Quarterly Market Wrap:

Volatility Returns In 2018- Remy Blaire (15/05/2018)

NEW YEAR, NEW TRENDS

The days of kicking back and watching the equity market hit new record highs came to an abrupt halt in 2018. Instead of cheering yet another record level for the Dow Jones Industrial Average, the S&P 500 or the Nasdaq Composite Index a new trend emerged: wild swings that would propel equity averages higher one day and then pull them lower the next. It is no longer abnormal to see several sessions of losses followed by a day or two of recovery and a convoluted mix of ups and downs.

Volatility finally returned from its extended vacation this year and announced its presence with unabashed intensity. The low volatility stock market rally chose to exit stage left as we embarked on our year-end holiday celebrations and cheered the annual growth in our portfolios. Little did we know how soon the calm would be coming to a screeching halt.

WHIPSAW MARKET: HANG ON TIGHT FOR ROLLER COASTER RIDE

The first quarter started out on a positive note with January’s stock market performance bringing yet another record high and further gains for the equity indexes. The popular narrative included caution over the heightened euphoria and grumblings over the impossibility of an extended bull market run. At the same time many market players opined that strong equity market gains at the beginning of the year usually equate to gains for the rest of the year.

Fiscal stimulus measures and optimism over U.S. tax cuts helped lift global bourses and bond yields in the first month of the year. While global growth continued, the potential for mild risks to the business cycle began to garner attention. Expectations of monetary policy changes by the world’s central banks hang amid the backdrop of trade tensions and uncertainty over regulation and policy over technology companies.

The first week of February kicked off with unexpected velocity as bond rates spiked and equity markets nosedived. The global growth story and corporate profits were intact but inflation fears became prominent and volatility instruments took a hit. On Feb. 5 the Dow Industrials tumbled 1,175 points after sliding as much as 1,600 points marking the largest intraday decline on record.

Ahead of the Easter holiday weekend U.S. equity averages settled in negative territory.

For Q1 2018 the Dow Jones Industrial Average lost 2.3% while the S&P 500 declined 1.2% and the Nasdaq Composite extended its seventh straight quarter of gains adding 2.3%. The Dow and S&P 500 failed to notch ten consecutive quarters of gains while the Nasdaq managed to advance for seven straight quarters.

Now that the DJIA snapped its longest winning streak since 1997 what does this mean going forward? More reasonable stock market valuations can be expected but for now it would make sense to pare back on expectations for long-term returns.

EARNINGS MOMENTUM RELIEF SHORT-LIVED

The beginning of earnings season brought focus back to factors affecting corporate fundamentals. Performance for most corporations beat estimates as widely expected but it is telling that profit forecasts for the upcoming quarters have been eased.

According to the latest data from FactSet, the S&P 500 forward 12-month PE ratio stands at 16.6 as of April 20, 2018.[i] The level is above the 10-year average of 16.1. At the same time the debt to total equity ratio is at its highest level since 1999. So keep an eye on how credit conditions affect buybacks.

S&P 500 Forward 12M PE Ratio. Source: FactSet, Date: April 20, 2018.

The 10-year Treasury note yield topped the 3% level on April 24, 2018. The psychological level had been eyed with plenty of frenzied anticipation. This is the first time since January 2014 that the yield cleared 3%. As the yield rose and U.S. equity averages declined there was plenty of dissent about the Fed tightening cycle, economic growth and inflation expectations. It is important to keep in mind that global bonds will also feel the effects of central banks removing stimulus measures.

GOLD: WATCH THE VOLUME

Gold futures managed to post a gain in Q1 2018 to mark its third consecutive quarterly advance. To put the uptick in perspective it should be noted that the latest quarterly gain was the smallest recorded since 2011. Gold managed a gain of just 1.03% while other precious metals failed to post a gain. Silver lost 5.1% while platinum pulled back by nearly 1.2% and palladium slid a staggering 11%.

Prices hit a two-year high in the second week of Q2 pushing gold’s advance over the 3% mark for the year.

Gold prices are utilized as a gauge of investor risk appetite under normal trading conditions. As a new quarter gets under way the equity markets continue to see plenty of swings to the upside and downside. Traditionally gold is seen as a hedge against inflation.

Gold prices are a long way from their all-time record high of $1,917.90 an ounce seen in 2011. Nevertheless, gold has outperformed the stock market in Q1 2018 and continues to edge higher. Any breakout to the upside will be eyed as, perhaps, an indication of the broader market outlook.

In addition, gold contracts continued to see record volume in Q1 2018. Surprisingly the latest quarter extended volume records to mark the fifth consecutive quarter of an increase in volume. While volume itself is not an indicator of future price action it is telling of the conviction of any move, especially when there is a technical level that is surpassed or broken.

Despite the extended increase in volume for gold contracts and the slow trek higher for prices, the move into the precious metals and related ETFs has not been as positive as one would expect. This may be another sign that there are no major issues on the horizon for the equity markets.

Spot gold may seem to be stuck in a perpetual consolidation range while prices play tug-of-war with bullish and bearish phases. In the meantime, the technical levels will continue to serve as a test of strength over the central line.

OUTLOOK: TOLERANCE FOR RISK OR IMMUNE TO WARNING SIGNS?

Q2 2018 got underway with notable volatility in the broader market. Fears of a trade war and geopolitical risk kept investors on their toes. The market-moving headlines and accompanying uncertainty continued to push and pull the tide. Trade developments between the U.S. and China, ongoing geopolitical disputes over Iran and Syria, and sanctions on Russia will remain in the headlines for the foreseeable future. Ahead of Trumps’ meeting with North Korean leader Kim Jong Un it appears as though de-escalation of hostilities between North Korea and South Korea is unfolding by the hour. For the time being, the pause button has been hit on saber-rattling.

The first reading of Q1 2018 U.S. GDP expanded at an annual rate of 2.3%, surpassing expectations but coming in below the prior quarter’s reading of 2.9%.[ii] A slowdown in consumer spending contributed to the pullback in the latest quarter. The Trump administration’s tax package has yet to be fully realized by American households as paychecks didn’t reflect the cuts until well into the first quarter. With the trifecta of the labor market nearing full employment, lowered tax rates and an uptick in government spending, U.S. GDP may reach 3% in 2018.

At the same time, Fed economic forecasts are on the horizon and, in turn, their implications for the broader market. The Federal Reserve will meet on May 1-2 and its policymakers are sure to incorporate the data from the first Q1 GDP reading. At the March meeting the FOMC raised interest rates and announced expectations to raise rate two more times in 2018. The Fed also increased its median estimate for annual GDP to 2.7% at its latest meeting.

Corporate earnings season will soon draw to a close with ongoing observations about valuation relative to earnings. Market volatility will continue but it is the fundamentals that will shape the bigger picture.

[i] S&P 500 Earnings Season Update. Source: FactSet Insight, Date: April 20, 2018.

[ii] National Income and Product Accounts

Gross Domestic Product: First Quarter 2018 (Advance Estimate). Source: https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm Date: April 27, 2018.