The string of nine straight quarterly gains for the S&P 500 Stock Index was finally broken in the first quarter of 2018, but only modestly. Stocks exploded out of the gate in January, buoyed by the recent passage of the tax reform package by the Republican-led congress. As the quarter wore on, however, investors became increasingly concerned by a range of issues, which led to a sharp spike in market volatility. Although punctuated by a number of strong up days, beginning in late January the general direction of prices was downward. From a peak of about a 7% gain in January, the S&P 500 finished with a loss of 0.76% for the quarter.
The relative calm of the last several years was dramatically broken in the first quarter. 2017 passed without a single day decline of 2% or more, but the S&P 500 posted five days of 2% or more losses in Q1 of 2018. During the quarter, the stock market ended the longest streak in history without a 3% correction.
Developed markets outside the US also declined, with the MSCI EAFE Index falling 1.5%. But emerging markets (MSCI Emerging Markets Index) managed to eke out a small gain, rising 1.5% (in dollar terms).
A jump in average hourly earnings in January rekindled investor fears about inflation, leading to a sharp rise in bond yields. The US 10-year bellwether Treasury bond yield rose from 2.46% to a high of 2.95% during the quarter, before settling at 2.74% at quarter-end. The rise in bond yields resulted in a negative return of -1.46% in the broad US bond market index (Barclays Aggregate Bond Index).
Higher interest rates led to substantial declines in interest-sensitive assets such as real estate investment trusts (REITs) and energy master limited partnerships (MLPs). Infrastructure stocks, subject to higher debt costs when rates rise, also posted declines.
In short, while a measurement from the peak in late January feels severe, the quarterly decline in most asset classes was relatively minor.
Outlook and Strategy
The anxiety that gripped equity market investors in the first quarter arose from several issues. As we have noted, the long uninterrupted rise in equity prices left investors feeling vulnerable to even a hint of negative news. That came in late January, when an unexpected jump in wage growth focused attention on the threat of higher inflation down the road. With the economy humming along at a nice clip, the additional stimulus expected from the new tax legislation, and the potential for further deficit spending from the federal government, the prospects for higher future inflation are real. Fortunately, inflation fears moderated later in the quarter, as economic activity softened a bit and wage growth slowed to a rate more consistent with recent history. We believe inflation will be relatively contained by the Federal Reserve’s plan to keep increasing short-term rates.
More troubling is the recent spate of protectionist measures enacted by the Trump administration, and the initial retaliatory actions by our trading partners. History is clear that stock markets do not take kindly to walls erected to protect domestic businesses from foreign competition. Protectionism results in reduced foreign trade, higher prices for consumers, and an inefficient allocation of resources in the global economy. It may be that President Trump is staking out an aggressive position on trade as a negotiating tactic, and intends to reach a compromise that addresses the primary actor in unfair trade practices, which is China. In either case, a satisfactory resolution of these trade issues would be a major positive for equity markets.
More fundamentally, the recent decline in share prices and the increase in earnings expectations from tax reform have relieved much of the overvalued condition in the US equity market. With consensus earnings expectations for the S&P 500 at $157 per share in 2018 and $170 in 2019, the US market is trading at a multiple of 16.9 times 2018 earnings and 15.6 times 2019 earnings, respectively. Foreign stock markets, having sustained similar declines in the first quarter, are also trading at more reasonable valuations. We continue to view the emerging markets as most attractive for long-term investors, and view the recent declines in global stocks as a healthy digestion period of robust past gains. We believe the US economy will continue to gain strength through the year as tax reform works its ways through the system, and view the risk of a significant economic slowdown within the next several quarters as very low. As a result, we are optimistic about a recovery in stock prices going forward.
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