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Who's Driving the Bus? A Return to Volatility in 2018

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After an historically calm 2017 where progressively better and better news on the economic front (rising earnings estimates, tax reform, reduced regulation, improving GDP numbers, improving consumer sentiment, tame interest rates, and moderate inflation numbers) led to surging global stock markets, January of 2018 witnessed a massive blow-off rally in stocks as investors piled into the rally due to a “fear of missing out” mindset. However, February saw equity prices give back all of January’s gains and over the balance of the quarter previously serene markets gave way to periods of spiking volatility both on the upside and the downside.

The catalyst for this change in our market “driver” was the February 2nd employment report that showed average hourly earnings jumping 2.9 percent in January from a year earlier, the latest sign that the long, slow economic recovery was at last reaching Americans’ pocketbooks. Separate data released that week showed that private-sector wages and salaries rose 2.8 percent in the final three months of 2017 compared with a year earlier, the fastest growth since the recession.

These reports ignited fears that wage inflation was finally taking hold and therefore interest rates, our new driver, would be compelled to rise – posing a risk to the year-long stock market rally that had taken U.S. large cap stocks to valuation levels not seen since 2004. In March, the Federal Reserve raised short-term interest rates by 0.25% in response to an improving economy and anticipates raising rates twice more in 2018 to remove their “accommodating" stance as the economy no longer needs the crutch of artificially low rates.

Political News Reports Played a Significant Role
Subsequent to these data points stoking inflation fears were mixed signals from Washington where encouraging news about our future relationship with North Korea led to reports of a possible upcoming summit between President Trump and the North Korean leader, Kim Jong-un. This positive was offset by announced tariffs (a tax) on steel and aluminum imports, more turnover in the Trump administration, additional details coming out of the Mueller investigation into possible Russian meddling in the 2016 election, and President Trump’s personal legal woes. Later in the quarter, the equity markets became hyper-sensitive to any news reports and wide daily market swings became commonplace.

Pullbacks and Price Swings
After 2017 saw no S&P 500 pullbacks more than 3%, 2018 has seen three pullbacks of at least 8%. Another sign of recent enhanced volatility in the markets can be seen in the number of days that the S&P 500 has risen or fallen by at least 1%. In 2017, there were a total of eight of these days. In contrast, the first quarter of 2018 saw twenty-three days of more than 1% price swings. Since 1995, the stock market has averaged yearly pullbacks from its highs of around 14% so this year’s drop in prices is more the rule than the exception. While this volatility is unnerving to investors, it has served to return the equity markets to slightly above-average valuations that may present attractive entry points for long-term investors.

U.S. Equities 1Q2018 Chart

In the first quarter, Emerging Markets’ stocks (+1.4%) were the only equity class index to show gains. Within equities, technology and consumer discretionary stocks rose in value due to strong earnings growth forecasts. Cash was the second-best performing asset class rising 0.3% in value. Global Infrastructure stocks and Global Real Estate Investment Trusts (REITs) were the worst performers dropping 5.7% and 4.5%, respectively, due to concerns over rising interest rates.

1Q 2018 Returns Chart

Rising interest rates in 2018 have been responsible for falling bond prices and negative returns (-1.5%) for bond investors in the first quarter. This compares to positive bond returns for years 2014 through 2017 and in nine of the past ten years. History tells us that when interest rates reach a certain level, stock prices begin to suffer. Fortunately, we are approximately 1.5% below that level so equity markets are still attractively valued compared to the bond market. Despite the poor performance in bonds thus far in 2018, they still serve an important role in portfolios as a hedge against falling stock prices that come as a result of worries about a slowing economy. While McKinley Carter does not look for a near-term slowdown in the economy, we believe a well-diversified portfolio that includes some bond exposure is appropriate for most investors.

Where the Road May Lead
Looking forward, despite our “driver” having changed from earnings to interest rates and inflation concerns, we are still constructive on the equity markets and feel that the recent consolidation in stock prices is a healthy development that removed most of the market speculation that we witnessed in January. We believe that, ultimately, earnings drive stock market performance. With 18% projected growth in S&P 500 earnings over the next year and strong earnings growth in international markets as well as tame global inflation, the global stock markets should still produce positive returns in 2018. Broad exposure to non-U.S. markets is warranted as international equity valuations are more attractive than U.S. valuations and foreign central bankers plan to maintain a low interest rate environment longer than what we are experiencing in this country. Additionally, any pullbacks as a result of non-economic news stories should be viewed as opportunities to increase stock exposure in line with your current portfolio strategy.

McKinley Carter advisors and staff are eager to assist you in your pursuit of financial independence and to work with you and your family as you “invest in a good life.”

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