2018 has been a good time to fasten your seatbelts.
The markets have remained volatile over the last four months, after a stellar performance in 2017. The broader markets went parabolic through January, followed by 1,000-point swings. After the sharp correction in early February and continued volatility through early May, the market recovered much of the losses but remains below the all-time highs reached in January. We believe this turbulence will continue going forward, but the underlying fundamentals have not changed enough to warrant the end of the bull market.
Possible causes for the bumpy ride include:
- rising interest rates (the 10-year Treasury yield rose above 3.0%) which increase borrowing costs to consumers, businesses, and governments;
- growing market concerns over unexpected raises in short-term interest rates by the Federal Reserve in the next two years;
- worries about fiscal/government spending and potential increases in the deficit from the tax cut and the recent budget package (the Treasury Department expects to borrow $955 billion this fiscal year, a six-year high and a jump from the $519 billion borrowed last year);
- computer-based program trading with time horizons in nanosecond, which adds daily volatility both on the upside and the downside;
- unpredictable political issues, which can have a pronounced short-term impact on trading.
Going forward, we will continue to see increased volatility in the market; these periods are a normal part of long-term investing. However they can also be a wake-up call to make sure your portfolio is adequately diversified and that your risk-tolerance is at an appropriate level for your portfolio. Market changes are a good time to rebalance your portfolio by selling some positions that have become overweight in relation to the rest of the portfolio and by possibly increasing exposure in areas that experienced pullbacks, but still have sound market fundamentals and robust economic activity.
The Economy
Real gross domestic product (GDP) increased at an annual rate of 2.3% in the first quarter of 2018, according to the advance estimate, down from 2.9% growth in the fourth quarter of 2017–a pace equal to the performance for all of last year. The first quarter is usually the slowest of the year, so it is expected that GDP growth will pick up over the remainder of the year, with most economists expecting growth of 3% for 2018.
Growth in consumer spending, which accounts for more than two-thirds of U.S. economic activity, slowed to a 1.1% rate in the first quarter. That was the slowest pace since the second quarter of 2013 and followed the fourth quarter’s robust 4.0% growth rate. Consumer spending was undercut by a decline in purchases of motor vehicles, clothing, and footwear as well as a slowdown in food and beverages outlays.
Business spending on equipment slowed to a 4.7% rate in the January – March quarter after double-digit growth in the second half of 2017. The cooling in equipment investment partly reflects a fading boost from a recovery in commodity prices. Economists expect a marginal impact on business spending on equipment from rising interest rates and more expensive raw materials. Government spending grew at a 1.2% rate, slowing from the fourth quarter’s 3.0% pace, but is expected to accelerate in the second quarter after Congress recently approved more outlays.
Trade added 0.20% to GDP growth as rising exports offset an increase in imports that was driven by royalties and broadcast license fees related to the Winter Olympics. A weak U.S. dollar and strengthening global economy are boosting exports.
Personal Consumption Expenditures (PCE) increased to 2.0% annually in March, up from the 1.7% increase reported in February. At the same time, core PCE, which strips out volatile food and energy prices and is the Federal Reserve’s preferred inflation measure, showed an annual increase of 1.9%, up from February’s reading of 1.6%. The data was in line with economists’ expectations. Gold prices, usually a good indicator of inflation, are ignoring the inflation data, reacting to a stronger U.S. dollar and easing geopolitical tensions
Along with inflation data, reports say personal spending rose 0.4% in March, up from a 0.2% rise in February. However, consumers continue to spend more than they make as income only rose 0.3% last month, down from February’s 0.4% rise. The data confirms that consumption gained momentum towards the end of the quarter; however, the slightly softer income numbers may dampen expectations a little for second-quarter consumer spending.
