April 5 2018 Market Update

For the quarter, the S&P 500 Index closed down 1.2% at 2,640.87, after being as high as 2,872.87 (on January 26th, up approx. 7.5% for the year) and as low as 2,532.69 (on February 9th, down 5.3% for the year).  Note these are the returns of the S&P Index itself, not including dividends. On the Fixed-Income side, the 10-year U.S. Treasury closed 2017 at 2.40%, rose to a high of 2.94% by mid-February, and closed the quarter at 2.74%.[2] An investor in an ETF tracking the Barclays Aggregate Index lost 1.50% in the first quarter, after dividends and distributions. [3]

Each month in the first quarter can be summarized with a different word.  January’s word is “2017”; February’s is “inflation”, and March’s is “tariffs.”  Let us explain.

As we wrote to you earlier, January was a “more of the same” month, continuing the of 2017.  The economic picture was good. The popular catchphrase on Wall Street was “global synchronized growth”, which means that all OECD countries were projected to grow their GDP in 2018. The positive economic implications of the December Tax Cuts were just around the corner.  This was enough to push equity markets — such as the S&P 500 — up about 7.5% in the first three weeks of 2018 after a 20% rally in 2017, and keep the VIX index at low levels of about 12 or below throughout most of January.[4] Equity investors effectively pushed aside known risks that the Fed will be forced to raise interest rates more than the three times and 75 basis points, the risk of a flattening yield curve and, perhaps most poignantly, the risk of inflation. Bond investors, meanwhile, paid more attention to these risks and the interest rate on the 10yr Treasury moved up within a month from 2.46% on January 2, 2018 to 2.85% on February 2.[5]

Then came February and the fear of “inflation.” The immediate trigger was the release of the Government’s estimate of non-farm payrolls before the start of trading on February 2, 2018.  The Bureau of Labor Statistics reported that average hourly earnings increased 0.3% for the month of January and 2.9% on an annualized basis, the biggest increase since the early days of the economic recovery in 2009.  This might seem to be a positive item (and indeed it is for those getting a pay raise), but the Fed viewed it as a sign of wage inflation and potentially overall inflation, both of which have been missing from the recent recovery. This piece of news reminded equity investors of inflationary risks.  The S&P dropped by 2.1% and 4.1% on two consecutive days following the release of that BLS report, and for the first time in 2018 the S&P 500 Index closed below its December 31, 2017 level. The S&P 500 Index dropped by 3.9% during the month of February as volatility shot up significantly, with the VIX reaching a high of over 50, a level not seen since 2011.[6]

The month of March was dominated by “tariffs.”  First, The President imposed global tariffs on steel and aluminum imports;[7] however, they were not as harsh as originally feared (Canada & Mexico are excluded until NAFTA is renegotiated). Gary Cohn, the President’s chief economic adviser, who objected to imposing these tariffs and whose opinion was overruled, announced his resignation soon after.[8]  The president replaced Cohn with Larry Kudlow, a CNBC commentator;[9]  and went on to impose tariffs on $60B of imports from China, the world’s second largest economy. China responded by saying that it will match the US tariffs with similar tariffs on US imports of the same scale and intensity.[10]  This sparked concern of a global trade war, which affected financial markets all month long.  Throughout March, news that suggested intensifying tensions spooked the markets and sent risk assets down; news that suggested otherwise sent risk assets higher. The S&P 500 Index dropped 2.7% in March.

The Federal Reserve took note of these headlines and other data and raised short-term interest rates by 25 basis points at its March meeting – the first hike under the new Chairmanship of Jerome Powell. They also indicated that they intend to stay the current course of additional rate hikes. As of the writing of this newsletter, Fed Fund Futures (financial instruments reflecting market participants’ opinions on the future direction of interest rates) imply, with a 68.5% probability, that the Federal Reserve will hike short term interest rates between three to four times in 2018,[11] and a June hike is a near certainty, with a 78.44% probability.

Looking out to the second quarter, we are focusing on tariffs and on the possibility of a trade war.  It is too early to tell if recent headlines are the opening salvo in a trade war between the world’s two largest economies or if it is simply part of negotiations relating to North Korea. We are also focusing on the upcoming earnings season (which will start next week) for clues on the ongoing health of Corporate America.  Eyeing equity valuations, we note that if the S&P 500 is at 2,615, the S&P 500 Index is trading at a 16.85[12] multiple of earnings, on a forward 12 months basis; this is significantly less expensive even from the 17.49 multiple recorded a month ago. In effect, this indicates that stocks are not expensive or overpriced.

The one trend to anticipate is ongoing and possibly even heightened volatility.  It seems as if big, daily swings are again the norm, which poses challenges but also potential opportunities.  We hope that the economic and market-related events that we experienced during the first quarter of 2018 will encourage you to reach out to us and inform us of any changes to your financial plans. We want to make sure that the risk of your portfolio correctly matches your need and willingness to bear risk so that you can stay invested amidst the uncertainty inherent in financial markets.

We thank you again for your continued confidence.

Sincerely,

JSF Financial