Winter Note 2018
Confidence and Complacency
The chart above illustrates the price changes in the S&P 500 index for 2017 through March 9, 2018. As an aside, March 9th happens to be the ninth birthday of the current bull market in stocks, which from the 2009 low has appreciated more than 315%. If the bull market holds through August 21st, it will become the longest sustained bull market in the post WWII era. (Source: ABC News)
As we noted in our Fall Investment letter, the level of volatility in the stock market was at historic lows and unlikely to persist. Looking at the chart above, it is clear that we did not have to wait long to see this change. The quick correction in late January and early February was significantly greater than anything experienced in 2017.
As the economic data unfolded throughout last year, it became increasingly clear that the economic expansion the U.S. has been experiencing for many years was spreading to the rest of the world. Indeed, synchronized global economic growth was the theme for the market last year.
Coming into the new year that confidence transformed into unapologetic enthusiasm as investors pushed the S&P 500 index up over 7% in the month of January alone. That gain was very near many analysts’ projections for the market for the entire year.
The sharp acceleration in the rate of growth that occurred in January, which begins on the vertical line on the above chart, seemed attributable to the Tax Bill signed into law on December 22, 2017. Additional fiscal stimulus for the U.S. economy with a back drop of synchronized global economic growth inspired investors, to say the least. However, for market skeptics investors had become complacent and were ignoring the already high valuations of stocks and the likelihood that interest rates may rise faster than expected due to unexpected inflation pressures.
Higher Rates and Inflation Concerns
The stock market made its first significant move lower on February 2nd on the back of the January employment report. Both the equity and bond markets reacted to a higher than expected reading of wage gains that was part of the employment report. The strong reaction by the markets is a clear signal that investors are concerned about inflation.
Specifically, if expectations for inflation go up on a sustained basis, the Federal Reserve will likely act by raising interest rates faster than expected. That would be a negative surprise for the bond market and tighten financial conditions throughout the economy. We have noted that interest rate sensitive sectors of the stock market had been underperforming all year.
Uncertainty is Higher
Rising wages are not the only element that can lead to higher inflation, but it is an important factor and one that the market knows the Federal Reserve is watching closely. Hence the market’s high sensitivity to this data point. In addition to the uncertain inflation outlook, there were several other factors that emerged for investors to consider.
On February 9th a Budget Deal was reached in Congress and signed by the President, which will raise the level of government spending. Combining this legislation with the recently enacted tax cuts has raised forecasts for the budget deficit considerably. This will lead to an increase in bond issuance by the U.S. Government.
Add to that the Federal Reserve is decreasing the number of U.S. Treasury bonds it holds on its balance sheet. Recall that to help stimulate the economy in the aftermath of the financial crisis the Federal Reserve began buying U.S. Treasury Bonds and was a for a long time the largest buyer. Now that the economy has improved it has reversed this policy in a step toward normalization.
The supply of treasury bonds for investors is going up for two reasons now. First because the U.S. Treasury will have to issue new debt to cover the increasing budget deficits and second because the Federal Reserve is buying less and less each month. The U.S. will need to attract more buyers of its debt to borrow at the same rates or raise its interest rates to attract more buyers. The market is well aware of all of this and is watching closely.
Additionally, the administration just signed new tariffs on Steel and Aluminum imports. It is noteworthy that on the same day 11 nations adopted a new Asia-Pacific trade agreement, formerly known as the Trans Pacific Partnership. The long term affects of this policy are hard to predict. A full-scale trade war is the primary fear for all market participants.
Trade wars are inherently inflationary for consumers. When countries raise tariffs against each other, the cost of trade goes up for everyone. It is too soon to tell how this new trade policy will work out and what it portends for the future.
What we do know for sure is that the level of uncertainty for corporate managers and investors is higher than it was last year and there are a number of forces already at play that could push interest rates higher. We believe it is safe to assume that the market will remain sensitive to signs of inflation for the better part of this year.
As we have said before and will likely repeat, uncertainty is an inherent part of investing. The market, economic and political risks that we face today we have faced before and will likely face again in some fashion or another.
After reviewing our portfolios in this changed environment, we are comforted in the fact that we have already prepared for a more challenging environment. The increased volatility is a feature of the market that we, at Cornerstone Advisory, are able to turn to our advantage and have.
As always, if you have any questions or would like a conversation, please let us know or contract your Portfolio Manager.
The Cornerstone Team
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