The first quarter of 2018 delivered an unwelcome (but probably overdue) return of investment market volatility. The last time markets experienced similar turbulence was in early 2016, when stocks posted their worst calendar year start in history. Unlike 2016, however, this past January saw stock markets extend their strong performance of last year. That ended abruptly in February, when plummeting valuations more than erased all of January’s gains. Markets then ended the quarter in March relatively unchanged, which obscured the extreme swings that occurred throughout the month.
All major investment markets delivered negative first quarter returns, ranging from a narrow loss of less than 1% for international stocks to a painful drop of 7.4% for Real Estate Investment Trusts. The S&P 500 lost 1.2%, while broadly diversified bond markets fell 2.2%.
Both investment market performance and volatility were influenced by several factors. Interest rates continued to rise, as the Federal Reserve maintained its steady program of increasing short-term rates; and long-term rates rose in anticipation of higher wage inflation. As the quarter drew to a close, stock markets around the world sold off in fear of a potential trade war, triggered by the announcement of widespread US tariffs on imported goods. These tariffs have yet to be imposed, and there’s substantial reason to believe that negotiations might avert a “worst case” outcome. But the mere threat of a trade war with China thoroughly unnerved the equity markets, which ended the quarter down more than 10% from January’s highs – the technical definition of a market “correction”.
Nevertheless, the underlying fundamentals remain very healthy. The US economy has maintained its upward trajectory, with overall growth and employment posting solid gains. Meanwhile the global economic environment continues to benefit from rebounding worldwide demand and generally accommodative monetary policies.
Ironically, perhaps the greatest threat is “too much of a good thing”. The US tax cuts enacted in December – which represent $1.5 trillion of stimulus over ten years – are just now beginning to ripple through the economy. The recent spending bill approved by Congress adds further stimulus in the form of dramatically higher deficit spending, extending out for the foreseeable future.
These measures are expected to further boost GDP growth and reduce unemployment … all positive in the near term, but eventually producing conditions that are often precursor to recession. As increasing economic growth heightens the threat of inflation, the Federal Reserve may (will?) feel obligated to accelerate its program of interest rate hikes to head off that threat. This has been the classic historical pattern that usually leads to the end of the business cycle. All of which supports the thesis presented in our January management report – a very positive forecast for the remainder of 2018 and into early 2019, followed by likely recession as the decade draws to a close.
With regard to investment markets, we continue to believe what we expressed in January. It “would be … unrealistic to expect investment markets to again deliver the kind of outsized performance enjoyed by portfolios in 2017. Stock markets will generate moderately positive returns, falling somewhat short of historical averages. Fixed income and Real Estate Investment Trusts (will be flat), as interest payments and dividend distributions are offset by gradually rising interest rates”.