reserve is raising the cost of borrowing, thus putting further upward pressure on interest rates. At this point in the economic cycle the government would ideally be looking for ways to run a balanced budget to pay down some of the massive amount of debt accumulated over the prior 12 years from fighting a war on terror and attempting to avoid a depression that resulted in the Great Recession. It appears that the baton of economic support is being passed from monetary policy to fiscal policy – let’s hope the baton is not dropped by the Federal Reserve by raising interest rates too quickly to cool down inflationary pressures. We believe the Federal Reserve will err on the side of letting the economy run a bit “hot” for a while since it ran a bit “cold” for so long.
We are also watching the current administration’s stand on trade policy for potential negative effects on economic growth. While the idea of re-examining entrenched trade deals to be less onerous on America seems reasonable, the risk is that we start down a path that results in a trade war with one or more of our leading trade partners. In that scenario, economic activity is reduced, which would have a very negative impact on stock market valuations and growth. This potential outcome is quite difficult to predict and will be reflected in greater volatility in the stock market as this administration takes on various trading partners. Look for this to continue to be in the news for the near future.
One of most striking changes that has taken place since early 2016 is the marked change in small business confidence, which has helped lead the stock market higher. After last week has that confidence changed? That is a question that will take a bit more time to answer, but we don’t think there will be a meaningful change to business confidence. Short-term investor psychology has changed from greed to fear, suggesting a period of time before markets continue higher, but we do believe they will continue higher. We do not believe that overall small business or consumer confidence has been damaged in any material way that would impact plans for business expansion or consumer spending. In fact, just the opposite is what we expect post tax reform. The benefits of tax reform clearly are skewed to corporate America, which is responding in a way we have not seen during this long expansion. Corporations are reporting record sales and profits and indicating more is coming in 2018. Post tax reform companies are also raising wages, hiring more workers and investing in more plant and equipment, which should keep confidence high and the economic expansion going.
Risk asset valuations are high by any measurement standard, but not terribly so when compared to the still low (but rising) level of interest rates. Valuation has never been a great timing mechanism for making large asset allocation decisions as markets can stay undervalued or overvalued for long periods of time. Bull markets end when economic activity declines and we do not see that happening any time soon.
Our overall summary and recommendation is that while last week’s roller-coaster ride was harrowing and caused feelings of fear and unease for many, market corrections during bull markets are normal and the overall market fundamentals do not lend to making any major moves at this time, so we will be staying the course.