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Unlike much of 2017, the first quarter of 2018 saw the reintroduction of volatility into the equity markets. While periodic bouts of volatility are not uncommon in financial markets, after having enjoyed many months positive, low volatility returns, the sudden and abrupt moves that we saw in February and March of 2018 seemed almost like rude awakening. At the very least, it has served to remind investors everywhere that markets, over the short term, can move up and down, sometimes sharply and without warning. If one is able to look beyond the volatility they will see, in general, positive macroeconomic indicators and market fundamentals that would seem to support the current valuation levels and further gains in the equity markets. Given the relatively elevated valuation levels however, and the recent narrow market leadership, indications are that further gains will likely continue to be accompanied by additional volatility and price swings.
As 2017 drew to a close and the calendar turned to 2018, investors across most major asset classes were relishing a year of largely positive if not exceptional gains. The equity markets started off the New Year on a very positive note with equity markets continuing to climb fueled, at least in part, by the anticipation of tax reform and generally positive economic data. Globally, growth seemed to be accelerating based on earnings trends and with the promise of lower taxes coupled with low interest rates and minimal inflation, valuations, while somewhat stretched, did not appear extreme. This relative stability in the financial markets would not last however and, as we moved into February we began to see signs of uncertainty in the markets.
Initially the volatility seemed to be driven by a “buy the rumor, sell the news” effect of tax reform. With a tax reform package that amounted to historical levels of fiscal stimulus for the US economy, many investors saw an opportunity to take some profits and the markets shuddered. In general, tax reform and specifically a reduction in the corporate tax rate would be expected to be a positive for the markets. Given the extraordinary period of solid growth, low volatility, low rates and minimal inflation that we had experienced over the past calendar year however, the implementation of this fiscal reform also brought with it the specter of accelerating inflation. With economic growth accelerating, a strong labor market and low inflation, some might argue that a massive dose of fiscal stimulus at this point was not necessary. As with many things in politics however, the opportunity to pass legislation with a party line vote requires both political capital and a majority in both legislative chambers. Facing the possibility of an unfavorable outcome in the midterm elections and with the strong desire to deliver on a campaign promise and secure a legislative victory the administration was able to pass a massive reform to the US tax code and meaningfully reduce the corporate tax rate in an attempt to improve the competitive landscape for US corporations.
While we have yet to see the full effects of these tax reforms on corporate earnings it is widely expected that first quarter reports will show an acceleration of earnings growth. Along with accelerating earnings growth however, the markets also began to consider the prospect of increasing inflation. As beneficial as accelerating growth might be considered for the markets accelerating inflation can be just as troubling. The prospect of an increase in the rate of inflation has implications for both the equity and fixed income markets. The rate of inflation is one of the data points that the Federal Reserve monitors to determine the correct monetary policy to pursue to keep the economy moving forward but at a sustainable rate that does not lead to runaway inflation. As we move into the second quarter of 2018, much attention is being given to the Fed’s plan to increase short term interest rates in an effort to bring us back to a historically more normalized rate environment and keep the economy from overheating. Coming into the year it was widely anticipated that the Fed was targeting three rate increases over the next twelve months. While that is generally still the prevailing estimate, the potential for a fourth or even fifth rate increase this year cannot be entirely discounted.
There are, of course, always other risks to the markets and to economic forecasts in general and this time is no exception. As the first quarter came to a close we were given a glimpse of what the manifestation of political risks might look like and how the markets might respond to the rising threat of protectionism. The introduction of potential tariffs along with the current administrations apparent inclination towards protectionist leaning policies has increased the probability of an escalating trade confrontation. While the immediate impact of the proposed tariffs on the US economy would still appear to be relatively benign, any escalation could potentially lead to a meaningful decline in global growth. Protectionist policies play well to the administrations current political base but in the end, the administration has thus far demonstrated that its interests are generally aligned with the needs of the business community and the market volatility brought about by the prospect of a potential trade war is likely sending a strong message about the risks of dismantling global trade agreements.
In general, our outlook for the markets and the economy is still reasonably constructive yet cautious. While the risks of an economic decline would increase with any broad implementation of protectionist trade policies, we still see the risk of a larger confrontation over trade as being relatively low. Beyond that, the fundamental factors that are supporting the financial markets are still largely intact; an improving economy driving corporate revenue and earnings growth and mild inflation that, while trending higher is still relatively benign and at levels that should continue to support further gains in equities. Furthermore, volatility has historically been something that investors have needed to accept, and even endure, in pursuit of longer term gains. Sometimes an increase in volatility can be an indicator of an impending economic slowdown and sometimes it can just be normal market gyrations. In this case it would appear to be more short term than secular and seems to be reflective of the challenge that investors are facing in navigating a strong economic and earnings growth environment coupled with the prospect of higher rates and accelerating inflation. Volatility, at its core, is generally short term and amplified by traders and speculators with shorter time investment horizons. Underlying fundamentals drive the markets over the longer term and currently the fundamentals still appear to be relatively sound. From time to time however markets are subject to becoming disconnected from the underlying fundamentals and it is in these times that we are reminded to stay disciplined in our approach as investors, maintain a diversified portfolio that accurately reflects our risk tolerance, longer term objectives and, perhaps most importantly, our liquidity needs. At the moment, we continue to believe that the foundation has been set for additional gains in equities throughout the year. While the risks to the markets appear to be rising modestly we do not expect there to be a meaningful deterioration of economic conditions over the next twelve months. While of course, this outlook is subject to change, we try to avoid forecasting corrections in the financial markets because we are not traders, we are investors. Accurately timing the market has historically proven to be extremely difficult and has led many investors to make ill timed decisions that have negatively impacted their long term returns. In our mind, a solid strategic approach that is tailored to one’s individual situation and objectives will ultimately prove to be more rewarding over the long term than attempting to predict the timing and scale of near term market moves.
Founded in the 1950s, Carroll Consultants, Ltd. provides investment advisory, retirement plan consulting and administration services to clients throughout the country. For further information about this article, please contact Marcie Carroll at email@example.com or (610) 225-1210.