During Q1, Mr. Market sure did his best to compensate for 2017’s lack of volatility. The S&P 500 Index ETF was up +5.6% in January, followed by -3.6% and -2.7% in February and March, respectively. Does this mark the end of the bull market?
The short answer is: not likely – but we are watching carefully.
2017 was defined by a near-perfect backdrop of steady global growth, low inflation, and accommodative monetary policies, helping fuel a broad-based rally in asset prices. This “goldilocks” scenario was unsustainable, and a +5.6% move up in January was a potential red flag for us.
While we continue to experience the most synchronized global economic expansion that we have seen in years, the stock market is forward-looking, and is a good barometer of whether an economic slowdown is around the corner. Even though we think global recession risk remains low – at least for this year – markets are responding to "the punch bowl being taken away" (meaning, less accommodative monetary policies.) With less accommodative policies comes the possibility of less robust growth. And Trump’s newly minted tariffs on selected imports are not helping the situation.
Most developed economies are in a mature (mid-to-late) stage of the business cycle – except for the Eurozone, which is not as far along as the United States. The chart below tells the story well. U.S. equities have far outpaced non-U.S. equities, indicating a stronger (and more stable) economic expansion.
So, where do we go from here?
Watch Fed policy and inflation. Jerome Powell, the newly elected chairman of the Federal Reserve, has taken charge at a time when the U.S. is likely shifting gear into faster growth, somewhat higher inflation, and ongoing declining unemployment. We believe that growth and inflation are firm enough to keep policy makers continuing to increase interest rates over the course of the year.
Keep an eye on the yield curve. The yield curve has been an important indicator in the last seven U.S. recessions, with the yield curve inverting (short rates moving higher than long rates) prior to each recession. In February, Powell hiked interest rates at his first opportunity, which was the fourth hike since the low in 2016. This caused short-term rates to rise relative to long-term rates, triggering the yield curve to continue to flatten. The curve, however, remains positively sloped - and steep relative to prior late economic cycles. But, it bears watching closely if the Federal Reserve continues to raise rates, as we expect.
Be aware of the time it takes for legislation to take effect. While the new tax legislation will likely provide a boost to GDP, these kinds of changes are like turning the Titanic, not a speed boat. So, it may take a couple of years to see an increase in productivity growth. In the meantime, we have an economic cycle – both in the U.S. and globally – that is rather “long in the tooth.”
Watch for reduction in accommodative polices globally. While global expansion continues to be underpinned by solid global export and manufacturing sectors, the outlook for global trade – and as a result, global expansion and multinational profits – will largely be determined by China’s economic policies. Policymakers in China have already begun to tighten financial conditions, resulting in the sharpest deceleration in credit growth in nearly a decade. Like the U.S., China’s economy remains broadly steady, but less-supportive policies make the outlook more uncertain and a growth deceleration probable.
In short, we expect continued volatility throughout the course of the year – and potentially even greater volatility as we head towards the mid-term elections in November. Our models that we have developed to help us in our investment decision-making process reflect the increase in risk, with a couple of our models indicating a reduction in exposure to equities. Keep your seat belt buckled!