May 1, 2018
Adrian Cronje, Ph.D., CFA
Chief Investment Officer
All good things must come to an end. The unusually long period of calm which presided over stock markets came to a screeching halt in late January with a sharp correction of nearly 10%. Investors finally conceded the “goldilocks” (not too hot, not too cold!) economic environment could not continue indefinitely. Questions of whether accelerating economic growth with tight labor conditions would spark wage pressure and inflation led bond markets to price in the possibility that the Federal Reserve would have to raise interest rates more quickly than previously anticipated. Long-term interest rates rose to reflect these concerns, and investors wondered whether corporate earnings growth would be enough for stock prices to continue their ascent.
Adding to the angst is the risk of a global trade war, regulation of the technology sector after Facebook’s alleged misuse of customer data, and the seemingly endless political chaos emanating from Washington. As difficult as stock markets were in the first quarter, bonds fared worse with rising interest rates. As such, diversified strategies with uncorrelated return drivers (e.g., reinsurance, alternative lending, and real estate) outperformed public market strategies for the first time in quite a while.
The return of market volatility, despite its potential to unsettle investors, is a healthy sign of markets transitioning to a more “normal” environment. In fact, none of the telltale signs of a major market top are presenting themselves. Though short-term rates appear set to rise by another 1% over the next year, credit spreads remain relatively tight, and the yield curve has not yet inverted, indicating the Fed’s monetary policy stance has not become overly restrictive. Against this backdrop of gently rising interest rates, corporate earnings growth must continue to exceed expectations if stocks are to remain attractive relative to bonds.
The often contradictory and misleading headlines of the first quarter mask an important development occurring beneath the surface. The trend of greater performance dispersion across various segments of global stocks continues, providing a greater opportunity to add value by picking and choosing areas of emphasis. While the rising tide in 2017 highlighted the opportunity cost of holding strategies with uncorrelated returns, the first quarter offered a glimpse into the benefits of diversification.
Despite heightened volatility, the current economic cycle passed a significant milestone in April: We are now officially experiencing the second longest period of uninterrupted expansion since the 1850s. Only the expansion of the 1990s has lasted longer. Capital markets are grappling with whether the pro-growth fiscal and deregulation policies implemented by the Trump Administration will serve to boost business investment and productivity growth, characteristics which helped to sustain the previous boom. If productivity and business investment are to reemerge, it could create additional capacity for the current cycle to continue without aggressive interest rate hikes by the Fed.
However, given the second longest and strongest stock bull market since the 1920s, today’s valuations for most public market asset classes imply tougher sledding ahead. As this cycle matures, the economy may finally begin to outpace capital markets.
For now, the evidence suggests that it is premature to position portfolios for the end of the current expansion and bull market. The first quarter’s overdue gyrations simply look like a pit stop to a new high for stocks in the coming months.
The yield curve is said to be “inverted” when short-term rates exceed long-term rates for bonds of the same credit/quality because bond markets expect short-term interest rates to decline in the future in response to future economic weakness.
Source: The National Bureau of Economic Research since it began compiling data in the 1850s.