Volatility Returns

Markets have been resilient for quite some time, fueled by broad-based global economic growth and strong corporate earnings. The S&P 500 index is coming off a stellar year and is up over 300% in the nine years since the financial crisis. This upward momentum continued during the first four weeks of 2018, with sentiment readings reaching extreme optimism, as investors feared missing out on the market’s climb.

It seems reasonable then that the U.S. equity market, which had gone over 400 days without a 5% pullback, was overdue for one. The stock market sell-off last week was largely a result of a sharp rise in interest rates fueled by strong growth and increased inflation expectations. Friday’s jobs report, which showed the fastest wage growth since 2009, raised speculation that the Federal Reserve may have to increase short-term interest rates at a quicker pace than originally anticipated. The S&P 500 index suffered its worst week since January 2016, while international equities declined by a lesser degree. The 10-year Treasury note yield, which began the week at 2.66%, closed nearly 20 basis points higher at 2.85%. Meanwhile, the extraordinary period of calm witnessed last year gave way to an uptick in volatility, with the CBOE Volatility Index (VIX), closing above 16 for the first time since the U.S. presidential election.

A Tug of War

The U.S. equity market is weighing an improved outlook for global growth and double-digit earnings against a pickup in inflation expectations and interest rates. Given the momentum in economic indicators and easy financial conditions, we expect our central theme of synchronized global growth will remain intact. Our outlook is for real gross domestic product for the U.S. and the world to come in at 2.7% and 3.8%, respectively. Additionally, the boost from the recent tax cuts should support our outlook for an earnings-driven equity market.

Despite the better-than-expected fourth quarter earnings to date, investors have become more concerned with signs of inflation and whether the move higher in rates would stifle the equity market. Similar to past economic cycles, a gradual drift higher in inflation, as well as modestly higher short- and long-term interest rates, is normal at this point in the economic cycle. Even though the rise in the 10-year Treasury note occurred quickly, we would not be surprised to see rates continue to drift higher over the next few quarters only to come down again. In the end, we expect earnings and growth will win this tug of war as markets adapt to higher rates.

Investment Implications

In our view, synchronized global growth and stronger earnings will continue to provide an equity-friendly environment. All bull markets go through these periods of pullback, but we believe this one will turn out to be a correction and not the beginning of the end. Although volatility may persist in the near term, this weakness may present buying or reallocation opportunities at lower prices. We believe investor portfolios are well positioned and will benefit from our emphasis on diversification, rebalancing and customized hedging strategies during this period of rising rates and volatility. We will continue to watch valuations, inflation, the shape of the yield curve and credit spreads for signs of a market top — but we just don’t see signs of it yet.

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