February 6 2018 Market Update

Only three weeks ago, the equity markets were posting all-time highs every day and volatility was extremely low; in fact, on the day we last wrote you, January 11, 2018, the CBOE Volatility Index closed at 9.88.[1] This index measures equity market volatility by inference from the prices of equity options; high volatility is typically interpreted as investor nervousness; lower volatility as the lack of nervousness, and extremely low volatility as complacency.

On February 5, 2018, after two consecutive days of big drops in equity markets, the VIX index closed at 30.  At the same time, equity markets tumbled: on January 11 the S&P 500 Index closed at 2,767.56, a 3.5% move up for the year.  By January 26th, the index had moved 4% higher, to an all-time high of 2,872.87, a 7.5% move up for the year. Then they took a turn for the worse, closing on February 5, 2018 at 2649.86, the first time in 2018 it had closed below the December 31, 2017 level of 2,673.61.[2]  What is the cause of these violent moves, and what should we expect going forward?

In financial markets, January 2018 started off as an extension of 2017.  Fueled by the remarkable post-elections turnaround in business and personal sentiment, by several quarters of stellar company earnings, by the December Tax Cuts, and by forecasts for “global synchronized growth” in 2018, equity markets returned about 20% in 2017 and another 7.5% in the first three weeks of January 2018.  Despite the Fed hiking interest rates three times in 2017 and planning to continue to do so in 2018, interest rates remained relatively low at approximately 1.25%-1.5%,[3] helping an equity rally continue upwards.

Equity investors pushed aside risks such as the risk that the Fed will be forced to raise interest rates more than is expected, the risk of a flattening yield curve (at approximately 55bps between the 2yr and the 10yr Treasurys[4] the yield curve is reasonably flat, which does not typically bode well for the US economy) and, perhaps most poignantly, the risk of inflation. Bond investors, meanwhile, paid more attention to these risks and the interest on the 10yr Treasury moved up within a month from 2.46% on January 2, 2018 to 2.84% on February 2nd. [5]

The big drops in equities came on Friday, February 2, and on Monday, February 5, 2018: -2.12% and -4.06%, respectively.[6]  The immediate trigger was the release of the Government’s estimate of non-farm payrolls before the start of trading on Friday.  On the surface, this was actually a positive report, with 200,000 new jobs created in January in the US economy (vs. an expected 180,000) and the unemployment rate holding at 4.1%.[7]  More importantly, average hourly earnings increased 0.3% for the month and 2.9% on an annualized basis, the best gain since the early days of the recovery in 2009.  This might seem to be a positive item (and indeed it is for those getting a pay raise), but the Fed believes it is a sign of wage inflation and potential consumer-level inflation, both of which have been missing from the recent recovery. This piece of news has served as a reminder to equity investors of the risks that they have been ignoring so far, hence the violent correction downwards, and the first time this year the S&P 500 Index closed below its December 31, 2017 level.

There is also another narrative, perhaps favored by equity investors, saying that equity markets have moved up too much in too short of a time, and simply had to correct at some point.  According to this line of reasoning, a drop in equity markets was expected after such a strong rally and against a background of equity markets trading at just shy of 20 times earnings.  A CNBC interviewee said [8] of the report: “Overall it was really fabulous. People are just looking for an excuse to sell.”  In other words, had it not been for the employment report and the inflation scare it brought about, markets would have dropped on something else.  Perhaps that’s the case.

What happens next? In the short term, anything is possible. We could drop further, or we could move back higher.  But in the medium term, we believe the outcome depends on growth in the US economy.  If the economy continues to grow at a rate similar to the current one (real GDP grew by 2.6% in the fourth quarter of 2017 [9]) or higher, equity markets might regain their footing and move higher again, even with higher interest rates.  If, however, the economy sputters, we might fall into a recession.  At this point, however, we remain on the side of continued economic growth, aided by tax cuts, repatriated funds and positive sentiment from both businesses and individuals (despite the hit to their investment portfolios over the past few days).

We remind you of the number one lesson we have taken from 2017, as we discussed in our previous newsletter. One should take every financial prognostication with a huge grain of salt, as markets have a way of working out the way they please, and not necessarily the way you expect.

We hope that the headlines of the last few days will encourage you to reach out to us to discuss how recent events affect your portfolio or your financial plans and goals. This will help us together confirm that the risk level of your portfolio correctly matches your need and willingness to bear risk so that you stay invested amidst uncertainty and volatility in financial markets.

We thank you again for your continued confidence, and look forward to our next review meeting with you in early 2018.

Sincerely,

JSF Financial