The unemployment rate fell in April to 3.9%, the lowest level since 2000. The number of jobs increased by 164,000 in April compared to a monthly average of 191,000 additions over the past year, and the number of unemployed dropped by 239,000 between March and April. That is why the employment-to-population ratio — the percentage of all people of working age (16 and up, including those who have stopped looking for work) that are employed — dropped from 60.4% to 60.3%. More people disappeared from the labor rolls. The biggest categories of gainers month-to-month were in construction and in professional and business services where there were new hires for business tax compliance and budgeting.
Economic theory suggests that when workers become scarce, employers raise wages quickly to recruit and retain employees. But wage growth has persistently undershot economist expectations. May’s report showed average hourly pay grew 4 cents over the past month and 2.6% over the past year. That is better than the 2% gains seen early in the recovery, though still a modest gain historically.
According to the National Association of Realtors (NAR) existing home sales grew 1.1% to a seasonally adjusted annual rate of 5.72 million in March from 5.54 million in February. Even though sales grew for the second consecutive month in March, they are still 1.2% below a year ago. “Robust gains last month in the Northeast and Midwest — a reversal from the weather-impacted declines seen in February — helped overall sales activity rise to its strongest pace since last November at 5.72 million,” says Lawrence Yun, the association’s chief economist. But he notes that “while the healthy economy is generating sustained interest in buying a home this spring, sales are lagging year-ago levels because supply is woefully low and home prices keep climbing above what some would-be buyers can afford.”
In addition, the NAR reported that the Pending Home Sales Index, a forward-looking indicator based on contract signings, crept up 0.4% in March from a downwardly revised 107.6 in February. Although pending sales rose for the second straight month, they remained below year-ago levels for the third month in a row and the March forecast had been for a 1% increase. The latest results show that interested buyers continue to face a persistent shortage of affordable inventory that is driving up property prices faster than wage growth. Also, as mortgage rates climb to an almost five-year high, affordability declines.
The median existing-home price for all housing types in March 2018 was $250,400, up 5.8% from March 2017 (when the median was $236,600). March’s price increase marks the 73rd straight month of year-over-year gains. In addition, total housing inventory at the end of March rose 5.7% to 1.67 million existing homes available for sale, but is still 7.2% lower than the 1.8 million of a year ago and has fallen year-over-year for 34 consecutive months.
Unsold inventory is at a 3.6-month supply at the current sales pace (it was 3.8 months a year ago). Properties typically stayed on the market for 30 days in March, which is down from 37 days in February and 34 days a year ago. Half of all homes sold in March were on the market for less than a month.
We note that affordability of housing is not only negatively affected by home price but also by debt/income levels, required down payment, rising interest rates, rising property taxes, and increasing insurance costs. According to Freddie Mac, the average 30-year fixed-rate mortgage increased for the sixth straight month to 4.44% in March from 4.33% in February. The March rate was the highest since it hit 4.46% in December 2013. The 30-year mortgage rate ended 2017 with a December rate of 3.95%.
According to The Conference Board, a nonprofit business research group, their Consumer Confidence Index® increased moderately in April to 128.7 after decreasing in March to 127.7 (The Consumer Confidence Survey® reflects prevailing business conditions and likely developments for the months ahead. This monthly report details consumer attitudes and buying intentions, with data available by age, income, and region. The 1985 index equals 100). “Consumers’ assessment of current conditions improved somewhat, with consumers rating both business and labor market conditions quite favorably,” The Conference Board stated. “Consumers’ short-term expectations also improved, with the percent of consumers expecting their incomes to decline over the coming months reaching its lowest level since December 2000 (6.0 percent). Overall, confidence levels remain strong and suggest that the economy will continue expanding at a solid pace in the months ahead.”
