Volatility Returned – Roof Advisory Group’s MarketView
After the best January start in almost 30 years, volatility returned to equity markets with a vengeance. February snapped the S&P 500 Index’s longest monthly winning streak since 1959 and ushered in the first 10% correction in two years. Markets gyrated wildly in both directions for most of the quarter as investors grappled with a confluence of fears – ranging from rising interest rates, inflation concerns, unsettling turnover of senior White House staff, escalating global trade tensions and declines in high-flying technology stocks. Equity markets finished the quarter modestly in negative territory marking the first quarterly decline for the S&P 500 since the fall of 2015.
Bonds did not provide the typical cushion to stock market declines. Fixed income performance was negatively impacted by rising interest rates which could be linked back to inflation concerns. Long maturity bonds declined significantly more than short and intermediate-term bonds and cements our decision to avoid the long end of the maturity range within the fixed income universe.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
We saw a disconnect between solid economic and corporate fundamentals and equity market results. Focusing on the real economy, payrolls are soaring, jobless claims are at the lowest level in 45 years, forecasts for the U.S. and global growth continue to be ratcheted higher, and both the manufacturing and services sides of our economy are growing at well above-trend levels.
Despite the decline in equity markets, estimates for corporate earnings growth increased steadily throughout the quarter. Analysts expect almost 18% year-over-year earnings growth for S&P 500 companies for the first quarter. This would represent the best result in over seven years. And estimates for the full year are even stronger.
This commentary may seem a bit optimistic given recent market’s volatility, risks, and concerns. We cover a number of those issues below. However, the real economy is doing well.
We ended 2017 with our equity allocation at the one step above mid-point level and maintained that position until mid-February. With the backdrop of a 10% equity market correction, more attractive valuations, solid economic fundamentals and expectations of stellar corporate earnings growth we used the weakness to increase our equity allocation. We ended the quarter with all investment policies positioned at maximum equity levels. Engrained in our decision to increase equity exposure is a view that at some point markets will refocus on the positive fundamentals mentioned above.
Fixed income allocations were reduced in February to fund the additional equity purchases. We continued to reduce our duration to further insulate portfolios from the negative impacts of rising interest rates. With the likelihood of additional interest rate hikes by the Federal Reserve, strong economic growth and a pickup in inflation readings we remain comfortable with our short duration stance.
The first quarter presented a challenging investing environment. With domestic and global stocks as well as bonds all posting modest declines in the quarter, it should be no surprise that our portfolio results were also slightly in the red. However, performance results were better (less negative) than both stock and bond market indices. Several key performance drivers are detailed below.
- Fixed Income – Our fixed income allocation was relatively insulated from declines due to our limited interest rate risk exposure. Our results here were much better than broad bond market indices and exponentially better than performance results of long maturity bonds.
- Growth and technology stocks – Despite the late March selloff in certain segments, the quarterly results from the technology sector and growth-oriented stocks still firmly outpaced the S&P 500 Index and was a positive contributor to portfolio results.
- Value stocks – Value stocks lagged the broader market driven by significant underperformance in the telecom, utility and energy sectors. While this outcome fits into the detractor category for performance results, these are small segments of the market and areas where we are generally carrying less than market level exposure.
The first quarter felt like a classic heavyweight boxing match with both fighters landing damaging blows but unable to end the fight with a knockout victory. We may continue to see more of this slugfest as the year continues as the bulls and bears struggle for the upper hand. Both can cling to market narratives that support their views.
In the bull corner, we have strong synchronized global growth, robust employment growth, soaring confidence levels, best corporate earnings and revenue growth in seven years, and valuations that are now more in line with long-term averages.
The bear corner can point to a bull market that is long in the tooth, the potential for full-scale trade wars, political turmoil, rising interest rates and more difficulty maintaining the same velocity of economic and earnings growth after 2018.
We do not dismiss or take lightly any of the bear case arguments. But our views and corresponding portfolio positioning is tilted towards the bull case which we feel is more representative of the underlying fundamentals.
To say there is a lot going on in financial markets right now is an understatement. The information above provides a brief overview of some of the recent developments.
Inflation Concerns Justified?
The initial catalyst for the late January/early February market correction was higher than expected wage growth data associated with the January employment report. This kicked off concerns about inflation forcing interest rates to move higher and at a quicker pace than previously expected and fears of inflation taking a bite out of corporate profits.
Below is a longer-term view of inflation using 20-year CPI or Consumer Price Index data. Inflation has increased from anemic levels which is reflective of a strong economy and a significant rebound in energy prices. But overall current inflation rates are roughly in-line with average levels over this extended period. The data does not point to runaway inflation.
