May Investment Update: Volatility, Growth, and Interest Rates

In many year-end reviews last December, we discussed with several clients that while we did not know when it would occur, a correction was likely, and would be healthy for the markets as it would shake out the weak hands of short-term traders and form a foundation on which the market could build. In addition, we told many clients to expect lower returns over the near-term as strong markets in 2016 and 17 had likely “borrowed” some returns from the future. Fast forward 5 months later and on May 1st the market closed at roughly the same level as December 1st , 2,644 on 12/1/17 vs. 2,649 on 5/1/18 (Yahoo Finance).

While these two dates might suggest that the market has been flat or inactive over this time, many of you know the reality has been anything but. 2018 has seen a reemergence of volatility with a February uptick in volatility playing a role in the start of the 10% market correction . Through this time, the market has seen multiple periods of large gyrations, both up and down, but the market now finds itself as previously stated roughly back where it was in December of 2017.

Now that we have painted the picture for what prices have done, we thought it would be helpful to describe the fundamental backdrop as well. On the back of the tax cuts passed at the end of 2017, the S&P 500 is on track to record the best quarter for earnings growth since Q3 of 2010. Through April 27th, S&P 500 companies reported Q1 earnings growth of 23.2% (FactSet).

Perhaps more importantly however, is the resurgence of revenue growth. Through the same period, the S&P 500  recorded Q1 revenue growth of 8.4%, the highest mark since Q3 of 2011 (FactSet). Because revenue growth is not directly influenced by the tax cuts, it gives a better picture for true demand growth in the corporate economy. Time will tell if sales growth will sustain, but it appears possible that we are seeing the ignition of genuine demand growth, which would be a strong positive for the equity markets. This combination of flat prices and improving fundamentals leads us to believe that for the long-term investor, equity markets have become increasingly attractive.

Turning an eye to fixed income, 2018 thus far has been a difficult year for bond investors. The combination of Fed rate hikes, and higher than expected growth and inflation data has led to increasing bond yields across the yield curve, including the notable cross of the 10 year Treasury above 3%. This has created lower bond prices for investors (as bond yields rise, prices fall). Over the short term, we think this is likely to continue as yields re-set higher. However, if fixed income investors can accept this and re-invest coupons as yields rise, the result will be higher yielding bond portfolios, and thus higher expected returns in the future.

Looking ahead, we believe broadly diversified portfolios stand to benefit as the international profit cycle appears to still be in its early stages, potentially offering diversification benefits for global investors. Additionally, we would favor the short end of the yield curve where you can get more than 2.5% yield (2 yr. US Treasury bond yielding 2.57% as of 5/15/18 per CNBC) without the interest rate risk of longer-term bonds. We believe the bumpy ride will continue in the equity markets, but think a recession is likely a discussion for 2019 or 2020. As a result, we would not be surprised to see higher equity prices by year end.

May 2018