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Ferris Capital is incredibly proud of our many community engagements and contributions to charitable organizations around the country. This blog is intended to share these many achievements as well as notable news from within the Ferris family and important financial updates that could affect our clients. Please check back often and don’t hesitate to call us if you’d like more information on anything you see here.

April 13, 2018

2018 Q1 Recap & Market Outlook

Capital Market Action Summary

Volatility is Back.

After a 2017 marked by record low volatility in the capital markets and an upside surprise in performance, 2018 began with a return to the levels of volatility closer to historical norms. January saw a continuation of the hot stock market only to see gains erased in February and most indexes turning negative in March. The chart below from Charles Schwab illustrates the relative calm in the markets which ended in late January with a selloff in stocks and a spike in the VIX Volatility index):  

We still believe that the underlying economy and fundamentals remain sound and that the fiscal stimulus effects of greater spending and the implementation of lower corporate tax rates should keep domestic stocks above water for the near future. Abroad, both developed market stocks and emerging market stocks started the year in much the same fashion as their domestic counterparts with developed market stocks just slightly trailing US stocks and Emerging Market stocks just ahead of both.

The downturn wasn’t confined to equities. Bonds also saw a challenging environment as rates shot up (+.50% on the Ten Year Treasury Rate by mid-February) on inflation concerns and the expectation of continued Federal Reserve rate hikes. In fact, this was the first time in the past four Fed rate raises where we actually saw the bond market respond to rising rates. The bond market was also hit with a slight pullback when credit spreads widened in the correcting market. We believe that the Fed will continue to raise rates in 2018 and that credit spreads (the rate over Treasuries demanded by investors for taking on credit risk) are still too tight and offer more risk to the downside than possibly helping high yield bond total returns.

As we’ve been saying for some time, the bulk of the risk we see in the capital markets is derived from geo-political concerns and we began to see evidence of that in the first quarter of 2018, with North Korean sabre rattling and the potential of a trade war with China spooking the markets. We believe much of the rhetoric is part of President Trump’s negotiating tactics: start on the end of the spectrum, act aggressively and then move to the middle to get a deal done. We will see if that is the case with the potential trade war with China, but unless China devalues their currency in response to US tariffs, we don’t see a meaningful trade war erupting as there are already exemptions being carved out for Canada, Mexico and potentially Europe. However, there will likely be some fear and panic as we move through the negotiating process. Even still, we are long way from the true trade wars of the distant past as evidenced in this chart from Blackrock:

Additionally, over the past sixteen months where we witnessed record low volatility despite the political turmoil in Washington of an ever-changing cabinet and no clear agenda. However, we are now seeing the market begin to react to political miscues, tariff announcements, and data scandals such as Facebook. While the swings can be concerning, it is normal market behavior. Plus, all is not negative in Washington. We’ve seen a recent spending bill that should quiet shut-down fears and provide fiscal stimulus to the economy and the switch to a new Federal Reserve Chairman, Jerome Powell, who seems up to the job thus far.

In the end, the first quarter proved challenging for almost every asset class as evidenced by the index returns detailed below. Nevertheless, the cooling off of a red hot market and the Federal Reserve raising rates can be expected.

Major Index Returns for the First Quarter of 2018

  • S&P 500 Index (Large Cap Stocks): -.76%
  • Russell 2000 Index (Small Cap Stocks): -.08%
  • MSCI EFAE Index (International Stocks): -1.53%
  • Barclay’s Aggregate Bond Index (Fixed Income): -1.46%

Outlook

While we are starting to see some signals that we are late in the economic cycle, we believe that markets will benefit from the recent tax reform, spending plans and continued trend of deregulation. Additionally, the recent correction along with the earnings revisions have brought the S&P 500 back down into a more normalized valuation. Much of the performance of 2017 was the pricing in of tax reform which investors knew would have a large impact on stock prices given the resulting impact on earnings. The two charts on the following page demonstrate just how impactful tax reform was to earnings:

We feel that the global bull market is nearing the end, but is not over yet and that investors need to remain invested as market timing is a very difficult, and oftentimes costly event. Remaining in the market even when it is at heightened valuations still breeds better results. Goldman Sachs illustrated this perfectly in their study of what would happen if an investor consistently cashed out when valuations were above the 90% mark and bought back in when they reverted to the 50% mark. As you can see below, investors would have been better off remaining invested rather than selling and waiting for more attractive valuations:

The biggest risk we see for returns in 2018 is policy mismanagement from the central banks. If rates are raised too quickly, we could see the return of recessionary forces. On the flip side, if the central banks remain accommodative in a time of low unemployment, we could see economies overheat and bubbles form. Beyond central bank actions, we also see risks of North Korean military tensions and a potential trade war with China as the other immediate concerns.

We also recommend staying in short term bonds until we see an additional rate raise or two from the Fed. At that point, we will consider adding back core and municipal bonds to our client portfolios as both have heightened interest rate sensitivity.

In summary, we continue to have a positive outlook for risk assets, but feel that investors should look to diversify away from US stocks to those with more attractive valuations to take advantage of the global economic growth. With the specter of 2-3 more rate hikes from the Federal Reserve in 2018, we intend to remain in less interest rate sensitive bonds until rates climb further reducing interest rate risk and increase cash flows. We also remain committed to our MLP position for now as we feel that it is only a matter of time until investors return to the sector. The secular case for master limited partnerships continues to improve and we feel that prices will catch up soon enough. Lastly, we anticipate an uptick in inflation in 2018 and expect our allocations to commodities to move up as they are one of the best inflation hedges available to investors.

 

Past performance is not necessarily indicative of future returns.  The performance described in this report is based on investment selections for the period in question.  There is no guarantee that these same investments will continue to perform as described.  All investing carries a risk of loss, including principal that clients should be prepared to bear.  Clients are advised to inform us of any changes in their circumstances, as such changes may materially alter the appropriateness of the investments selected by Ferris Capital.