Volatility returned loudly and unannounced in the first quarter, giving complacent markets a rude awakening. Judging from the crosswinds that look likely to continue buffeting markets, volatility should play a more central role in 2018 than recent memory. The basic fundamentals – such as growth in economic output, employment and profits – continue to look solid. However, higher interest rates, rising inflation, trade disputes and a more complicated regulatory outlook suggest that prudent risk management and investment selection have become increasingly impactful.
In terms of market performance, the negative eclipsed the positive in the first quarter. After a seven percent tear out of the gate in January, the S&P 500 gave up all those gains to finish down about one percent, ending a streak of eight quarters in the black, and experiencing its first ten percent decline from peak to trough since early 2016. Volatility spiked, although it really just moved back toward its long-term average from an unusually low level. Bonds, which typically cushion stock-market drawdowns, unfortunately posted small negative returns as well.
The culpable factors behind the rise in volatility generally do not appear transitory. The global economy has now recovered to the point where capacity constraints could lead to higher inflation, which has picked up recently. This has prompted interest rate hikes from the Fed and also contributed to the sell-off in bonds. Inflation readings and forecasts have not sounded any alarms, but its potential paths forward appear skewed to the upside. Higher interest rates are also negative for investor and corporate risk tolerance, since they make borrowing more expensive and saving more attractive, and rates should continue to rise as long as the economy remains on solid footing.
Policy, formerly a strong positive, now appears more mixed, with notable potential downside. While deregulation of the Financial and Energy sectors should improve their profitability, Tech stocks have attracted the regulatory spotlight, both in terms of oversight of business as usual, as well as blocked mergers and potential antitrust actions that impinge more meaningfully on corporate strategy. This is especially significant given Tech’s current outsized influence on the overall market, as it has led the rally the last couple of years and now accounts for over a quarter of the S&P 500 Index. Trade disputes, if they escalate, also pose meaningful downside risk that is too complex to handicap precisely, but too important and realistic to ignore.
On the other hand, even if the fundamental backdrop is clouded by new uncertainty, it still remains solid as it currently stands – that market run to start the year did not just happen spontaneously. US GDP grew a decent 2.3% last year in real terms and is expected to accelerate this year. Unemployment is quite low at 4.1%, and new jobless claims have hit multi-decade lows. Corporate earnings are projected to have risen 25 percent in the first quarter from last year, turbo-charged by the huge tax cuts.
As legendary investor Howard Marks advised nearly twenty years ago, “You can’t predict. You can prepare.” The number and size of risks make volatility look like the new status quo, and uninterrupted equity market rallies look like a thing of the past; however, the moving parts create opportunities inasmuch as there are relative winners and losers. Potential returns must come from risks well managed as we enter the later stages of the current business cycle.