Plum Street Advisors
Q1 2018 Market Commentary – April 4, 2018
Volatility returned with a vengeance during the first quarter of 2018. Although the S&P 500 ended the quarter down just -0.76% on a total return basis, the ride was a lot wilder than the quarterly number makes it appear. In January, the S&P 500 total return was up +5.73%, only to decline by -3.69% in February and another -2.54% in March.
At times, it seemed like the market was just looking for an excuse to correct after a long run of quarterly increases. In February, inflation fears jumped, based on small increases in monthly wage and consumer price data. In March, technology stocks plummeted as Facebook was hit with a privacy scandal and Amazon was singled out for negative tweets by President Trump. At the end of the quarter, concern about a global trade war grew.
Despite the market’s ups and downs however, the underlying US economy shows continued strength. The estimated earnings growth rate for companies in the S&P 500 for the first quarter was +17% year-over-year. Average earnings estimates, which are usually revised downward as the quarter proceeds, were revised upward by the largest amount since Factset started collecting data (by +5.4%) as the quarter went on, largely due to analysts calculating the impact of the tax cuts passed late last year, but also due to improvement in their individual markets.
Fourth quarter GDP growth came in at a stronger than projected pace of 2.9%. Manufacturing showed solid growth, with durable goods orders showing increases in three of the last four months. Consumer confidence remains high, and solid job growth has kept the unemployment rate at 4.1%.
Fears of a trade war impacted the stock market this quarter. President Trump announced tariffs on washing machines and solar panels in January, steel and aluminum at the end of February, and a long list of Chinese goods in March. Just after quarter end, the Chinese threatened significant retaliation with a similarly-size list of their own which included major US exports like airplanes, cars, and soybeans. China and the US are seeking negotiation to avoid escalation into a true trade war – the tariffs don’t take effect immediately and there is still time for the sides to seek a truce. The market declined on the news of Chinese retaliation, but seems to be remaining cautiously optimistic that a global trade war will not ensue.
Stocks began 2018 with a strong surge in January, but more than gave it back in February and March. US stocks fell less sharply than international stocks in the first quarter, with the Russell 1000’s total return of -0.69% holding up better than the MSCI ACWI ex-US -1.91% net USD return. Emerging markets managed a small net increase for the quarter.
In the US, growth stocks continued to lead this quarter as they had last year, with the Russell 1000 Growth index returning a total of +1.42% in the first quarter compared to the Russell 1000 Value index total return of -2.83%. Small cap outperformed large cap, especially in March when small cap’s more domestic focus meant the small cap index was less impacted by trade concerns. The Russell 2000 ended the quarter almost flat at -0.08%.
The yield on U.S. Treasury bonds surged at the start of the quarter as investors believed the tax cut passed at the end of the year might soon lead to more growth and inflation. This view did not hold as the quarter went on, and by March the yield was falling, giving back some of the quarter’s increases but still ending up higher at 2.74%.
Overall, bonds as measured by the Bloomberg Barclays’ Aggregate Index lost -1.48% in the first quarter due to the rise in yields. Shorter term bonds, which are less affected by interest rate moves, fell less sharply. The Bloomberg Barclays 1-5 year government/credit index declined a more modest -0.50%.
In March, the Federal Reserve continued its policy of rate hikes with its first increase in the Fed Funds rate for 2018, to a range of 1.50% – 1.75%. The Federal Reserve is also still signaling two more hikes this year. The Fed painted a calm picture for 2018, increasing its GDP forecast, decreasing its unemployment forecast, and projecting a low 1.9% inflation rate.
The Bloomberg commodity index fell slightly by -0.40% for the quarter despite a rise in oil prices, due to sharp drops in agricultural commodities like coffee, sugar and lean hogs. Gold, the commodity we hold in most client portfolios, was up slightly +2.54% for the quarter, following a rise of +13.6% in 2017.
Summary – Has Market Risk Increased?
There are good reasons to cheer for the U.S. economy. Corporate earnings are up, inflation is low, and confidence remains high. On the other hand, there are significant geopolitical and trade concerns, rising interest rates, and fears that technology stocks won’t live up to their high expectations. It’s hard not to read the newspaper headlines every day and wonder – is too much downside risk building up?
Stock market risk as measured by daily volatility has increased from the historical lows we had seen for the last two years, as we recently wrote in our February article titled “Volatility – Same As It Ever Was”. We got used to steady market increases, and started to forget that the stock market pays investors better returns than bonds over the long run precisely because there is much more risk. We were all reminded of this with the market’s volatility this quarter.
We pointed out two other things about risk in our recent article, however. First, short-term volatility is not meaningful for the long-term investor. While in any given year, returns can swing quite wildly, over longer rolling periods, the stock market has been quite steady. The S&P 500 has never been negative over any rolling 15-year period back to its inception in 1926 – and that includes the period following the 1929 crash. Second, volatility can actually present opportunities for the patient long-term investor. Rebalancing portfolios can add value if prices jump around a long-term mean return as we buy assets that have recently underperformed and sell assets that have recently outperformed.
At Plum Street Advisors, we avoid taking unrewarded risk by diversifying and holding substantial weights in all the major markets, taking their volatility into account, because we believe that such a portfolio offers the best chance of optimizing the return for the risk you take on. As we said in our February article, riding out short-term volatility is business as usual for the long-term investor.