- Price volatility in stocks and bonds is normal and does not necessarily mean that market direction has changed
- Interest rate increases by central banks and the selling of bonds they’ve acquired (i.e., the reversal of their policy over the last seven years) will cause market perturbations
- Overall, the global economy seems well balanced with moderate growth
The investment markets are usually an unpaved road, bumpy, without clear paint lines or guard rails, besieged by wind, rain, ice, and dust, and all manners of traffic; this is the normal. But last year, 2017, daily market volatility was very low; the global investment markets had been mostly steam rolled smooth by cumulative years of easy monetary policy from central banks, low interest rates, good job growth, positive manufacturing and services indicators, and a change in sentiment that made people feel positive about their own local economies.
Then, in 2018, volatility resumed, and we returned to the usual potholes in the road. We saw strong levels of investor confidence in January, but two 10% declines in stocks, higher interest rates, higher gas prices, and threats of higher tariffs have led to some doubts. Thus, similar to how one would slow their car on a rutted dirt road, swerve to dodge rocks and large branches, and pull to the side to let a herd of animals pass or search for a shallow crossing, so too investors slow down, pause, and look right and left when market volatility ensues. Sometimes it means the direction of the road has changed, but often that is not the case. Of course, volatility is also a matter of perspective: US equities had their 9th least volatile first quarter return since the 1930s, but their 13th highest daily volatility. In other words, if you had closed your eyes to stocks on December 31 and reopened them on March 31, not much would have changed, but if you had kept them open, you would have had a jarring ride.
Economically, we are neither overheating nor underwhelming. Private lenders tell us that borrowing costs are in-line with growth, neither dis-incentivizing investment nor incentivizing over-extension. The combination of a tight labor market and strong job creation will push incomes higher, and may fuel inflation concern, but shouldn’t thrust inflation into dangerous territory. Overall, wages don’t seem to be rising too fast because as Baby Boomers with high salaries and benefits retire, their positions are replaced with lower compensated Gen X and Millennials. U.S. fiscal stimulus (a.k.a., expanding deficits) aids growth expectations, but capacity constraints could prevent stronger momentum in the global economy. Supplier delivery times have lengthened by the most in seven years; this stretched capacity is evident in Europe, where delivery times in some countries are near record levels, and in the U.S. where there is a shortage of truck drivers.
Following the Federal Reserve Bank’s 0.25% rate hike in March to 1.75%, expect the Fed to raise short-term interest rates (the federal funds rate) another 0.25% in June which will leave the door open for two additional quarter point rate increases in the second half of 2018, possibly bringing the rate to 2.5% by yearend. In addition, the paring of the Fed’s inventory of fixed income securities (its scheduled selling of Treasuries and mortgages) will be a stiff headwind for the capital markets. Every rate step higher takes us further from the paved road and increases turbulence for equities. To the extent that quantitative easing (the central banks’ easy monetary plans) served to force private sector investors to crowd-in to levered risk and sell volatility strategies, it stands to reason that quantitative tapering will eventually create a volatility-laden, crowding-out effect in risky assets, which may already be underway.
We remain constructive on the global economy yet cautiously optimistic regarding security valuations. Growth in the U.S. and the euro area has eased somewhat but remains solid, while China’s controlled slowdown is restraining growth in emerging markets as well as Australia, Korea, and Japan. Although international manufacturing and non-manufacturing indices have declined they both still point to solid growth and capital expenditures. Nonfarm productivity – which measures how much stuff is needed to make other stuff and is an important gauge of economic health – sits well underneath its historical trend; this is worrisome because better productivity allows for better growth; however, pundits debate whether productivity is underreported and not properly capturing gains from new technologies.
Inflation is low and the debt picture, mixed; since the great financial crisis of 2008, household debt has fallen, government debt has increased dramatically, and corporate debt is about the same across the U.S. and eurozone. Monetary policy remains supportive but is slowly reversing as central banks end bond purchases, start reducing their balance sheet (sell bonds), and begin to increase rates. Overall, the Fed’s path for the real funds rate is on par with US economic growth; therefore, a moderate yield increase should not trip up equities.
The views and opinions expressed are those of Hollencrest Capital Management and are subject to change without notice. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.