After a strong start in January, the equity and bond markets sold off in early February and we ended the quarter negative for the major indices.1 What was noticeable is that after almost two years of calm in the markets due to synchronized global growth, accommodative monetary policy and low interest rates, volatility came roaring back with the Volatility Index (VIX) spiking suddenly on February 5th and both the bond and equity markets selling off.2 What caused this shift in the markets? It is always hard to pinpoint for sure, but we attribute it to parabolic upward moves in stocks in January. The February job report was strong and showed some labor wage growth, which we believe could lead to more interest rate increases than originally telegraphed by the Fed. Jerome Powell became the new chairman of U.S. Federal Reserve. Despite the gyrations in the market, which feels new to us after the prolonged stability, it is our opinion that it is actually more normal to have volatility. 2017 was a record low year for the number of greater than 1% intra-day moves in the S&P 500 and we are starting to see moves that are in line with historical volatility. We believe that volatility provides opportunities for stock pickers.
S&P 500: Intra-Day price movements
The U.S. equity markets sold off across all market caps during the quarter.3 Small cap stocks, which had been underperforming, held up better than large cap stocks and most notably in March.4 For the quarter, the Russell 2000 benchmark representing small cap stocks was -0.08%, the Russell Mid Cap benchmark was -0.77% and Russell 1000 benchmark representing large cap stocks was -0.69% and the S&P 500 was -0.76%.5 Growth stocks dominated in January, but with concerns of President Trump’s announcement of tariffs and concerns about large Tech resulted in growth stocks selling off in March.6 In fact, the Russell Top 50 was down -4.03% in March and -1.86% year-to-date (YTD).7 Emerging market stocks continued to move upward with the MSCI Emerging Markets benchmark +1.42% YTD.8 The weaker U.S. dollar and improving economic conditions have helped emerging market stocks. Developed international stocks struggled during the quarter as it is thought that maybe growth has peaked and concerns about when the European Central Bank (ECB) and the Bank of Japan (BOJ) start unwinding the accommodative monetary policy. The EAFE index which represents developed international markets was down -1.53% YTD.9
The U.S. Treasury 10 year bond reached 2.94% yield in February, which was a 0.53% increase since the beginning of the year. For bonds, that kind of movement in interest rates is meaningful since it negatively impacts the price of bonds. As of the end of the quarter, the 10 year bond was 2.78%. As a result, there was nowhere to hide in U.S. bonds. It is unusual to have negative performance in bonds, but not unheard of. Since 1978, there have been four calendar years in which the Barclays U.S. Bond Aggregate10 has had negative performance including 2013 when we had the taper tantrum, which is when yields spiked over concerns that the Fed was starting to taper quantitative easing (QE).11
As mentioned, Jerome Powell, took over at the chairman of the Fed, and had his first official meeting in March. The Fed agreed to raise interest rate by 0.25% to 1.75%. The tone of the meeting was hawkish and there are expectations for two to three more rate hikes in 2018 and possibly two rate hikes in 2019.12 The Fed has control over short term rates or the front part of the yield curve, which is increasing. The longer end of the curve, which is influenced by expectations for inflation, global growth, demand for Treasuries is flattening. The concern becomes when the yield curve inverts, which historically has been one sign of a recession. In our opinion, what may be more likely in this case is the market telling the Fed to slow down on the rate increases. Also, due to the weaker U.S. dollar, the returns on foreign bonds look more attractive than the returns on U.S. treasuries, and as a result foreign bonds have attracted more investment flows. The effect is additional pressure on the yield curve. Another interest rate that investors and companies watch is the LIBOR rate13, which is the interest rate banks charge each other and is used to price many loans. The LIBOR rate has moved up from 2.11% to 2.66% since the beginning of the year. While it is still low by historical standards, many companies are getting used to the fact the interest payments will go up.14
One of the hot buttons in March was President Trump announcing tariffs on $60 billion of imported goods from China including imported steel. Several companies that rely on steel as part of their manufacturing process sold off as a result of this announcement. China responded with tariffs on $3 billion of imported goods from the U.S. It made for great headlines, but in the grand scheme we import $500 billion from China and they import $150 billion from the U.S., so the announced tariffs were relatively small.15 However, it was reported that trade talks would start between the U.S. and China, so there is hope for a reasonable trade agreement between the two countries.
Global Technology Companies
The top companies by market capitalization in the U.S. include Apple, Amazon, Alphabet (Google) and Microsoft and was a primary driver of returns in the S&P 500 at the beginning of the year. In March, it was announced that 50 million Facebook users unknowingly had their data scraped by the U.K. firm, Cambridge Analytica.16 It hasn’t been disclosed exactly what the data was used for, but it raised huge questions around privacy and how information about individuals is used. There have been allegations that Facebook news feed was manipulated around the U.S. presidential elections. In general, there is concern about the information that Facebook provides and also uses. Facebook is working on changing their privacy, security and disclosures to clients. Then there was discussion that President Trump wants to regulate Amazon and that Tesla’s bonds were downgraded.17 Between the news stories, the big technology firms as a group sold off and the reason that the Russell Top 50 and the S&P 500 were down so much for the quarter.18
According to sell-side research analysts, over the quarter, companies were better able to assess how much of the tax cuts announced in late 2017 they were keeping to reinvest in labor and capital expenditures versus paying out in higher earnings. Some companies are utilizing the tax cuts to fund programs to be competitive and paying out the rest to shareholders. We expect to see higher dividends and share repurchases over the course of the year and that actual tax rates will vary company to company. Overall, we believe the lower tax rate is positive and should help support earnings growth over the year.
The U.S. Dollar has been down over 10% over the last year.19 The weaker U.S. dollar helps large multi-national companies that export to other parts of the world and have to translate earnings and expenses back to the U.S. dollar for financial statements. There are a lot of reasons for the currency movements, but interest rate differentials, inflations and global outlook tends to play in whether a currency strengthens or weakens. It appears that investors are viewing stronger growth outside of the U.S. coupled with more accommodative monetary policy. Also, we believe some investors are viewing the increasing U.S. deficit as a pressure point.
WTI crude oil was up +7.3% ytd with oil trading above $65/barrel. The oil markets are befitting from constrained inventory levels. However, the energy sector was down -6% YTD.20 In our opinion, the market may be skeptical that oil prices can stay at these levels.
We expected that volatility would pick up with the normalization of monetary policy and that the equity markets would be choppy. Some of the news flow also contributed to the choppiness. The companies we talk to are positive about the economy and their businesses. We see the tax cuts as beneficial, allowing companies to pass along pricing, manufacturing continues to be in expansionary mode and employment continues to be strong. Globally we are still seeing strength. There is concern about the length of this bull market, although there may be a case to be made the markets reset in January 2016. Valuations are higher than historical average, but have come down recently the pull backs in the markets.21 There is concern that Fed will overshoot in raising interest rates. We do not foresee a recession and we believe that the backdrop is positive for equities this year. Bonds, on the other hand, are fighting rising yields and could be negative for the year. Cash, which does not generate high yields or high returns helps to act as a buffer and provides optionality when the market corrects. As a result, our portfolios tend to tilt more towards equities, diversified bond holdings with lower duration and cash.
To read the full article, click here.