Key Points

  • A wild ride would be an understatement to describe stock market action recently. A more aggressive Fed and a tariff announcement have played key parts, but we don’t see these as threats to the bull market; just consistent with the heightened volatility we have been expecting.

  • Economic growth has risen and inflation and inflation expectations have ticked higher; but we are just now getting back to the Fed’s target of 2% core inflation.

  • Many have wondered—including the Fed—whether the link between a tighter labor market and wage growth/inflation had been permanently broken, but it appears the secular forces restraining wages and inflation may be dissipating.

A bumpy ride to “normalization”

U.S. stocks have been on a wild ride recently—a stark contrast to the relative calm that dominated most of the last year. Stock indexes touched correction territory (+10% loss) in early February before staging a sharp rebound, with intraday several hundred point Dow moves more common than not. Last week the rebound began a retracement as investors expressed concerns about the potential for a more aggressive Federal Reserve and the initiation of more direct protectionist trade policies by the Trump Administration, including a 25% tariff on steel and a 10% one on aluminum. Stomach churning at times but should we be surprised? After a decade of abnormally loose financial conditions and global central banks massively boosting their balance sheets and taking rates to zero or below, we have begun the normalization process. Even in less unprecedented times, tighter monetary policy has led to higher volatility and weaker markets; so fundamentally, this is not a surprise. Interestingly, the timing seems about right according to famed economists Kenneth Rogoff and Carmen Reinhart, who in their 2008 book This Time is Different: Eight Centuries of Financial Folly revealed that the average recovery time from a severe financial downturn and debt bust for countries is about 10 years.

Positively, despite the sharpness of the correction, investor confidence in the financial system appears intact with the rebound seen in the immediate aftermath of the February correction. There was some concern that the carnage among the inverse volatility-related exchange-traded notes could spread to create more systemic issues; but that does not appear to be the case. But the stock market has been less forgiving about the announcement by President Trump of new tariffs on steel and aluminum, which lacked any details. The concern that this could lead to trade wars and retaliatory measures by other countries, and ultimately hurt economic growth and foster higher inflation, was enough to send shivers down the stock market’s spine. The upcoming details on these tariffs, as well as the foreign response, will be important to watch, as will any further actions undertaken by the Trump administration.

In the meantime, the strong earnings picture is intact for now, which should help to underpin stocks. According to FactSet data, the “beat rate” for profits was 74% for the fourth quarter of 2017—above the 69% average over the past five years; while the revenue beat rate was 78%—a record high since FactSet began tracking the data in 2008.

A longer-term perspective

We believe increased volatility will persist, with alternating bouts of spikes, followed by periods of easing conditions. Concerns over economic growth moving to a higher trajectory and inflation heating up will likely continue to be a factor, with worries that the Fed may be forced to tighten more quickly an ongoing volatility-driver. However, we refer back to a speech that former Fed Chair Janet Yellen gave in 2016 where she said that it’s useful to consider the benefits of a “high-pressure economy with robust aggregate demand and a tight labor market.” While she is no longer the chair, it is reasonable to conclude that she was expressing the general views of much of the Federal Open Market Committee (FOMC)—of which current Fed Chair Jerome Powell was a member. He had the “pleasure” of talking to (listening to?) Congress for two days; and despite his clear intention to say little that would immediately move markets, investors took his first day of testimony as slightly hawkish, resulting in some selling of stocks. But Powell adeptly came across as slightly more dovish in day two and stocks were rallying…until the Trump tariff announcement.