The beginning of the first quarter was serene and pleasurable, as equity markets levitated on the back of increasing earnings expectations and solid world economic underpinnings. But the market euphoria didn’t last long. February saw volatility awaken from its slumber with a jolt, kicking off a long-anticipated correction that reminded investors there is never a free lunch in the world of investing. As the quarter progressed and the correction intensified, investors were forced to endure an emotional roller coaster as markets swung wildly. By the end of the quarter, most developed markets had chewed through early year gains and returns fell mildly into the red.

As we start the second quarter, investors are left to wonder if the market is turning from bull to bear, or just correcting from an overbought and highly complacent condition.

Catalyst 1: Inflationary Transition

The start of the volatility flare up was largely predicated on an inflation scare resulting from details within the January employment report indicating that long-stagnant wages were finally beginning to rise. This catalyst appeared to align with the idea that the economy is transitioning towards the late phase of the cycle, causing markets to begin to discount the possibility that the disinflationary backdrop that has characterized the environment ever since the financial crisis is gradually turning more inflationary.

While inflation has been dormant for many years, there are several reasons to believe that inflationary green shoots are beginning to develop in the U.S. economy. From a cyclical perspective, actual GDP growth rates are starting to outstrip potential growth, meaning that aggregate demand has reached the point where it is starting to outstrip supply which typically causes prices to rise. One part of the economy where this seems evident is in the labor market, where the unemployment rate has already fallen below the equilibrium level that usually signals a pickup in wage levels. Other cyclical inflationary catalysts include a weak dollar and commodity prices that are steadily rising.

To compound the cyclical backdrop, the current administration’s stance on trade and immigration also suggests a more structural foundation for inflation is building as the pendulum appears to be swinging from peak globalization towards protectionism. As this gradual transition from disinflation to inflation takes place, it’s perfectly normal for markets to undergo a volatile adjustment phase, but it’s also premature for a slow normalization of inflation and interest rates to end the economic cycle just yet.

Catalyst 2: Tariffs & Trade Wars

In 2017, a major theme of ours was that a post-election “roadmap” was developing that would shape investment markets over coming years. The roadmap had three components. The first was that fiscal policy was set to pick up, and it has through the recent tax reform that was enacted. The second component was that the administration would focus on deregulation, and they have been addressing that as well. In 2018 these market friendly forces are still with us, but they have now been joined by the third element of the roadmap, which is a turn towards protectionist trade policy.