2018 first quarter investment and economic review

April 11, 2018|Dave Isaacson

Learn more about events and changes that impacted the U.S. equity markets, economy and interest rates in the first quarter of 2018.

The U.S. equity markets: Volatility is back

The U.S. stock market has returned to more normal volatility in 2018, which had been absent during 2017. Volatility has more than doubled (Exhibit 1) since last January, driven by two emerging worries: expected inflation and a possible trade war with China.

The U.S. economy continued to demonstrate economic strength in the first quarter. Strong employment, growing corporate profits and low cost of capital continue to provide a healthy backdrop in support of equities.

The U.S. is enjoying the second-longest economic expansion in U.S. history, so it is only natural that investors would expect some inflationary pressures. While investors are expecting inflation, we have yet to see any type of sustained economic data that provides evidence of unhealthy inflationary pressures.

The Federal Reserve has a 2% inflation target and primarily looks at the Personal Consumption Expenditure (PCE) Index as their gauge for inflation. As of February 2018, the PCE Index was up 1.75% year-over-year, remaining below the Fed’s inflation target.

The Federal Reserve moved the federal funds rate up by 0.25% to 1.75% and is expected to increase interest rates by another 0.50% by the end of the year.

Beyond our U.S. borders: Trade and economic ramifications

The U.S. administration has focused their attention on trade policy in 2018 with a goal of renegotiating the nearly 30-year-old North American Free Trade Agreement (NAFTA) and creating a more balanced trade relationship with China.

The renegotiation of NAFTA at this point is not causing any overt concern by the investment markets. However, the “tit for tat” proposed trade tariffs between the U.S. and China are creating fears of a trade war between the world’s two largest economies. The markets are justified in recognizing the possibilities of these proposed trade tariffs escalating into a trade war. The economic ramifications would be harmful to the constituents of both countries.

At this time, we do not believe this situation will escalate into a trade war and expect concessions to be made by both countries. However, over the course of April and May we fully expect the markets to be volatile as the U.S. and China ultimately negotiate their respective trade positions.

Exhibit 1 - CBOE VIX Index: January 3, 2017 – March 29, 2018

Data Source: Yahoo Finance

The U.S. economy: Continued strength

In broad and simple terms the market’s behavior is shaped by sentiment and data. In the first quarter of this year, we saw sentiment becoming more negative as the market braced for the possibility of future inflation and a trade war between the U.S. and China. Neither has occurred and simply represented possible outcomes, which caused additional volatility.

While economic and corporate financial data are intertwined with investor sentiment, they can at times send two different messages to the market. We believe an investor should primarily rely upon economic and corporate financial data to determine their investment decisions.

The U.S. economy continues to demonstrate strength in the first three months of 2018 with unemployment at 4.1%, year-over-year home appreciation up 6.18% (January: S&P/Case-Shiller Price Index), and the fourth-quarter U.S. economic growth (GDP) revised upward to 2.9%. First quarter profits for the S&P 500 Index are expected to be up 17% with topline revenue growth expected to be up over 7%.

Using estimated 2018 S&P 500 earnings of $157.99, the price-earnings ratio (P/E valuation) for the market was 16.7, representing a slight premium to longer-term historical valuations. Despite some recent erosion in market sentiment due to expected future inflation and the ongoing trade issues, we remain positive on the equity markets and believe valuations are supportive of positive returns in 2018.

Interest rates and fixed income: Return expectations

Investors rely upon fixed income investments for a combination of two characteristics: relative dependable cash flow from yields and an element of portfolio protection when equities are declining. We believe bonds will struggle to demonstrate the same historical degree of protection that investors have relied upon over the years.

The February market decline in equities also triggered a decline in U.S. investment grade bonds due to expected inflation fears, whereas bonds helped provide an element of protection during March as equities traded down in response to a possible trade war with China. We are more concerned about inflation versus trade war risks at this time.

The Fed is putting upward pressure on interest rates by increasing the federal funds rate and by reducing their balances of Treasuries and mortgage-backed securities to the tune of $420 billion in 2018. This dovetails with the recently passed the Bipartisan Budget Act (February 2018), which increases deficit spending and suspends the statutory limit, or “debt ceiling,” on U.S. government borrowing until March 2019.

Bottom line: While we are not expecting sharp increases in interest rates, we should expect interest rates to increase for the foreseeable future due to the Fed reducing their balance sheet and the need for more Treasury issuance due to deficit spending by the U.S. federal government.

Exhibit 2 - Investment Markets:

 Equity January February March 1st Quarter 2018
U.S. Large Cap Equity 5.73% -3.69% -2.54% -0.76%
U.S. Mid Cap Equity 3.05% -4.11% 0.96% -0.24%
U.S. Small Cap Equity 2.61% -3.87% 1.29% -0.08%
Developed Country International 5.50% -4.57% -1.61% -0.94%
Emerging Country International 8.33% -4.61% -1.86% 1.42%
 Fixed Income January February March 1st Quarter 2018
U.S. Investment Grade -1.15% -0.95% 0.64% -1.46%
U.S. High Yield 0.61% -0.64% -0.48% -0.52%
U.S. Inflation Protected -0.38% -0.09% 0.59% 0.12%
Foreign Debt -0.20% -1.96% 0.38% -1.78%

Source: Morningstar Direct

Exhibit 2 footnotes: The following indices were used for the total return calculations:

  • U.S. Large Cap Equity: S&P 500 Index
  • U.S. Mid Cap Equity: Russell 2500 Index
  • U.S. Small Cap Equity: Russell 2000 Index
  • Developed Country International: MSCI ACWI Ex USA All Cap Index
  • Emerging Country International: MSCI Emerging Market Index
  • U.S. Investment Grade: Bloomberg Barclays U.S. Aggregate Bond Index
  • U.S. High Yield: Bloomberg Barclays U.S. High Yield Intermediate Index
  • U.S. Inflation Protected: Bloomberg Barclays U.S. Treasury TIPS 1-5 YR Index
  • Foreign Debt: JPM Emerging Market Bond Global Index

 

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For more information or insight regarding the investment and economic outlook, please contact Dave Isaacson, chief investment officer of Schenck Investment Solutions at 800-236-2246.


Dave Isaacson has more than 25 years of experience providing wealth management and financial consulting services. He is skilled in portfolio and asset management, financial analysis, and market trend analysis.

Dave Isaacson is the Chief Investment Officer of Schenck Investment Solutions, LLC, a Registered Investment Adviser. Registration with the Securities and Exchange Commission does not imply any level of training or expertise. Schenck Investment Solutions, LLC is wholly owned by Schenck SC. Material presented herein is for informational and educational use only. The views, forecasts and opinions presented herein may change based on market conditions and other factors. Nothing herein should be considered to be legal, accounting or tax advice. Consult your lawyer, accountant or other advisor before making any financial, legal or investment decision.

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Any investment advice contained in this publication is not specific to any individual, entity, or retirement plan, but rather is general in nature. Therefore, the investment advice contained herein should not be relied on for specific investment solutions. Investment decisions should be based on a number of criteria, such as individual’s risk tolerance, time horizon and personal goals. Suitability on products must be determined on an individual basis. Not all products are suitable for all investors.

Both the issuers and counterparties of fixed-income securities face inflation, credit, and default risks. Stock markets are volatile, especially markets outside the U.S. All markets may decline significantly in response to adverse developments caused by political, regulatory, issuer, or economic factors, including other markets. Bonds generally present less short-term risk and volatility than stocks. However, bonds have the risk of default and interest rate risk, or the risk that issuers will be unable to make income or principal payments. Investing involves risk. And risk includes loss. Past performance is no guarantee of future results.



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