Early in the First Quarter, the stock market continued its streak of historically low volatility and positive momentum that was characteristic of 2017. Leadership was concentrated among a handful of large technology stocks as records were set on an almost daily basis. The market’s strength lasted for only a month, however, as volatility spiked in early February, and stocks suffered a brief, sharp correction. In fact, volatility recorded its largest ever quarterly increase during the First Quarter.
The causes of the February market correction do not appear to be fundamental in nature. Instead, it was likely the result of technical factors, and technical corrections tend to recover quickly once imbalances are resolved. Regardless of cause, volatility is a healthy reminder to investors that risk assets experience valuation resets from time to time. Each time a correction ensues, however, market participants immediately worry that a recession is imminent. In our view, global economic fundamentals continue to improve, and from that perspective, we consider the recent increase in volatility as offering opportunities to long term investors.
In recent weeks, the Executive Branch has invoked parts of Nixon-era laws to unilaterally impose trade restrictions under certain circumstances. Our research has revealed that nearly every Presidential administration since Nixon has utilized these provisions. The target of the latest policy stance on trade is China. For decades, US corporations have complained that the Chinese show complete disregard for global laws governing intellectual property rights and technology transfer. Some policy makers dismiss this as simply “the cost of doing business in China.” The Trump administration has chosen a different approach.
Because of the proliferation of automated trading systems and “rules-based” investment strategies, the term “tariff” was immediately associated with “trade war”. Consequently, the stock market suffered another bout of volatility in March. However, we do not believe recent rhetoric has had a fundamental impact on the economy. While retaliatory measures should be expected, we further do not believe a global trade war will erupt. Instead, we view recent announcements regarding trade as primarily a negotiating tactic. That said, we acknowledge that trade will be the focal point of the markets until such matters are resolved.
At our Symposium, we addressed what we believe is on everyone’s mind – i.e., when is the next significant recession and market downturn. Using history as our guide, we introduced several key indicators that have proved reliable in the past, some of which are flashing warning signals. Two such indicators are the narrow stock market and the flattening yield curve. However, other indicators suggest the economy has further upside. We also pointed out that indicators exhibit correlations only. In other words, correlations should not be construed as causal, and it is important to remember that each bear market tends to differ from its predecessors.
During our Symposium, we analyzed the Information Economy and, in particular, the data monopolies (e.g., Facebook and Google). Some of these companies have acquired immense market power through the reach of their networks. Such power automatically attracts the attention of regulators, but recent, high profile failures to protect data have drawn increased scrutiny. Breaches of the public’s trust and a lack of integrity in the information that is distributed are two factors that could result in significant modifications to the business models of several technology behemoths. We anticipate more changes will be forthcoming, and tighter regulations could reduce margins. For the long term, however, adjustments that preserve integrity and trust should facilitate the sustainable growth of this important sector of our economy.
Overall, we point out the health of our labor market, particularly the recent improvement in the labor force participation rate, as one of many positive indicators. We remain constructive on corporate earnings growth for 2018, and we do not believe the impact of the tax cuts has been fully reflected in economic performance. To the extent fundamentals remain intact, the recent broadening of stock market leadership is a welcome development. Finally, the initial reaction by the markets to new Fed Chair Powell is also encouraging. Therefore, we approach this year’s Second Quarter with optimism but also with the expectation that volatility will remain elevated.