What happened in stocks?
The ongoing rally in the stock market suffered a setback over the last several trading days. It was triggered mainly by a combination of rising interest rates and inflation fears creeping into the market based on last week’s Federal Reserve meeting and the positive jobs report. Exhibit 1 illustrates a pick-up in volatility that has been building for some time, suggesting market uncertainty had been growing as we entered the new year. It looks like the age of tranquility is coming to an end.
Some perspective on recent events
To put recent market events into a wider context, year to date, there have already been four instances when the equity market moved 1% or more compared to ten in all of 20171 , again perhaps foreshadowing some swings in financial markets. At this point, it is unclear how steep or sustained this correction will be; however, there are several factors that may act as counterweights to a sustained downturn in equities. Strong GDP growth, continuing strength in corporate earnings and residual momentum provided by the new tax legislation all create a positive fundamental environment for stocks.
Interest rates rising and Fed policy may be turning hawkish
Also appearing on the domestic landscape is the long-awaited shift in interest rates. Exhibit 2 shows the upward trend in the yields of the 10-year and 2-year U.S. Treasurys, with both benchmarks hitting multi-year highs recently. The Tax Cuts and Jobs Act of 2017 has been a key catalyst in driving rates higher in 2018, as its enactment has poured gasoline on the fire of economic expansion. Fed rate hikes, at least in the short term, have also helped the yield curve rise, along with some evidence, primarily through wage data, that inflations is starting to trickle into the economy. Global growth has been strong as well, leading central banks to consider removing their own quantitative easing measures and to start raising rates around the world. Most recently, the Federal Reserve stated at its meeting last week that it would “carefully monitor” inflation, raising the issue of a potentially overheating economy for some investors. Such concern has typically led to tighter monetary policy by the Fed and many market participants now expect up to four rate hikes this year. In addition, strong January employment numbers on Friday showed wage growth at its highest level since 2009.
Remain calm and stay invested
We have thought for some time, given market valuations (the current forward 12-month price-to-earnings ratio for the S&P 500 is 17x compared to its 5-year average of 16.5x), that a correction was likely and could even serve as a helpful catalyst in transitioning the market towards a more normal environment, and possibly extending the bull market. Additionally, the return to a more normal market—and the end of tranquility—is a good reminder that a diversified portfolio is a time-tested way to provide some protection from market volatility. This is an occasion for investors to remain calm, bringing any of their concerns to their financial advisors before making changes to their portfolios.