- There was no place to hide in February.
- Economic reports suggested accelerating strength.
- Via Nova’s outlook for the stock market remains positive, but increased volatility could be the new normal.
Is the market back to “normal”?
February is the shortest month of the calendar year, but it was exceptionally long for investors. Perhaps market participants had become a bit complacent after ten consecutive monthly stock market gains, but few expected the drubbing stocks and bonds endured in February accompanied by a surge in market volatility. The economic data strengthened, and corporate profit reports surpassed expectations, but it was this broad strength that raised fears of a more aggressive interest rate response from the Federal Reserve. 2018 is shaping up as a year when we’ll see tension between economic strength and the policy reaction to that strength. Is the market finally back to “normal?”
There was no place to hide in February.
The S&P 500 lost -3.7% in February, following the 5.7% surge in the previous month, trimming the year- to-date gain to 1.8%. The decline snapped a ten-month winning streak, which had been the longest in almost 70 years, and the index suffered its first -10% correction in nearly two years. Within the S&P 500, only the technology sector managed to tread water. The remaining ten sectors lost between just under -3% (financials) to over -10% (energy). This combination expanded the lead of the growth style over the value style to nearly 18%.
Bond yields rose, pushing the Bloomberg Barclays Aggregate down another -1.0% in February and -2.2% year to date. All sectors experienced weakness. The return over the previous twelve months was a meager 0.5% compared to a 17.1% return in the S&P 500. In other markets, gold and oil prices declined as did real estate investment trusts (REITS). There was no place to hide.
Economic reports suggested accelerating strength.
The month began with stronger than expected increases in jobs and manufacturing activity. Disposable personal income jumped 0.9%, following the passage of tax reform giving at least a temporary boost to the savings rate. February 15th was the official deadline for companies to adopt the new federal tax withholding tables, and the Treasury Department estimates that 90% of wage earners will see an increase in take home pay. Consumer confidence, as measured by the Conference Board, rose to its highest level since 2000. The economy also dodged an extended government shutdown, after Congress passed, and the President signed, a bipartisan two-year spending bill that would increase spending for both defense and domestic programs by roughly $300 billion.
While the economic reports suggested accelerating strength, the data also showed increased inflation pressures at the beginning of the year. Both the Consumer Price Index (CPI) and the Federal Reserve’s preferred measure, the Personal Consumption Expenditures Deflator (PCE), rose more than expected in January, and the pace of inflation over the previous three months showed a pronounced acceleration (4.4% annual rate in the CPI and a 2.9% annual rate in the PCE).
This accelerating economic momentum was mentioned by new Federal Reserve Chairman Jerome Powell in his inaugural testimony to Congress on monetary policy. Indeed, the stronger economic statistics were cited as a possible reason the Federal Open Market Committee (FOMC) might consider raising short-term interest rates more than the planned three times.
Via Nova’s outlook for the stock market remains positive, but increased volatility could be the new normal.
We remain positive on the economy and the equity markets in 2018, but the period of high returns and low volatility may become a wistful memory. Bond investors are likely to be facing steady headwinds.
The early economic reports following the passage of the Tax Cuts and Jobs Act suggest a stronger consumer and above-trend growth, at least over the near term, but they also suggest building inflation pressure. Companies, in response to the new legislation, have announced plans to utilize their newly found largess by increasing capital investments, raising employee compensation, acquiring new companies, lifting dividends and buying back stock, though the mix of spending is still not clear. The combination of a stronger economy and healthy corporate earnings and investment offers a favorable underpinning for investors.
However, the evolving market challenge in 2018 is that, while economic growth and earnings are likely to accelerate, market valuations are already somewhat elevated, suggesting investors have discounted at least some of the expected improvement. In that sense, investors may wait for earnings to live up to existing expectations, which may put downward pressure on valuation metrics such as the price/earnings ratio for a time.
We also appear to be seeing three emerging forces that may prompt investors to temper their elevated expectations: accelerating inflation, a more aggressive Federal Reserve and a looming trade war. The surge in stock market volatility during February was a surprise given the recent period of quiescence, but it quickly settled back to a higher level in line with the longer-term average. This higher volatility could be the new normal for the equity markets.