1Q 2018 Commentary
The first three months of 2018 diametrically opposed what investors experienced just a few short months ago.
2017 yielded very strong equity market returns with extremely low volatility, while so far this year has delivered bouts of extreme volatility and slightly negative returns. We have been expecting market turbulence and in our Q4 commentary wrote “As we look ahead into 2018, we expect increased volatility and most likely a normal market correction.” The U.S. equity market peaked on January 26th, and then had a precipitous drop led by 2 separate 1000 point drops within a week’s time for the Dow Jones Industrial Average. From peak to trough, the broader based S&P 500 index dropped about 12%, in line with other historical market corrections. The U.S. bond market, normally a hedge against these setbacks offered no help as interest rates moved higher and bond prices fell by 1.5%.
The impetus for the correction was threefold: fear that an overheating economy would cause the Fed and its new President, Jerome Powell to raise interest rates faster than anticipated, the market got a bit ahead of itself as valuations were stretched and needed to let some of the air out, and news flow regarding a potential trade war injected fear and uncertainty into the minds of investors. With all of the recent turmoil and volatility, our core investment strategies performed quite well in Q1, delivering net returns in the -0.50 to -1.00 range. Q1 earnings season is upon us, and with equity valuations at much more attractive levels than they were a few months ago, we are optimistic that fundamentals will soon grab hold and equity markets will respond accordingly.
Economic data continues to impress with the final Q4 GDP reading coming in higher than analyst expectations at a 2.9% annual rate. Additionally, the labor market is strong and consumer sentiment readings are on the rise as personal incomes have improved by 3.7% over the past 12 months.
Part of investing in the capital markets is having to deal with the inherent volatility that comes with it. It is extremely frustrating because the market tends to grind higher over time, while the downside is usually quick and violent. There is an old saying about investing in the stock market, “Markets take the stairs up and the elevator down.”
For perspective, here are the recent pullbacks the S&P 500 has experienced since 2010:
After each of the corrective market actions above, the stock market recovered and moved to new highs. We fully expect the same outcome this time around. Based on earnings guidance compiled by Thomas Reuters, the S&P 500 is currently trading at a forward P/E ratio of 16.3, which coincidentally is right about the average multiple over the past 25 years. Foreign markets have the same dynamic of increasing corporate earnings coupled with a recent market correction, making valuations attractive at current levels. In fact the forward P/E ratio of the broad foreign market is well below its historical average.
Using a baseball game as a metaphor, we would say that the U.S. economic cycle is in the 7th or 8th inning, developed foreign markets such as Europe and Japan are in the 5th or 6th inning, while the emerging markets are in the 3rd or 4th inning of its economic cycle. Accordingly, we took action during the quarter, shifting equity exposure from domestic equities to both developed and emerging markets. Client equity holdings are currently positioned 66.5% in U.S. stocks and 33.5% overseas.
Reasons for optimism around equity markets include: a robust economic backdrop, strong corporate earnings growth, reasonable valuations, and geopolitical concerns haven’t escalated.
Reasons for cautiousness include: political rhetoric could lead to a trade war, the Fed could raise rates faster than anticipated, the economy could heat up causing inflation to rear its head, and tensions overseas could intensify.
Fixed Income Overview:
Bonds turned in losses during Q1, as upward pressure on yields forced prices down. The quarter wrapped up with the Fed raising interest rates by another 0.25%, an action that was widely projected by the market. In fact, it is expected that we will see an additional 2 or more interest rates hikes throughout the remainder of 2018 as the FOMC continues its path of rate normalization. These actions are a vote of confidence that the economy and labor market are healthy enough to sustain higher rates. It is a positive for investors in that bond yields are beginning to look more attractive than the anemic yields that have been the norm since the Great Recession almost a decade ago. The downside of rising rates is short term pressure on bond prices.
We have been positioned to sustain rising rates for some time, and Q1 was a testament to our asset allocation strategy, as our clients’ bond holdings and non-traditional assets outperformed the broad U.S. fixed income benchmarks.
As we head into the spring months, we are well positioned to sustain whatever the capital markets throw at us. Although continued volatility would not be surprising, lower valuations, strong economic data, recent tax reform and solid corporate and consumer sectors all point to opportunity over the short and intermediate term.