March 11 2018 Market Update

We begin March by taking a moment to review what happened over the last month in the financial markets. February was an extremely turbulent month, one that we have not experienced the likes of since 2011.

Consider the CBOE Volatility Index (“VIX”), a key measure of market expectations for near-term volatility conveyed by S&P 500 stock index option prices, which has been widely considered to be the world’s premier barometer of investor sentiment and market volatility.[1] For reference, the VIX index spent January 2018 between a low of 8.92 and a high of 15.42[2] and its 2017 range was 8.56 to 17.28.  In contrast, February saw a VIX high of 50.30 and the index closed the month at 20.46, indicating a significantly higher volatility and fear among investors. As is usually the case, this was accompanied by a significant drop in the S&P 500 Index, which reached a low of 2,593.07 [3] on February 6^th, the same day the VIX reached an intra-day high of 50.30. At that point, the index S&P was down approximately 9.7% since reaching the intra-day high (and all-time high) of 2,872.87 on January 26, 2018.

Overall, both the equity markets and bond markets dropped in February.  SPY, an ETF tracking the S&P 500 index lost 3.63% of its value in February[4]; and AGG, an ETF tracking the Barclays Aggregate U.S. Bond Index, lost 1.0% in February.[5]

We last wrote to you in early February and explained the cause of the extreme volatility.  We noted that the equity rally in 2017 extended to the first three weeks of January 2018 due to (a) improved business and personal sentiment (b) strong company earnings, (c) expectations for an improved economy due to the December Tax Cuts, and (d) forecasts for “global synchronized growth” in 2018.  All these were enough to counter the impact of three interest rate hikes in 2017 and FOMC forecasts for at least three more in 2018, which typically damper the markets. Then, on Friday, February 2, the Government[6] released its estimate of Non-farm payrolls; this was actually a positive report, with 200k new jobs created in January in the US economy (vs. an expected 180k) and the unemployment rate remained at 4.1%, but the rub was that average hourly earnings increased 0.3% for the month and 2.9% on an annualized basis.  This was the largest gain recorded wage gains since the early days of the recovery in 2009.  In our last newsletter we explained that this data point, viewed by the Federal Reserve, is a sign of wage inflation and potentially overall inflation (both of which have been missing from the recent recovery) and a reason to pursue the course of future rate hikes.

At the end of February, the Fed Fund Futures (financial instruments reflecting market participants’ opinions on the future direction of interest rates) imply, with a 66.5% probability, that the Federal Reserve will hike short term interest rates between three to four times in 2018.[7] In fact, a March hike and a June hike are near certainties, with an 86% probability and a 74% probability, respectively.  Treasury yields convey the same message to investors; the yield on the 10yr Treasury bond is at 2.87% as of the end of February, up from 2.4% on December 31, 2017.[8]

Therefore, we think that February was a period of adjustment in financial markets, as market participants absorbed the reality of a stronger economy and greater wage inflation that requires the Federal Reserve to normalize interest rates from the extremely low level of the global financial crisis.

From the early February lows, equity markets recovered much of their losses and reached an intra-day high of 2,789.15 in the early trading of Tuesday, February 27.  This level was 7.5% above the lows of February 6 and only 2.9% below the January 26 all-time highs.[9] Then the newly[10] appointed Fed Chief Jerome Powell began his testimony to the Senate Banking Committee.  CNBC reported[11] that “Powell made it clear that the Fed could find reason to raise interest rates more than the three times it forecast for this year, based on the economy and inflation.”  In 2018, Powell is expecting a continued improvement in the labor markets and in the overall economy. At the same time, Powell delivered a mild rebuke to the administration, criticizing it by saying “We really need to get on a sustainable fiscal path, and the time to be doing that is now.” These and other comments made on Tuesday in Powell’s Senate testimony and on Wednesday in Powell’s subsequent appearance in front of a House of Representatives panel spooked equity investors and sent the SPX down 2.7% from the intra-day high, closing on February 28 at 2,713.83.

Where do the financial markets turn in the near- and medium-term?  We believe that absent a major political or a geopolitical shock, the global economy will continue expanding at a moderate pace and thus 2018 will merit the “global synchronized growth” description that was articulated in so many predictions, including ours.  Indeed, on Wednesday the government reported[12] that U.S. GDP grew at an annual pace of 2.5% in the fourth quarter of 2017, in-line with expectations.  However, we anticipate continued volatility which will hopefully provide opportunity for rebalancing and shifting portfolios based on your long-term goals.

In this uncertain market environment, we urge you to take every financial prognostication (including ours) with a huge grain of salt.  We hope that the economic and market-related volatility that we experienced in February will encourage you to reach out to us and inform us of any changes to your financial plans and schedule your next review. We want to make sure the risk of your portfolio matches your need and willingness to bear volatility so that you can stay invested amidst the uncertainty inherent in financial markets.

We thank you again for your continued confidence.

Sincerely,

JSF Financial