Its About Time

Posted by on 02/07/18 in Behavior, Markets, Risk

While only a few weeks have passed since sharing our 2018 Outlook, the recent market volatility creates a timely opportunity to revisit our process and near-term sentiment, and to add context to recent events.

Following an unprecedented period of steady stock gains and ultra low volatility, it is almost a relief to see what is currently only a small correction—historically quite normal and well overdue. Corrections are a healthy part of markets, keeping investors honest and limiting speculation. The recent market events also highlight the importance of a well-grounded and disciplined process. We build our market sentiment based on a three-year time horizon, and the issues bubbling up in recent weeks have been on our radar for years now.

The contrast from last year’s tranquility makes it all too easy to focus on the symptoms–market declines and volatility– but we are more interested in the causes. Market volatility alone is no reason in itself to take action. In fact, sorting through the details from Monday’s stock market sell-off reveals that several volatility-oriented Exchange Traded Funds (“ETFs”) likely added to the surge in volatility. The market is now wrestling with multiple valid issues that should be addressed, but none of them are cause to alter a thoughtful long-term investment strategy.

The source of market uncertainty this time is due to a series of generally positive developments in labor markets and economic growth, which seems oddly fitting given that in recent years, frequent bad news pushed equity markets higher on investor expectations for more central bank stimulus.

Currently, at least some investors are concerned that wages will rise and stoke inflation; the US Federal Reserve (the “Fed”) will be forced to raise rates more quickly, and that growth, inflation, and the Fed combined will push interest rates higher.

In moderation and during the later stages of an economic cycle, each of these possibilities would be normal and healthy. Wages, inflation, and interest rates have been severely depressed for years and inconsistent with broadly positive global growth and healthy labor markets. We cover these topics in detail within both our 2018 Outlook and 2018 Capital Markets Forecast.

The concerns expressed by some investors over higher wages are valid, but should create only modest headwinds to corporate margins and have the added benefit of supporting inflation. Speculation on the pace of Fed action is nothing new. For the last several years, markets have priced in a more dovish pace of interest rate hikes than the Fed’s own forecasts. The potential for the Fed to move too quickly or too aggressively are risks we are closely monitoring. That said, it will take several years—not weeks—before we know how skillfully the Fed can navigate the shift to tighter monetary policy. Lastly, the higher interest rates that we have seen over the past month appear justified to us; however, a host of structural factors, discussed in our 2018 Outlook, should limit how high rates can go.

This shift in mindset towards higher wages, inflation, and interest rates was overdue. Like any shift in thinking, it will take time for market participants to process these changes and develop new sentiments. Fundamentals for the global economy and corporate profits do not change overnight and currently remain highly supportive of risk assets such as equities and real estate. Headwinds from the above concerns are normal for this stage in the cycle and consumers and companies are well-positioned to face those challenges effectively. A normalization of interest rates and more frequent volatility can even help to keep in check excesses of all kinds and prolong the economic cycle.

As we move later into this economic cycle, there will many more opportunities to test our process; for now, we recommend that investors stay fully invested in the strategy and allocation that best reflects their long-term objectives. We believe speculating on the direction of short-term events that have not occurred and cannot be easily predicted is a loser’s game. Just think how much has changed over the 72 hours during which we have been writing this piece!