- Strong wage growth in January ignited inflation concerns and sent equity markets tumbling
- Talk of tariffs and trade barriers in March further dented already fragile investor sentiment
- The cross currents of greater stimulus from tax cuts and a potentially inflationary labor market have put the Fed in a challenging position and increase the odds of policy mistakes
- Valuations across asset classes remain high, with the exception of certain assets that are sensitive to accelerating inflation, namely commodities and emerging markets
It should be no surprise that the longest stretch of calm in market history ended as it did in Q1, with an explosion of volatility. Initially, commentators blamed complex volatility instruments for the sudden turn of events, but the timing coincided better with shifting perceptions of inflation risk and were amplified later by concerns about US trade policy and the possibility of policy mistakes on the part of the Fed. These catalysts of course occurred within the context of a richly-valued market and a sustained period of aggressive risk taking across most asset classes, giving markets ample reason to freak out. Even though markets have now stabilized where they began the year, (more than 6% below their January peak) we believe many of these issues remain unresolved and will continue to contribute to volatility throughout the year.
2018 started out with a breathtaking run up in US equities of more than 6% in the first three weeks of the year, one of the strongest starts to a year since the late 1990s. During the same period, global developed markets and emerging markets also ripped higher. By the end of the month, that picture had changed dramatically. A February 2 labor market report showing 200,000 new jobs in January and year-on-year wage growth of 2.9% stoked market participants’ concerns about a strengthening inflation outlook. The jobs numbers were well above expectations, and were accompanied by upward revisions to 2017 numbers. However, it was the wage inflation number that really got attention; it was the highest increase in wages since the end of the Great Recession. Most importantly, it was perceived to increase the chances of a faster pace of interest rate hikes by the Federal Reserve.
Global markets fell sharply following the report, with the S&P 500 dropping by more than 10% and volatility spiking to levels not seen since 2008. As we had written in recent communications, volatility had been falling for a while and had touched new all-time lows in 2017. When market indices turned negative, volatility exploded, having started from such a low base and remained low for such a protracted period of time. Volatility itself may have also contributed to further instability as bond, foreign exchange and commodity market volatility began to roil cross-asset positions.
However, even before the furious first week of February, there were hints in fixed income markets that all was not well. Prior to the strong jobs report, bond markets had been rattled by a plan by the US Treasury, announced the morning of January 31, to slightly increase the auction size of Treasury securities. This was viewed as possibly an early indication that the government would be stepping up its effort to raise more cash to fund the growing budget gap resulting from (among other things) the large tax cuts announced in late 2017. Such an effort, in itself, can contribute to higher inflation expectations in certain circumstances. Bond yields immediately rose on this news and created some volatility in fixed income markets even before shifting inflation expectations registered in equity markets.
While the Trump administration had already laid the groundwork in mid-January for a trade policy discussion, talk of new tariffs and trade barriers in March further dented already fragile market sentiment. After an initial volley of new taxes on imported solar panels and washing machines on January 23, the US shocked trading partners on March 23 with 25% tariffs on imported steel and 10% tariffs on imported aluminum. China, who was not exempted from the tariffs like many of our major trading partners were, retaliated with $3 billion of its own tariffs on US products. This tit-for-tat extended to much of March, with the latest round escalating to potentially $100 billion in new tariffs by the US on Chinese products.
While tariffs may carry with them certain isolated economic and political benefits (fostering specific industries, providing a source of government revenue, etc.), by and large, they are considered a drag on broader economic growth. In raising prices for imported goods, they both reduce demand and stimulate inflation (among other things). By the end of March, much of the euphoria about the potential benefits of last year’s tax cuts had been replaced with valid anxiety that we might give it all back in the form of slower global growth, higher budget deficits and accelerating inflation.
These cross currents have put the Fed in a particularly precarious position, a position that is not lost on markets. On the one hand, the Fed is faced with the nearly impossible job of targeting monetary policy today based on actions it took more than 18 months ago. The effects of quantitative easing, including the massive size of the Fed’s balance sheet, continue to dominate the current economic environment and Fed policy. At the same time, the Fed is faced with certain realities today that both amplify (tax cuts) its past policies and counteract them (trade tariffs). The US has never introduced such large stimulus at the tail end of an economic cycle when the job market is tight and inflation expectations are creeping upward, putting the Fed in uncharted territory on a number of fronts. The Fed had already acknowledged that exiting quantitative easing would be a challenging task; adding to that the countervailing forces of tax cuts and a potential trade war dramatically increase the chances of policy error on the part of the Fed. Markets have simply not been able to move beyond the uncertainty this creates, remaining roughly where they were when they began the year.
While we continue to believe that the US economy is on solid footing, valuations across many asset classes warrant caution, particularly in the context of escalating trade tensions and a Fed that may be more prone to policy mistakes going forward. We are particularly mindful of having any overconcentration to individual sectors, as trade spats can have catastrophic effects on individual industries and sectors. We have increased exposure to emerging markets and commodities as we believe that increasing inflation expectations should be supportive of commodities and commodity-driven emerging market economies.