Volatility returned to markets in full force in February, and the reversal of some very crowded trades led to a 3.7% decline for the S&P 500. Macroeconomic fundamentals however, remain sound, in our view. Despite some uneven data points in recent weeks, we maintain our positive stance on the market and continue to believe that strong corporate profits can carry stocks higher.
Stocks corrected in early February. In our view, this was largely a function of equities having been overextended following the run up through January. We believe that the unusually long period of market stability resulted in too many investors crowding into low beta and low volatility strategies, leaving these areas ripe for correction. While sharp declines and surging volatility are not ideal for markets, we currently are not overly concerned, as we view these conditions as largely technical in nature rather than reflecting weakness in underlying fundamentals.
Inflation has been a focal point for investors of late. Markets appeared to be caught off guard by the 2.9% wage growth reported for January, and yields moved abruptly higher in the aftermath. Subsequently, both the CPI and PPI for February printed numbers ahead of consensus expectations. These data points have heightened concerns among certain investors that the Fed may be behind the curve with regards to its interest rate policy and may have to ramp up the pace of rate hikes as a result.
However, we note that while inflation has surprised investors by moving incrementally higher, its absolute levels are still modest by historical standards. Moreover, we would expect that the yield curve would flatten if markets were truly signaling a policy mistake, but that has not been the case. In fact, the yield curve has steepened in recent weeks. Should inflation to move sharply higher from current levels, we would expect valuation ratios to compress and stocks to decline. We are therefore keeping a close eye on consumer prices and other inflation indicators, and stand ready to act should conditions warrant.
President Trump’s decision to impose tariffs on steel and aluminum imports – 25% and 10%, respectively - has rekindled investor concerns about potential trade wars. While some industries will likely benefit from these policies, we believe that they may also have the potential to negatively impact the aggregate economy. That being said, we are more keenly focused on trade as it relates to the NAFTA negotiations, which, while ongoing, grant Mexico and Canada exemption from the tariffs. We are closely monitoring these talks to better understand how US trade will be impacted in the coming years.
We maintain our positive stance on the market. With consumer sentiment strong, job growth continuing apace and wage growth accelerating, we would expect to see healthy consumer spending this year, which in turn should boost overall economic activity. A healthy economic backdrop should help to sustain what has been a very strong period for corporate profits. In this regard, we note that following the robust fourth quarter earnings season, analysts have hiked their earnings estimates for both this year and next. With consensus S&P 500 forecasts now in the low to mid $170’s for 2019, the market’s forward PE is a reasonable 15.5x as of this writing. This is noteworthy as valuations had become somewhat extended in recent months, but the combination of higher earnings estimates and a pullback in the market has left stocks more reasonably valued, in our view.
While we are not concerned with inflation levels at the moment, a potential spike in inflation remains a key risk. The latest CPI reading came in at 2.1% - essentially in line with the Fed’s 2% target – and if sustained, would be quite comfortable for markets, in our view. However, with unemployment having been at very low levels for some time now, it is not difficult to conjure a scenario in which inflation moves materially higher, perhaps exacerbated by the recent tax reform which is expected to give a further boost to economic activity. With bond yields still low by historical standards, we would expect them to move higher in this scenario as well. Most notably, the Fed may have to accelerate its planned rate hikes. While this is not our base case, it is one which would likely roil markets and we will therefore continue to monitor pricing pressures closely.
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