On the heels of one of the least volatile years for the stock market in the last century, 2018 is proving to be something very different. A very strong 5.7% gain for the S&P 500 Index in January was entirely wiped out just three trading days into February. Since that point, we have seen significant swings up and down. After falling nearly 10% in February, the NASDAQ was able to rally enough to make new all-time highs in March before again pulling back.
In the end, stock market losses were moderate considering the wild swings of the first quarter. The decline of 0.8% for the S&P 500 in the first quarter is just the second down quarter since the 4th quarter of 2012. Even with the recent volatility, the index is still up over 100% since then. February’s drop also broke a 15-month streak of monthly gains for the S&P 500.
Most major asset classes moved slightly lower during the quarter. Of note, after a bang-up 2017 and a great start to the first quarter, foreign stocks ended up with the largest decline among equity asset classes. The MSCI All-Country World Index (excluding the US) fell 1.1%. But bonds were the biggest disappointment with the Barclays Aggregate Bond Index down almost 1.5% for the quarter as interest rates inched higher.
|Market Index Returns as of March 31, 2018|
|Index||1st Quarter||1 Year||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||-0.8%||14.0%||10.8%||13.3%||9.5%|
|Russell Midcap (US Mid Cap)||-0.5%||12.2%||8.0%||12.1%||10.2%|
|Russell 2000 (US Small Cap)||-0.1%||11.8%||8.4%||11.5%||9.8%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||-1.1%||17.1%||6.8%||6.2%||3.1%|
|MSCI EM (Foreign Emerging)||1.4%||24.9%||8.8%||5.0%||3.0%|
|Barclays Aggregate Bond||-1.5%||1.2%||1.2%||1.8%||3.6%|
|Barclays Muni Bond||-1.1%||2.7%||2.3%||2.7%||4.4%|
|Past performance is not an indication of future performance.|
The stock market has been on quite a run since President Trump’s election victory. His economic policy promises—regulation reform, tax reform, and infrastructure spending—boosted investor confidence and drove stocks ever higher throughout 2017 and to an all-time high in late January of this year. Then some better-than-expected economic reports halted the climb and sent stocks lower in early February as investors worried about an overheating economy and the potential for higher interest rates.
The Labor Department’s jobs report for January showed a 2.9% average hourly earnings gain for private-sector workers—a larger gain than was expected. The S&P 500 fell over 6% in just two days on fears that rising wages may finally start to push inflation above the Federal Reserve’s 2% target (fears we’ve been hearing about since the Fed first started its quantitative easing program back in 2008). Inflation has been hovering just above 2% recently but this report reignited worries that inflation could start to pick up as labor costs rise and consumers with higher incomes ratchet up their spending.
So while this jobs report was good news for the average American and does not indicate a recession is looming, it could signal that the end of the bull market is at least edging closer. Inflation typically picks up later in the business cycle as unemployment falls and the pace of wage gains quickens. In a normal economic cycle, tight labor markets and rapidlyrising incomes prompt the Federal Reserve to raise interest rates to help manage rising inflation.
The Fed has a statutory mandate established by Congress: Full employment, stable prices and moderate long-term interest rates. Absent the need to keep interest rates low with US unemployment at a historically low level of 4.1%, the Fed could see a need to begin raising rates more quickly than planned. This would lead to higher borrowing costs and slower economic growth. Some of February’s inflation fears were soothed by the February jobs report which showed private-sector average hourly earnings rose just 2.6%. But by then, a new issue had taken center stage.
The tariffs on imported solar panels and washing machines announced by President Trump in January didn’t garner much of a market reaction. It turned out he was just getting started. In late February, reports came out that the President would announce tariffs on steel and aluminum imports and this news sent the S&P 500 lower by 3.7% in the three days prior to the official announcement on March 1st.
Tariffs of 25% on steel and 10% on aluminum went into effect in late March. Temporary exemptions were granted to Canada and Mexico which may help spur negotiations to revamp NAFTA that have stalled over the past year. While these tariffs may boost steel and aluminum production domestically, they’ll also push up input costs for domestic manufacturers or other companies who use these commodities in production. Home building is by far the largest industry that will be affected. We may see higher home prices and fewer new homes being built if these tariffs persist.
Steel has long been a target of protection and the US has had several steel tariffs over the years to promote US steel production, even as recently as 2002 under President George W. Bush. The Bush tariffs were short-lived as the World Trade Organization deemed them illegal and the retaliation from other countries proved very costly for US exporters in other industries. The justification for the new tariffs is different, however, as the Trump administration imposed them on the basis that domestic steel is vital to national security. The WTO has not yet ruled on the matter and it is still unclear what kind of backlash there will be from trading partners or from those US companies that stand to lose as a result of higher costs.
The market fell again a few weeks later when President Trump announced another round of tariffs directly targeting up to $60 billion in annual imports from China; this move stoked fears of an allout trade war with China. China’s officials responded with their own tariffs on 128 US products, though they only account for about $3 billion worth of US exports.
For the moment, the market appears to have calmed down on reports that the US and China have been having closed-door talks on how to resolve the current dispute. The US trade deficit with China is by far the largest among any countries in the world. Any kind of long-term disruption of the relationship could be costly for both sides. That’s not to say that the recent protectionist actions by the Trump administration aren’t warranted to some degree. It has been obvious for some time that China has used anti-competitive policies that have benefited Chinese industries at the expense of competitors around the world.
Looking at the fundamentals, the global economy is still on solid footing. The table above, posted in March by the Organization for Economic Co-operation and Development, shows expectations for global growth are not only widespread but have been rising in recent months.
For several years we’ve estimated that stocks have been, at least, fully valued and that stock prices have run ahead of earnings. Based on what we saw in the first quarter, 2018 may be a year where the fundamentals outperform stocks. This doesn’t necessarily mean stocks need to fall. It may just be a back and forth kind of year as earnings hopefully catch up with, and justify, the prices we’re seeing.
Historically we’ve see that it usually takes a recession to put an end to a bull market despite what market prices do in the short term. While the strong projections in the nearby chart of GDP projections could be overly optimistic, there is good evidence to support a continuing expansion. Risks remain of course. Rising inflation which results in higher interest rates, tough talk on trade that escalates into a trade war, or one of those “unknown risks” could put an end to the party. Our advice as always is to remain diversified and to use these bouts of volatility as a good opportunity to rebalance your portfolio.