• The recent stock market decline started over concerns of rising interest rates and inflation; technical trading mechanisms accelerated the move down. Fundamentally speaking, however, nothing has changed materially over the last several days.
• Without a significant pullback since January 2016, stocks have delivered exceptionally high returns, particularly last year. We believe that this is a case of stocks going through a healthy pullback that is long overdue, rather than the start of a bear market.
• We are still optimistic about the markets going forward. Although higher inflation and interest rates could lead to more market volatility, we don’t expect this to derail the economy anytime soon. Times like this provide long-term investors the opportunity to invest cash and rebalance their portfolios.
What Happened in the Markets and Why
Stock markets have risen since February 2016 without any significant disruption until now. Stocks started to move down on January 26th, but their declines quickly accelerated during the first few trading days of February. The initial catalysts for the decline in stocks were higher interest rates and inflation expectations. Stock market volatility gained momentum as fear spread across markets around the world, and declines compounded with sharp intra-day dips in stocks likely driven by automated computer algorithm trading.
So, what started as a decline based on investor concerns over fundamental market and economic conditions (i.e., rising interest rates and inflation) eventually evolved into declines driven by technical trading mechanisms. The good news is because it is not based on fundamental realities (such as earnings and economic growth that ultimately drive long-term market returns), market movement that is driven by technical trading is usually short-lived.
Fundamentally speaking, nothing has changed materially over the last several days. Data still suggest that economic growth around the world is solid and corporate profits in the U.S. and abroad are strong. According to FactSet, around 80% of U.S. companies in the S&P 500 that have reported fourth-quarter earnings as of this writing, announced better than expected results.
The reason that investors are generally concerned about a rise in inflation, particularly in the U.S., is that at a time of near full employment and accelerating economic growth, the U.S. Federal Reserve (the Fed) is likely to raise interest rates faster than expected. Adding to these concerns is the uncertainty around the new chairman of the Fed, Jerome Powell, who was recently sworn in. Although the new chairman hasn’t given any indication that he will be more aggressive with raising interest rates, investors will likely be on edge until they get more familiar and comfortable with his line of thinking.
Investors Need to Look Back
Rising interest rates are not bad for the market and economy as long the absolute level of interest rates is relatively low, and rates are increased at a gradual pace. Although borrowing costs go up for consumers and businesses, history shows this doesn’t start to negatively impact markets and the economy until long-term rates are much higher than they are today. Additionally, rising rates tend to negatively affect markets when rates are increased quickly. However, the Fed has provided plenty of guidance that it plans to raise policy rates gradually over the next few years. Looking back over the last two years, they have delivered on that direction, and we don’t expect that to change this year.
Before the recent declines, we need to remember that stocks delivered exceptionally high returns, particularly last year. Improved growth drove a lot of it, as well as expectations for further growth. But without a significant pullback since January 2016, we can reasonably conclude that stocks got ahead of themselves. This often happens, which is why it is typical for stocks to experience significant declines during bull markets. We believe that this is stocks going through a healthy pullback that is long overdue, rather than the start of a bear market.
Our Market and Economic Outlook Has Not Changed
We are still optimistic about the markets going forward, but higher inflation and interest rates could lead to more volatility (please see our 1st Quarter 2018 Investment Perspective). We expect global economic growth to continue and moderately accelerate in 2018 . Almost all the various economic indicators we monitor are trending in a positive direction, and there are no imminent signs of a recession.
Considering our outlook that markets are inevitably going to recover given solid fundamentals, we think that situations like this are times to consider accelerating the investment of available cash into both stocks and bonds to achieve target asset allocations. As usual, for portfolios that are already fully invested, we are monitoring and rebalancing those that have materially deviated from their target allocation. Managing a portfolio in a disciplined manner and sticking to one’s long-term investment plan usually result in better outcomes during times like this and others to come.
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