Monthly Markets Memo - February 2018

World Money Small.jpgby Dan Zalipski, CFA & Scott Rosenquist, CFA

The collective euphoria within the markets was shattered by a surge in volatility that led to several days of intense selling.  After peaking on January 26th, the S&P 500 index had dropped over 10% by market close on February 8th, the first technical correction for the market since the 1st quarter of 2016.  Both developed and emerging international equity markets could not escape the turmoil as they declined in lockstep with the U.S. markets.  

Fixed Income was not immune as one may think, primarily because the sell-off was related to the concerns of rising interest rates.  This put pressure on the sector, driving up yields and pushing down prices.  The rebound came as quickly as the sell-off.  The S&P turned negative for 2018 on February 5th, bottomed on the 8th and was back in positive territory by Valentine’s day.  These dramatic down and upward movements demonstrate the type of volatility that has been absent from the marketplace for the better part of two years.   We expect continued volatility, but do not believe this bull market has seen its final days.

Volatility Returns

The dramatic shift in momentum started with a relatively positive January jobs report.  The economy added 200,000 jobs and the unemployment rate continues to hover at 4.1%, the lowest since 2000.  The report also revealed that wages grew at their fastest pace since 2009, and that was enough to get the correction started.  

In another set of circumstances, wage growth would be a more positive development for the economy. Consumers are making more, and thus spending more, further driving economic growth.  Today, however, investors are focused on it as a precursor to higher inflation.  Should inflation move higher, the Fed may see the need to increase the pace and magnitude of their rate increases.  A change in leadership at the Fed is further complicating the uncertainty around their next moves.  Former Fed Chairwoman Janet Yellen handed the reins over to the new Fed Chairman Jerome Powell.  Powell previously worked as a partner at private equity firm The Carlyle Group and was nominated to the Fed’s Board of Governors by President Barack Obama in 2011.  Powell has only been on the job for a few weeks, but thus far indicated the Fed will continue with its forecasted rate increases and balance sheet normalization as laid out by his predecessor.  

It’s the potential changes to those forecasted rate increases that has investors on edge.  As rates move higher, bond prices move lower. Stocks can also experience some negative effects of rising interest rates. Their cost to borrow capital increases and rising wages eat into their bottom line.  In addition, as bond yields increase, they become more competitive relative to other asset classes.  This has the potential to draw money away from equities, which would result in downward pricing pressure.  Should rates increase quicker than expected in response to rising inflation, both stocks and bonds would likely react negatively.  

Looking Forward

The market should tolerate an increase in inflation if it is supported with decent economic growth.  The manufacturing and service sectors are reporting strong activity as shown in the latest report from the Institute for Supply Management.  Companies are reporting positive earnings growth and upbeat outlooks for 2018.  Analysts are revising their earnings estimates to incorporate tax cuts and a healthy economic backdrop.  This should continue to support the case for equities, but volatility may persist if spikes in interest rates or inflation catch investors off guard.

"Listening to others, especially those with whom we disagree, tests our own ideas and beliefs. It forces us to recognize, with humility, that we don't have a monopoly on the truth." -  Janet Yellen, Former Chair of the Board of Governors of the Federal Reserve System, 2014–2018

 
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal.  Past performance is never a guarantee of future results.

 

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