Investment Review — First Quarter 2018 April 3, 2018
The U.S. stock market ended the first quarter of 2018 virtually unchanged from year-end 2017 levels, but with dramatic volatility along the way. For the first three months of 2018, the S&P 500 index declined by -1.2%, while the Nasdaq showed a small gain of 2.3%. In the bond market, the yield on ten-year Treasury bonds rose from 2.40% to 2.74%, corresponding to a decline of roughly 4% in bond prices.
After a relatively smooth and steady advance throughout all of 2017, stocks continued to move higher in January 2018, driven by economic optimism along with new cash flows pouring into the market with the start of the new year. However, such strong gains were unsustainable, and by late January the market had become very overextended and due for a pullback. A selloff began in early February, sparked by worrisome economic data showing higher inflation. As shown in the following chart, instead of a mild pullback, the selloff quickly turned into a violent 10% correction, as a wave of selling rapidly unfolded, exacerbated by volatility-related strategies that may have been used by some hedge funds.
S&P 500 index – Late 2016 through March 2018
Following this sharp plunge, the market recovered in the second half of February as cooler heads prevailed, but stocks then turned down again in March. This increased volatility and market turmoil occurred amidst a number of major political, geopolitical and economic developments.
One of the main issues that came to the forefront was international trade, particularly with China. The U.S. has been running huge trade deficits with China for years, and China has been accused of many unfair trade practices, including stealing intellectual property. In early March, when President Trump first announced tariffs on steel and aluminum imports, the stock market dropped sharply due to worries that a trade war with China would disrupt the global economy. Then on March 22nd the Dow plunged by over 700 points in one day when the President announced an additional $60 billion in tariffs on imports from China. However stocks rallied in late March when China indicated that it will come to the negotiating table for trade talks, implying that a trade war is less likely.
The large omnibus spending bill of $1.3 trillion passed by Congress in late March also contributed to the recent market weakness. The size of the spending bill and the manner in which it was written raised worries that Congress is not serious about reducing the national debt and will continue to run trillion dollar budget deficits.
Bad news for technology stocks also played a role in the recent market decline. Leading technology stock Facebook plunged by more than 20% in the first quarter, falling from a high of $193 in early February to a low of $152 in late March, as the company has come under scrutiny for how it uses or sells personal data. Major technology firms such as Facebook and Google now face increasing pressure for more government regulation.
On March 21st, in its first meeting under new Chairman Jerome Powell, the Federal Reserve raised short-term interest rates by a quarter-point, to a range of 1.50% – 1.75%. Two more quarter-point rate hikes appear likely this year, with three additional increases in 2019. The Fed’s interest rate increase in March was expected, and the policy of gradually raising interest rates is normal and rational, given the strength of the U.S. economy. Recently revised data on the gross domestic product (GDP) showed a healthy GDP growth rate of 2.9%, consumer confidence remains at an 18-year high, and the monthly employment report for February was stronger than expected with a gain of over 300,000 jobs.
Looking ahead to the remainder of 2018, stock market volatility is likely to continue, as there are a number of crosscurrents and risk factors in the environment which could affect the markets in either direction.
On the positive side, the strengthening U.S. economy has already led to notable improvement in corporate earnings growth, and first quarter earnings reports, which will be reported beginning in mid-April, are likely to show strong double digit gains. However the stronger economy and tight labor market have led to worries about inflationary pressures, and investors are watching inflation data very closely. Signs of higher inflation could lead the Federal Reserve to tighten its policy and raise interest rates more aggressively than the markets now expect. History shows that environments of rising interest rates have been difficult for the stock market.
The issue of international trade, especially with China, will continue to be watched very closely. The Trump administration is pursuing economic policies that are nationalist rather than globalist. This tougher approach to trade may be very positive for the U.S. in the long run if it curtails China’s unfair trade policies, but in the meantime it may cause worries about protectionism and trade wars.
Other geopolitical developments may also affect the markets in the months ahead, including the President’s meeting with the leader of North Korea, and U.S. relations with Iran. New national security advisor John Bolton is viewed as a hawk on defense who wants to exit the Iran nuclear deal. On the domestic political front, the outcome of special counsel Robert Mueller’s investigation remains unclear, and talk of a Constitutional crisis or impeachment would likely be a negative for the stock market.
In conclusion, the investment climate changed significantly in the first quarter of 2018. After a 15-month period of consistent stock market gains, from November 2016 through January 2018, market volatility has now increased substantially. At the end of March, stock market indices were oversold and near technical support levels. However, given the complex economic, political and geopolitical developments now evolving, market gains this year are likely to be more difficult than they were in 2017. Thus we are holding diversified portfolios to reduce risk and will continue to monitor developments closely as events unfold.