In March, as anticipated, the Federal Reserve (FED) chose to raise the Fed Funds rate target by an additional 25 basis points to a range of 1.50 – 1.75%. This was the sixth increase since December 2015. The FED’s target rate helps determine rates for mortgages, credit cards, and other borrowing. “Information received since the Federal Open Market Committee met in January indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate,” the FED noted on the action. “Job gains have been strong in recent months, and the unemployment rate has stayed low. Recent data suggest that growth rates of household spending and business fixed investment have moderated from their strong fourth-quarter readings. On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. Market-based measures of inflation compensation have increased in recent months but remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”
At the March meeting, the FED hinted it would favor a more aggressive pace to keep the economy humming in the coming years. It also shifted its plans to raise interest rates for next year, calling for three more rate hikes instead of two. Market participants expect the FED to raise the FED Funds rate an additional two times in 2018.
The Stock Market
The broader markets peaked on January 26th with the Dow, S&P 500, and NASDAQ increasing by 7.67%, 7.45%, and 8.73%. From there, the market became more volatile with 1000-point swings, and in two weeks had erased all its January gain with all three falling — the Dow by 10.4%, the S&P 500 by 10.2%, and the NASDAQ by 9.7%, respectively.
For the first quarter of 2018, the S&P 500 was down 1.22% while the Dow was down a greater 2.49%. The NASDAQ Composite however showed gains with a first-quarter increase of 2.32%. Of the 10 sectors represented in the S&P, only two sectors saw positive performance for the quarter, as measured by the SPDR sector ETFs. The best performing sector was Consumer Discretionary (2.97%), followed by Technology (2.65%). Eight sectors saw negative performance with the worst performers being Consumer Staples (-6.96%), followed by Energy (-6.00%). The remaining underperforming sectors were Materials (-5.55%), Real Estate (5.08%), Utilities (-3.31%), Industrials (-1.36%), Health Care (-1.18), and Financials (-0.93%).
In Fixed Income, for the first quarter of 2018, the 10-year note rose by 28 basis points to end the quarter at 2.74%. While the long end of the yield curve continued to flatten, the 30-year bond also increased 13 basis points-but at a slower pace than the 10-year note-and ended the quarter at 2.97%. In 2018, 10-year Treasury bond yields have continue to rise due primarily to strong economic data, signs of higher inflation, higher funding needs by the Federal Government as a result of higher budgets and the tax reform package in addition to concerns about FED tightening policies.
We expect the FED will continue to raise short-term interest rates as inflation pressures are building. The FED is also tightening policy by shrinking its balance sheet, which means the market will need to absorb about $400 billion more in Treasury bond supply this year than in 2017. Thus, yields will likely need to rise to attract buyers to the market. That said, when stocks selloff sharply, Treasury bonds tend to rally because they serve as safe haven investments in times of heightened volatility.
The Barclays U.S. Aggregate Bond Index, after rallying through the full year of 2017 (up 3.54%) and 2016 (up 2.65%), swooned in the first quarter of 2018 and ended the quarter down 1.46%. This is the first quarterly decrease for the Index since the fourth quarter of 2016 and represents one of only eight decreases in 37 quarters going back to 2009.
In March 2018, global oil prices averaged $66 per barrel after briefly hitting $70 per barrel in January, up from a 13-year low of $26.55 per barrel in January 2016. Oil prices have been more volatile due to swings in oil supply. After peaking in early 2017, the Wall Street Journal Dollar Index declined through the first nine months of 2017, bottoming in September at about 84.49. The index rallied into November, but then retreated to end the year at about 85.98. The Index continued to weaken through the first quarter of 2018 ending the quarter at about 83.73.
Disclaimer:
While this article may concern an area of investing or investment strategy in which we supply advice to clients, this document is not intended to constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. Any statements regarding market or other financial information is obtained from sources which we and/or our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.
Past performance should not be taken as an indicator or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. As with any investment strategy or portion thereof, there is potential for profit as well as the possibility of loss. The price, value of and income from investments mentioned in this report (if any) can fall as well as rise. To the extent that any financial projections are contained herein, such projections are dependent on the occurrence of future events, which cannot be predicted or assumed; therefore, the actual results achieved during the projection period, if applicable, may vary materially from the projections.