“The key to making money in stocks is not to get scared out of them.” — Peter Lynch
First Quarter Highlights
After a fairly tranquil 2017, volatility returned to the markets in the opening months of 2018. The potential pullback mentioned in our last commentary did unfortunately come into fruition this first quarter.
After rising in an unsustainable fashion in January, U.S. stocks sold off suddenly in February, resulting in the first correction since early 2016. Globally, most equity markets followed suit, especially in developed countries. Curiously, bond prices also fell, with 10-year Treasury yields spiking up to 2.9% by late February before settling at 2.74%, up from 2.40% at the beginning of the quarter. Commodities were mixed, with oil and gold finishing higher.
The initial cause for the selloff centered on the spike in longer maturity yields and the concern that inflation might also be rising too rapidly, leading the Fed to tighten credit conditions more aggressively than the three projected rate hikes for 2018. As economic reports softened, the focus shifted to an escalation of trade tensions between the U. S. and China, as well as NAFTA renegotiations between Canada and Mexico which dragged on after a missed 2017 deadline.
So far, 2018 has repeated a pattern of sluggish first quarter economic growth similar to the past several years. After ending strongly last year, consumer spending moderated, especially in the Northeast, with inclement weather playing a factor. Also, companies continued to draw down inventories, which will have to be replenished soon.
If the seasonal pattern continues, the second quarter should see a snapback due to consumer and inventory rebuild. The synchronized global growth of 2017 has moderated, with China continuing to be robust while Europe has weakened, in part because of a strong Euro which impacted exports.
Trade Policy and Other Issues
After the Trump Administration instituted trade tariffs on steel and aluminum, Beijing retaliated with its own restrictions on U. S. agricultural products. This was followed by a second round, with Washington proposing $50 billion in tariffs on items such as medical equipment, machine tools, auto parts, dishwashers, televisions and chemicals. China answered back with similar dollar amount of restrictions on American cars, plastics, chemicals, soybeans, sorghum and tobacco.
The tariffs, if fully implemented by each country, are estimated to represent 0.1-0.2% of real GDP — a manageable cut. If the current skirmish escalates into an all-out trade war however, both countries would be significantly impacted, with major repercussions for the global economy.
While the risk is real, we assign only a low probability to a full-scale trade war. The Administration has given companies until late May to comment on the proposed tariffs, with an implementation date of up to 180 days later. This gives plenty of time for a negotiated agreement.
Fortunately, since the first two rounds, the inflammatory rhetoric has abated. The latest $100 billion U. S. proposal was met by a more conciliatory rather than retaliatory response by Premier Xi at the annual Boao economic forum in southern China, suggesting there may be workable negotiations between the two nations.
In other international developments, Middle East tensions have flared up again after reports of Syria using chemical weapons and Iranian-backed Houdi rebels firing missiles into Saudi Arabia. This has caused oil prices to rise to their highest levels since late 2014. On a more positive note, tensions between the U. S. and North Korea have eased as leaders of the two nations prepare to discuss possible denuclearization of the communist nation.
Meanwhile, although the Federal Reserve has been relegated to the background, it is still important. New Chairman Jerome Powell cautioned observers not to read too much into Fed communications (including the “dot plots”) and has indicated a continuation of gradual rate increases initiated by predecessor Janet Yellen. Though the Fed expects the economy and inflation to pick up this spring, it remains alert to possible disruptions, especially with trade policy.
Although equities are in a correction similar to others experienced so far this decade, we believe that fundamentals and improved valuations (now at levels similar to those of two years ago) support a constructive overall view of the markets. Patience will be important, however, as the correction may last awhile longer due to all the issues highlighted above.
It is important to note that the volatility in equities has not spilled over to other asset classes. For example, both high yield and currency markets have been calm. Treasury bond yields are in a trading range for now, although they should eventually work their way higher. After a sluggish start this year, the economy should also contribute to the rise.