John Lynch Chief Investment Strategist, LPL Financial
Market volatility resurfaced in the first quarter of 2018, following the stock market’s calm and steady rise in 2017. This week’s Weekly Market Commentary recaps first quarter stock market performance, discusses some of the themes that were in play, and summarizes our outlook for the rest of the year.
A Look Back at Q1
Stocks fell slightly in the first quarter, losing 0.8% on a total return basis and ending a streak of nine quarterly wins for the S&P 500 Index. The return of volatility was the big story of the quarter (besides the bull market’s ninth birthday), as the index suffered its first 10% correction since January 2016. Weakness was driven by several factors that led to the return of market volatility:
- Federal Reserve (Fed) fears. Heightened concerns that the Fed would quicken its pace of rate hikes after a bigger than expected increase in wages was the primary catalyst that drove the stock market correction in late January through early February. In addition, markets tend to test new Fed chairs, as they did when Alan Greenspan, Ben Bernanke, and Janet Yellen began their terms. Jerome Powell’s introduction was no different; in fact, Powell’s welcome was one of the most unpleasant, with the S&P 500 tumbling more than 4% on his first day in the new role.
Our view: We expect two more rate hikes in 2018, as we suspect the worst of the pricing fears will fail to materialize. We believe a move higher in the 10-year Treasury yield this year will be gradual and therefore manageable for the equity markets as inflation remains under control.
- The short volatility unwind. Though not the root cause of the correction, the sell-off intensified because of a complicated and crowded trade where investors essentially bet on volatility staying low. Once volatility began to increase in late January, many market participants who had aggressively expressed that view were caught on the wrong side of the trade.
Our view: We believe the market disruptions from the unwinding of short volatility trades are largely behind us, though we continue to expect further, periodic bouts of market volatility over the course of 2018.
- Escalating trade tensions. If an aggressive Fed is perhaps risk number one for this market, protectionist trade policy is probably “1A.” Trade tensions escalated in March after several “tit for tat” tariffs from the United States, on an estimated $50 billion in Chinese goods, and from China, though only on about $3 billion in American goods. Though a full-blown trade war appears unlikely, uncertainty over trade measures and potential retaliatory actions may continue to weigh on investor sentiment. As discussed last week, we believe both sides have the willingness and wherewithal to negotiate.
Our view: Bilateral negotiations with China may prevent an all-out trade war. We are encouraged by the relatively small economic impact of the announced tariffs (approximately $40 billion) relative to the amount of fiscal stimulus going into the economy this year (estimated $700–800 billion).