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Market Commentary — 1st Quarter 2018
As 2018 began, equity markets continued their march higher in much the same way as 2017. Confidence was high early on that equity indices would continue to make new highs on the optimism of continued economic growth brought about by tax reform and a change in regulatory enforcement. This completely changed midway through the quarter when the monthly employment report posted relatively strong wage gains after almost a decade of stagnant wages. Investors, fearing a rapid acceleration in inflation, drove equity markets into a tailspin with a one-day decline in the Dow Jones of just over 1,500 points (the largest one-day point drop in the history of the index).
From that point on, equity markets experienced a tremendous jump in daily volatility, breaking the nine-quarter winning streak of all of the major market averages. Ironically, this stumble took place as the current bull market celebrated its ninth anniversary from the lows of 2009. In numeric terms, the S&P 500 declined by 0.8% during the quarter, while the Dow Jones and Russell 2000 dropped by 2% and 0.1%, respectively.
Uncertainty and volatility also increased due to a change in tone from the President. During 2017 the dominant investment theme coming out of the White House focused on tax reform and deregulation, both very helpful to equity valuations. This theme shifted during the quarter to trade policy and protectionism, which, in general, is a negative for markets. Specifically, the President proposed initiating steel tariffs against China as well as other measures meant to reduce the trade deficit with China. In addition, chatter regarding the misuse of personal data from the likes of Facebook and Amazon heightened the likelihood of increased regulation on the technology industry. Needless to say, equity markets did not respond well to these developments.
Uncertainty and volatility also increased due to a change in tone from the President. During 2017 the dominant investment theme coming out of the White House focused on tax reform and deregulation, both very helpful to equity valuations. This theme shifted during the quarter to trade policy and protectionism, which, in general, is a negative for markets. Specifically, the President proposed initiating steel tariffs against China as well as other measures meant to reduce the trade deficit with China. In addition, chatter regarding the misuse of personal data from the likes of Facebook and Amazon heightened the likelihood of increased regulation on the technology industry. Needless to say, equity markets did not respond well to these developments. While we are keenly aware of the economic risk of such actions, we tend to view these announcements from the administration as the first step in what will lead to future negotiations and likely a much more benign final policy.
Despite the recent increase in volatility, it remains our opinion that once we separate out the “political noise” coming from the White House and the media, the underpinnings of the equity market that were so strong in 2017 generally remain in place. First quarter earnings are expected to be strong once they are reported in mid to late April, and we expect to see estimates rise throughout the year. Moreover, we continue to see corporations announcing capital expenditure plans and repatriating dollars from overseas as they take advantage of the tax cuts passed last year. This all bodes well for future sustained growth.
In addition, we are encouraged by the latest budget bill and its potential impacts on the economy. Firstly, the fact that it was passed with bipartisan support alone should be celebrated given the extreme level of bipartisanship currently infecting Washington politics. More importantly, however, substantial funding was allocated to infrastructure spending and defense. We believe that this also will lead to many high-paying jobs and further bolster economic growth forecasts.
One of the most trumpeted risks we hear from those that do not share our constructive view is that rising interest rates will negatively impact equity valuations. While in general this tends to be true, rates remain historically low and are likely to remain so despite the fact that the Federal Reserve is beginning to tighten monetary policy. We expect the Federal Reserve to increase interest rates by between 0.50% and 0.75% this year, but we also believe that economic growth will more than offset this small bump in interest. Further evidence that supports our view is the fact that credit spreads, the difference between yields on corporate bonds compared to government bonds, remain very tight. The implication is that the bond market sees very little risk in the future and remains willing to lend money to corporations at historically low levels of interest.
In addition, we continue to hear that the bull market is going to end simply because it has gone on for too long. After all, this market has been in an upward trend for just over nine years (the bottom of the market was March 9. 2009 in which the S&P 500 sank to 666 at its low). Basic economic theory postulates that after many years of expansion, the economy tends to develop excesses in capacity and companies overbuild and overinvest. This leads to a recession and a subsequent fall in equity markets. During this expansion however, economic growth has been much lower than in the past, and as a result, we believe the excess normally seen at this stage of the business cycle have yet to have been realized. Since the expansion began in 2009, real economic growth (GDP) has not exceeded 3% on an annualized basis. In addition, the labor participation rate has lagged at historically low levels, and we just are beginning to see wage growth for the first time in almost a decade. Capital spending has also lagged at near recession levels for much of this period. All of this points towards an economy with the potential for continued growth.
In our mind, the biggest risk to the markets and the economy continues to be increased geopolitical tensions, whether that is intensified trade wars with China, or increased tensions with Russia via Syria. These both have the potential to derail this near decade-long bull market. We expect both issues to ultimately be resolved amicably, but tensions between Russia and the United States are clearly escalating at the moment. We remain hopeful that this will not continue as it does not appear to be in either sides’ best interest. To date, the markets seemingly have taken little notice of this, but we would be surprised if this trend continues. We will continue to watch these developments closely.
Doheny Asset Management oversees assets for a variety of private clients, foundations, endowments and pension plans. We offer balanced, equity and fixed income strategies and provide each client with a superior level of administrative support and client service.
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