First Quarter 2018: “March Madness” in the Markets

Written by John Cox, CFA, CAIA on April 3, 2018

First Quarter of 2018

The college basketball season just wrapped up its post-season tournament, also known as “March Madness.” Every year, there are upsets that are impossible to predict. Millions of fans get frustrated as their brackets are “busted” by underdogs that seemingly had no chance to beat a much-higher seeded team. For example, this year’s tournament was the first one ever in which a 16th seed defeated a number one seed in the first round. Just as picking a perfect bracket is virtually impossible, it is also very difficult to predict the markets in the short-term. There are, however, things that are controllable, such as saving as much as you can for retirement and having a spending plan that is in line with your net worth and income. While markets can be volatile and unpredictable at times, history has shown that discipline and patience is rewarded in the long run.

The first quarter of 2018 could be described as a period of many transitions in the economy and in the markets. On the heels of a very strong 2017, in which volatility was essentially non-existent, many investors expected a smooth 2018, given the momentum of strong corporate earnings and tax reform. If the first quarter is any indication, it’s going to be a wild ride this year. First, markets are transitioning from lower volatility and lower interest rates to higher volatility and higher interest rates. Next, the U.S. economy is transitioning from low inflation to moderate inflation. Furthermore, the Federal Reserve is not only transitioning to a new Fed Chairman (Jerome Powell), but it is also implementing an unprecedented program to reduce its balance sheet by not reinvesting the treasuries and mortgage securities that it owns. Finally, and maybe most importantly, the global economy is trying to digest whether a trade war is imminent, given President Trump’s recent discussion of import taxes on solar panels, washing machines, steel and aluminum. Depending on how it is implemented, it could lead to retaliation and ultimately higher prices for consumers.

In times of fast-moving news reports and headlines, it’s important to remember that attractive capital market returns inure to investors who focus on their long-term goals. We know that there will be ups and downs. For instance, from January 29 to February 8, 2018, the U.S. stock market experienced its first correction (10% decline from peak-to-trough levels) in about two years. While this was a stressful time for investors, those who were patient and chose to ignore the daily swings in the Dow Jones Industrial Average may be rewarded in the future because the fundamentals of the economy and market continue to be strong:

  • corporate earnings are projected to accelerate for the foreseeable future;
  • tax reform is expected to make the U.S. more competitive in the global economy, as well as put money in the pockets of most Americans;
  • small business owner optimism is near a 45-year high;
  • synchronized global economic growth is reflected in both Manufacturing and Service Sector reports; and
  • innovation is occurring at a rapid pace.

On the other hand, rising interest rates and the potential for higher inflation have become concerning. While stock market valuations are not at extreme levels, they are slightly above historical averages, thereby signaling that the next 10 years will likely not be as good as the returns experienced since the financial crisis ended in March 2009. After a non-volatile year in 2017, investors will have to be prepared for more normal movements this year and in future years. We will continue to have geopolitical events that cause discomfort, as well as headlines that cause stress and anxiety. The successful investor understands that markets have highs and lows, but the longer the investing timeframe, the higher the probability of positive returns.

In terms of recent market performance, the first quarter ended in slightly negative territory for most asset classes. The proxy for U.S. large company stocks (S&P 500) was down 0.8%, while the Russell Mid-Cap index declined 0.5%, and the Russell Small Cap index was essentially flat at -0.1%. International stocks in the developed markets of Europe and Japan, as measured by the MSCI EAFE index, experienced the biggest decline at -1.5%; however, the MSCI Emerging Markets benchmark rose in value by 1.4%. Rising interest rates caused the bond market to finish in the red, producing a negative return of 1.5%, based on the Barclay’s Aggregate index. For the 12-month period ending March 31, non-U.S. stocks (MSCI ACWI Ex U.S. Index) outperformed the broad U.S. stock market (Russell 3000 Index), with the former generating a 16.5% return, while the latter captured a 13.8% return. Bonds were marginally positive, returning 1.2%.

*Disclosure

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