Another important component in the inflation equation is corporations’ ability to grow their top line revenue. Are companies able to benefit from strong economic activity and grow their revenue more than the inflation rate? Below is a graph of revenue growth for S&P 500 companies over the past several years and estimates for 2018 (shaded green bars). S&P 500 companies are experiencing the best revenue growth rates in over seven years and future estimates are encouraging as well. Corporations seem well prepared for a return to normal inflation levels.
Source: Standard & Poor’s
Corporate Earnings Growth
We mentioned a disconnect between solid fundamentals and negative stock market returns. Below is a chart that really highlights this statement. Here we show the performance and quarterly decline of the S&P 500 Index (blue line) compared to the multiple increases in expectations for the first quarter corporate earnings growth rate (orange line).
Investors may have brushed off the positive earnings picture in the short-term. But we remain focused on the long-term and well-proven link between corporate earnings and stock market performance.
Source: Morningstar Direct and Zacks Advisor Tools.
Short Duration or Why We Avoid Long Maturity Bonds
We talk a lot about our “short duration” positioning and avoiding long maturity bonds within our fixed income allocation. The first quarter performance results across different maturity ranges provide a solid example of why we maintain this stance.
If we remember our bond math, as interest rates rise, bond values fall. And longer maturity bonds have greater sensitivity to changes in interest rates, or more simply they tend to decline more than shorter maturity bonds in a rising interest rate environment.
The graph below illustrates the first quarter results using various maturity ranges of U.S. Government bonds. Short dated bonds held up much better. With the relatively modest increase in interest rates in the quarter, longer maturity bonds declined by a greater amount than the annual yields offered by those bonds.
We remain focused on protecting capital in a rising interest rate environment and continue to feel as though longer maturity bond yields are not attractive enough at current levels to increase our interest rate risk.
Source: US Treasury. Performance calculated from iShares 1-3 Yr Treasury Bond ETF, 3-7 Yr Treasury Bond ETF, 7-10 Yr Treasury Bond ETF, 10-20 Yr Treasury Bond ETF, 20+ Yr Treasury Bond ETF.
Bond Returns in a Rising Interest Rate Environment
Investors might be asking themselves – why do I want to hold any fixed income in a period of rising interest rates? While there are several immediate and obvious answers – including – income generation and reducing portfolio volatility, the graph below also provides a good visual answer to this question.
This graph covers the period of 1954-1981 when U.S. intermediate maturity government bond yields (orange line) increased from roughly 2% all the way up to 14%! However, annual returns (blue bars) were positive in 23 out of these 28 years. And the negative years (red bars) weren’t very severe.
The point is that the pace of the ascent matters too. During this period investors were able to frequently reinvest maturing bond proceeds into bonds that offered higher and higher interest rates. And those higher interest rates and coupon payments were significant contributors to the total return.
Source: The Schwab Center for Financial Research with data provided by Morningstar, Inc. Shown in the chart are the yield-to-worst and annual returns including price change and income for the Ibbotson U.S. Intermediate-Term Government Bond Index. Past performance is no guarantee of future results.
Trade Wars or Negotiation Process?
Investors have been rattled by announcements of steel and aluminum tariffs and more recently tariffs of $50 billion on Chinese imports. Compounding concerns has been the direct and rapid response from China with their intentions to fire back with reciprocal tariffs of $50 billion on the U.S. imported good.
Fears of an outright trade war are justified. We haven’t seen one in over 90 years and the economic impact was decisively negative. The question here remains – are these actions the start of such a trade war or the opening salvo to a negotiation process? We don’t know the answer but are monitoring developments closely. Here are some points that lead us to lean towards the outcome of the negotiations.
- The Trump administration has already granted “exemptions” to the steel and aluminum tariffs for most of our major trading partners.
- The tariffs on Chinese goods aren’t scheduled to go into effect for roughly two months. And China has indicated that they will hold off on implementing their tariffs until ours are in place. This two-month window was officially established to allow for public comments and consultations but could also be a good opportunity for negotiations and for cooler heads to prevail.
- Both sides have openly expressed willingness for negotiations.
Volatility Returned in Context
Yes, we have shown this chart several times. But it often helps to put near-term volatility and market declines into context. As indicated in the chart, the average intra-year decline (red dots) over these 38 years has been 13.8%. In comparison, the biggest drop in 2017 was a whopping 3%.
With the first quarter stock market correction and the wild daily swings, it certainly appears that we are transitioning back to a normal volatility environment. The massive and often seemingly schizophrenic market gyrations have felt uncomfortable, painful and gut-wrenching at times, but the volatility returned viewed in the context of historical outcomes, we are not in uncharted territory.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refer to the largest market drops from a peak to trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2017, over which time period the average annual return was 8.8%. Guide to the Markets – U.S. Data are as of March 31, 2018.
Volatility Returned MarketView is written by Dan Eye, CFA, Roof Advisory Group’s Chief Investment Officer.