Market Monitor & Recap

Market Recap

1st Quarter Recap and Outlook - December 31, 2017 to March 31, 2018

Recap

The market underwent a significant paradigm shift during the first quarter, and investors must adapt to a market dynamic that has been absent for quite some time, volatility. Following a strong start to the year for the S&P 500, up 7.54% year-to-date through January 26th, event-driven volatility quickly ensued bringing the index back to flat for the year by February 5th. Subsequently, the S&P 500 reached "correction" territory on February 8th, its year-to-date low, down over 10% from the January 26th peak. It is never a single event that triggers these kinds of market episodes, but rather a culmination of several factors. What we believe precipitated this volatility was a combination of tighter U.S. monetary policy, President Trump’s tough trade rhetoric, and the use of volatility-linked securities.

The most fundamental pillar of this paradigm shift is the higher interest rate environment due to tighter monetary policy by the U.S. Federal Reserve, and to a lesser extent the coming to the end of accommodative policies around the world. As a result asset prices, for our purposes of discussion risk assets, i.e. credit and equities, must respond to the adverse pressures of higher capital costs impose on both consumption and earnings. Until recently, risk assets have failed to significantly discount this factor. This has been easily observed in the credit market, of which overall investment grade credit spreads have widened twenty-five basis points since early February.

The new tariffs President Trump imposed on both aluminum and steel imports, to which the market reacted violently during early March, is another consequential factor with which investors must now grapple. According to our analysis, President Trump's tough talk, primarily directed at China, is just an extreme position that is a starting point for negotiations between the two countries. What we feel will be President Trump's greater bargaining chip in these future negotiations is the recent crackdown on the theft of U.S. intellectual property by China. It is of our belief that the U.S. could likely emerge better off from such a negotiation with China in regard to trade and the defense of U.S. intellectual property.

The sudden unwinding of large positions in volatility linked securities was the straw that broke the camel's back, in this case the stock market's. These derivatives in particular were structured to benefit when volatility is low, which it has been for several years. However, when volatility spikes investors are forced to sell equity index futures which exacerbates the volatility. Several days after these sells were triggered, the majority of the positions were unwound, and will not have another significant effect on the market.

Outlook

As we stated in our last outlook, we believe that the performance of the market during the first quarter will set the tone for the year going forward. Though we believe that the recent bout of volatility in the equity market will continue for at least the next quarter, we expect the S&P 500 will end 2018 with a single digit return. Much of this outlook is strongly based on our positive view of the U.S. economy over the next twelve months; growth has been stable, which corporate earnings have reflected, and inflation has been gradually improving.

Our base case for the number of interest rate hikes in 2018 by the Federal Reserve is two more, with a strong possibility of three if inflation continues to track above the Fed's target of two percent. So far, considering he is still early in his term, Federal Reserve Chairman Powell has been on balance more hawkish than expected. The implication of such aggressive policy is a flattening yield curve, which has consistently been the trend since the third quarter of 2017.

Though gradual spread widening is to be expected very late in the business cycle, the recent rate at which credit spreads have widened and the magnitude of corporate credit's underperformance has been surprising to us. We still remain constructive on credit and believe that spreads should revert tighter during the second quarter, but will consider reducing our overweight allocation relative to the various fixed income benchmarks if this underperformance continues. Agency mortgage-backed security spreads have continued to grind wider as the Federal Reserve gradually reduces reinvestments of principal payments. However, as the yield curve bear-flattens, which we expect it to, this should contribute to better mortgage-backed security performance relative to U.S. Treasuries.

Equity valuations are still rich, but have cooled slightly since January; the S&P 500 Index is currently trading at 17.6 times this year's earnings. Despite the market as a whole being close to fully valued, we are selectively bullish on energy and financial stocks. With energy prices stable, and crude oil trading over $60 per barrel, our analysis suggests that energy firms from producers to pipelines should trade higher. We expect financials, in particular banks, to fare well in the higher interest rate and stable growth environment that we currently find ourselves in. Along with higher rates, banks will also have much to benefit from recent tax reform.

 

Media Perspective

A recent article from the Wall Street Journal, (Investors on Edge After Bumpy First Quarter for Stocks) - A few of last year's most enduring trades staggered toward the end of the quarter. (By Akane Otani)

Read More of Akane Otani article at the Wall Street Journal online.

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