When we as investors began 2018, we were tuned in to the recent fiscal policy changes that were expected to propel economic activity and the financial markets higher in the coming year. The handoff in leadership from monetary policy to fiscal policy was well underway as a driver of consumer spending, business investment, and corporate profits. Instead of depending on the Federal Reserve (Fed) to move this expansion forward, fiscal incentives are now critical for continued growth, with the new tax law taking the lead.
We often don’t see massive change without a little drama, however, and thus we expected this shift to come with a rise in stock market volatility after a very quiet 2017. Volatility would be normal, even healthy, as a sign that market forces were playing a larger role in directing the economy and stock prices and the accustomed support from the Fed was slowly fading into the backdrop.
The first half of 2018 broadly played out in line with out views. The shift to fiscal policy leadership, through changes in the tax code, deregulation, and increased government spending, were initially well received by markets. Then, as it is often the case, investors grew concerned about the costs of these benefits, namely, Fed tightening, higher deficit spending, and the potential impact on inflation. As a result, early in the year we saw the S&P 500 Index’s first decline of over 10% since the Brexit vote in June 2016.
The stock market has been recovering since then. Although we believe the benefits of a return to the business cycle may further support markets and reward patient investors, navigating the volatility of a normal business cycle environment is something we haven’t seen in some time. This adds a layer of complexity to our current late cycle environment and the challenges we’re facing, such as trade tensions and upcoming midterm elections. There’s also the potential for greater market sensitivity due to the late cycle concerns that can emerge when the economy is doing well. Peaks in manufacturing and earnings, along with higher short-term interest rates, all reflect a healthy economy, but they can also lead investors to wonder if that means this is as good as it gets.
So indeed, the plot has thickened. But that doesn’t mean we’ve taken a turn for the worse. The underlying forces are still forging ahead and this expansion and bull market have not been defeated. And, when we think about these potential obstacles, we should try to remember that challenges can be overcome and they may not signal the end of the story. Volatility means ups and downs. So it doesn’t need to be the villain we fear; instead, we should embrace it and strategize accordingly.
It’s also important to think of the big picture. Right now, there are many positive fundamentals, like business investment and corporate profits. Supporting economic growth and potential market gains. With that backdrop, periods of weakness can be used as opportunities. Employing more active portfolio strategies, focusing on the beneficiaries of the shift from monetary to fiscal leadership. And positioning well-balanced portfolios for the long term are several ways to do this.
The LPL Research Midyear Outlook 2018: The Plot Thickens presents guidance on how the return of the business cycle may unfold during the remainder of 2018 and beyond, along with the investment insights to help investors navigate the twists and turns.