May 8 2018 Market Update

Last month we discussed how this year, so far, has been very different from 2017, and how each of the first three months varied from the prior one.

Turning to April, equity markets registered a slight gain. SPY, an ETF tracking the S&P 500 index, gained 0.51% in April, for a 2018 year-to-date increase of 0.48% (as of 4/30). [1] It is interesting to note that the lowest point of the month was intra-day on April 2^nd, the first business day of the month, when the ETF dropped by 3.2%, although that initial decline was erased by April 4^th. So far in 2018, it feels like we have been on a roller coaster ride we are exiting at the same place we initially started. It is no surprise that volatility in the marketplace declined significantly and the Volatility index dropped from 19.97 at the end of March to 15.93 at the end of April.[2] However, the real story of April 2018 was in the fixed income markets, where the 10 year Treasury yield continued its march upward and reached 3% on April 24^th;[3] the last time the 10 year Treasury yield reached that level was more than four years ago, on January 2014.  The yield on the 10 year Treasury completed a strong move during April 2018, from 2.74% on March 29^th to 2.94% on April 30^th.  Bond prices move in opposite direction to bond yields, and AGG, an ETF tracking the Barclays Aggregate U.S. Bond Index, lost 0.95% in April, for a year-to-date loss of 2.47% (as of 4/30). [4]

The increase in Treasury rates isn’t surprising, especially since the economy is strong and the Federal Reserve has been raising interest rates. Under Jerome Powell, the Federal Reserve is clearly set on continuing to hike short-term interest rates.  In March, the Fed hiked those rates by 0.25%, to range of 1.5%-1.75%, and suggested that it intends to continue raising rates this year.[5] There are eight Fed meetings a year, and four of them include a press conference by the Fed Chair and an update on the Fed’s long-dated economic forecasts. These four meetings are scheduled for March, June, September and December of 2018.  Fed Fund Futures suggest that it’s almost a certainty that the Fed will lift their target on the Fed funds rate to 2% at their June 13th meeting. [6]  In addition to rate hikes, the Fed is in the midst of a quantitative tightening program, currently pulling liquidity of $30 billion a month out of the economy. If the Fed stays on plan, the number will climb to $40 billion/month in July and to $50 billion/month in October, and will reduce the Federal Reserve’s balance sheet by $420 billion in 2018 and by an additional $600 billion in 2019.[7] To put these numbers in perspective, the total assets of the Federal Reserve Bank system were worth about $870 billion at the end of August 2008; rose to just over $2 trillion by the time the recession was officially over in June 2009 and peaked at $4.5 trillion on December 2014 before very gradually declining to the current $4.35T.[8]

In our opinion, the Federal Reserve is attempting to normalize interest rates from the extremely low level from the Global Financial Crisis[9] while the economy is growing.  The first GDP growth estimate in the first quarter of 2018 (which will likely be revised) suggested[10] that the U.S. economy expanded at a 2.3% rate during the first three months of the year, slightly down from 3.2% and 2.9% in the third and fourth quarters of 2017, respectively. [11] While this is not as strong as we’d hope, it is consistent with how the economy has behaved during the current expansion. The Fed knows that the current expansion is very long, stretching from early 2009, and we are likely closer to the end of the business cycle than to its beginning.

We continue to think that volatility in the financial markets – equities and fixed income alike – has been a period of adjustment, as market participants adjust to a stronger U.S. economy and a Central Bank that is actively normalizing interest rates. This period of adjustment has been accompanied by violent moves in equity and bond markets, as we described earlier. We are also of the opinion 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 widely forecasted.[12] We expect more choppiness in the market in the Spring, in part because of Federal Reserve actions to normalize rates and efforts to drain excess liquidity from the market, combined with uncertainty arising from geopolitical events that could affect the U.S. economy.

One geopolitical headline is the state of trade between the United States and China, the two largest economies in the world. This past week, a senior U.S. delegation, led by Treasury Secretary Mnuchin and Commerce Secretary Ross, was in Beijing for negotiations. We expect a trade deal will eventually be reached – although perhaps not in the current round of talks – and do not anticipate a trade-war.  This does not preclude, however, the risk of negative headlines.

For example, this morning, we watched along with the rest of the World as President Trump announced that the U.S. is pulling out of the Iran Deal and levying harsh sanctions on Iran.  The President also effectively called on the Iranian people to topple the government and said that Secretary Pompeo is on his way to North Korea to discuss the country’s denuclearization. Shortly thereafter, the Treasury posted on its website its intent to reinstate the various sanctions on Iran that were revoked by the “Joint Comprehensive Plan of Action” (“JCPOA” or the “Iran Deal”).  We think the administration is determined to exert pressure on the Iranian regime in the hopes the government will be replaced.

The earnings season is still underway for U.S. companies, and so far, it is exceeding expectations, thanks in part to the U.S. tax cuts enacted in December 2017.  As far as valuations are concerned, the S&P 500 Index now trades at a 16.82 multiple (the ratio between price to earnings) on a 12-months forward basis. [13] This a significantly cheaper market than that one that traded at approximately 20 earlier in the year.

As we enjoy the longer days of Spring, we encourage you to reach out to us and inform us of any changes to your financial plans and to review your current goals and objectives. We want to ensure that the risk of your portfolio correctly matches your need and willingness to bear risk so that you can remain invested amidst the inevitable uncertainty in financial markets.

We thank you again for your continued confidence.

Sincerely,

JSF Financial