From the Pyke Family of Firms April 2018 Newsletter
The first quarter of 2018 has been a rocky one, with volatility surging to levels not seen in several years, and investors awakened from the low- volatility environment of 2017. January saw record inflows into equity markets, with retail investors looking to take part of the gains enjoyed over the last several years, and outsized flows into technology stocks that have lead the rally. After the S&P 500 climbed over 6% in a matter of weeks to start the year, a massive unwind began in February as volatility exploded higher and equities experienced a violent, though brief correction of over 10%. Just as quickly as they fell, markets then rebounded back to positive territory, where they remain as of this writing.
One phenomenon contributing to the recent market turbulence was skyrocketing bond yields, as the 10 year Treasury rate rose over 20% in the first several weeks of 2018 and now sits over 40% higher than the lows of 2017. This remarkable move in rates directly impacts a number of factors in both the real economy and financial markets, as borrowing costs, corporate profitability, consumer financing, and valuation metrics all rapidly adjusted to a regime of higher rates. With the Federal Reserve continuing on their path of tightening monetary policy through reduced bond purchases and increasing short-term borrowing costs to keep a lid on inflation and financial excesses, it appears likely that higher rates are here to stay.
The global economic expansion continues to move forward at a steady pace, as fundamentals improve and earnings surprise to the upside. Europe appears to have finally turned a corner, with a pickup in prices and economic growth, as the European Central Bank leaves their foot on the accelerator for now and governments have eased their fiscal restraint. Even Japan, after decades of stagnation, looks to be moving in the right direction as corporate profitability moves higher. The biggest opportunity could likely be emerging markets, where after lagging for most of the last decade, markets look attractively priced and dollar weakness, coupled with outsized revenue and earnings growth, could propel stock prices higher.
The biggest unknowns and possible upsets looking into the second quarter are likely political shocks, an overly aggressive Federal Reserve, trade wars, or lackluster earnings reports. The ongoing drama within Washington contin- ues to plague investors, as stability is the market’s friend. As more noise clouds actual policy action, significant disruptions appear unlikely, particularly as markets are becoming ever more accustomed to political wrangling from the “Swamp”. Trade issues are likely to be the biggest threat out of Washing- ton to the current bull market, if tariffs and other tactics turn ugly and result in an escalating trade war. A more consistent interloper to market expansions is the Federal Reserve, who has a consistent record of overshooting rate hikes and removing the punch bowl from the party too soon. For now, however, the most likely culprit in our view of trouble ahead could be surprises in corporate earnings that miss estimates. As the fundamental driver of equity prices which are currently priced with very high expectations, any disappointments could portend trouble for investors.
Despite these potential headwinds, we continue to believe that there is much to be optimistic about, as record unemployment, signs of increasing household wages, and the reasonably stable balance sheets of consumers and corporations support a positive outlook. We encourage investors to maintain vigilance and not become greedy after years of excellent returns. Monitoring your portfolio and keeping in line with your long-term risk allocation is paramount in the environment we find ourselves today. The stakes are high and as every seasoned investor knows, market sentiment can turn on a dime. For as Warren Buffett says, “only when the tide goes out do you discover who’s been swimming naked.”
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