Markets shot out of the gate to start off 2018, with the MSCI ACWI index (our benchmark global equity index) posting a robust +5.6% gain by the end of January. Investors were enthusiastic about the benefits of US tax reform, especially when combined with the additional stimulus provided by an ongoing synchronized global economic expansion. But the mood soured abruptly by early February, as some of the irritating side effects of stronger economic growth began to manifest themselves. The most bothersome of these consequences were higher interest rates, which rose rapidly by nearly half a percentage point by early February. The size of the move caught markets off guard, and somewhat reduced the relative attractiveness of equities. The ACWI index sold off in response, falling –4.2% in February and a further –2.1% in March, leading the index to an overall loss of –1.0% in the first quarter.
The level of volatility may have felt abnormal, and it certainly was relative to very recent history. For example, the S&P 500 had only 8 trading days in 2017 where the market moved by 1% or more. Already in 2018, that total has more than tripled, at 31 days and counting. However, if we look from a longer-term perspective, volatility is still below its long-term historical average. In other words, the recent “spike” in volatility only looks unusual against the exceptional calm of 2017. In reality, market volatility in 2018 has been relatively normal, while 2017 was the actual anomaly.
Exhibit #1: A historical chart of the VIX, which measures market volatility.
One consequence of this higher—and more normal—level of volatility was that we finally began to see some divergence emerge in regional and sector performances. For example, emerging markets easily outperformed this period, rising by +1.4% for the quarter. Meanwhile, US stocks roughly matched the broader indexes, while other developed country markets generally underperformed. By sector, technology and consumer discretionary stocks did well during the quarter, eking out modest gains, while richly valued, “stable” businesses—such as in telecoms, real estate, and consumer staples—lagged handily, losing over –5% of their value. Elsewhere, fixed income returns were a mixed bag during Q1, with US bonds lagging at –1.5%. Global bonds, conversely, outperformed, rising by +0.8%, aided by the +2.1% appreciation of major foreign currencies versus the dollar.
While the return of volatility this quarter may lead some to question this upswing’s sustainability, we would note that the overall climate still looks favorable. We mentioned in a previous eNewsletter that we were closely watching four indicators for signs of an impending market downturn. These indicators, dubbed “the four horsemen,” include higher credit spreads, rising unemployment, an inverted yield curve, and increased volatility. We’ve already noted that volatility has increased, albeit off of historically low levels. But, aside from this, all of the other horsemen remain in benign territory, and as such, we still don’t see a downturn on the medium-term horizon.
Exhibit #2: High yield bond spreads, one of “the four horsemen,” remain at very low levels relative to US treasuries.
Exhibit #3: Meanwhile, the US unemployment rate is near an all-time low, at 4.1%.
Exhibit #4: And, the Treasury yield curve is still upsloping, although it is starting to flatten out.
Where are the flies in the ointment? Aside from the potential risks we reiterate every quarter (a sharp downturn in China’s economy; higher-than-expected inflation and/or interest rates), we now also have some concerns about US policy errors. For example, while tax reform provided a necessary leveling of global corporate tax rates, it was achieved by increasing US federal budget deficits to an estimated $1 trillion annually by 2020. At some point, these deficits will likely come back to bite us. Simultaneously, immigration restrictions are reducing the number of new workers entering the US, with likely negative longer-term economic consequences such as labor shortages and constrained growth in GDP. Thirdly, the aggressive anti-trade rhetoric coming from DC is increasing tensions, not only with China but among allies, with apparently little analysis of foreign trade’s actual costs and benefits.
While we worry about some of the long-term ramifications of these policies, the short-term effects are likely to be neutral or even positive. For now, the economy continues to chug along despite less than ideal fiscal policies and potential political surprises. In fact, the current economic expansion is now tied as the second longest in US history, at 8 years and 10 months. We are within spitting distance (14 months) of surpassing the high watermark, and given the relatively muted growth rate experienced so far during this economic cycle, we think it is likely that this expansion will turn out to be the longest ever. Combining the accommodative backdrop with valuations that are mostly reasonable, we continue to believe that stocks will provide attractive returns for at least another year or two.
Dr. Ken Waltzer, MD, MPH, AIF®, CFA, CFP®
Managing Director, KCS Wealth Advisory
Laura Gilman, CFP®, PFP, MBA
Managing Director, KCS Wealth Advisory
Nick Nejad, CFA
Director of Investment Research, KCS Wealth Advisory
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