The serenely rising equity market that was the highlight of the last World Headlines report lasted precisely one month into 2018, and then the furies descended. The Dow Jones Industrial Average and the S&P 500 both posted new all-time highs on January 26. Nine trading days later, both indices had plunged to levels around 12% lower. For the balance of the quarter, U.S. equities seesawed violently, with daily trading ranges of as much as 2.5 – 5.0% and swings of 5.0 – 10.5%, putting an emphatic end to the tranquility of the previous 15 months. Major bourses worldwide followed suit, ending the quarter with substantial declines.
Global bond yields rose as equities faltered and the dollar rallied. Then, as the equity turbulence continued through the term, bond and currency markets reacted to the volatility itself. The U.S. 10-year yield declined from a February high of 2.95% to close the quarter at 2.73%. The bonds of other G-10 countries saw yield declines of as much or more. The yen, a risk-off indicator, rose 5.5% before yielding some of its gains. The Canadian and Australian dollars and the Brazilian real, reacting to declines in commodity prices, lost ground through the quarter.
What happened? The first knock seemed fairly innocuous, hardly the sort of factor that could derail a months-long bull market. The U.S. employment figures released on February 2 showed a robust job market and, ominously, faster-than-expected growth in earnings. Investors took these data to signal a potential rebound in inflation, leading the Fed perhaps to accelerate its planned pace of interest rate increases.
The rout that ensued alerted investors that the underpinnings of the market’s rise might be less stable than anticipated. Indeed, threats that the market had successfully ignored throughout 2017 suddenly became headline news.
The second bearish development appeared at the beginning of March, when President Trump unleashed his long-promised trade and tariff policy. After an opening salvo of a 25% global tariff on certain steel imports (quickly modified by exceptions for various important trade partners), Trump leveled his intentions squarely at China, where tough talk and threatened tariffs on both sides sparked concerns of a wider trade war.
As is becoming a recognizable pattern with President Trump, an initiative starts with aggressive, even outlandish, rhetoric which is then followed by various degrees of softening. NAFTA discussions with Canada and Mexico, for instance, seemed at the end of the quarter to be approaching a negotiated solution, with one result being that both the Canadian dollar and the Mexican peso strengthened in the last weeks of the term. Nevertheless, a market unused to seeing negotiations carried out in full view and primary colors reacted to the China spat with continued volatility. The VIX index, a measure of volatility in the equity markets, stabilized after the post-payrolls sell-off, but spent the balance of the first quarter fluctuating around 20%, sharply higher than the 10% level that marked most of 2017.
A third destabilizing factor that affected the first period is the persistence of geopolitical risks, which variously heated and cooled — again, following the somewhat chaotic style of the Trump presidency. At quarter’s end, the nuclear showdown with North Korea seemed to be moving toward a negotiated solution, but tensions with Russia were at their highest in decades after the attempted nerve agent assassination of a Russian double agent in the UK and the threat of a Western military response to the Assad regime’s purported use of poison gas against civilians in Syria’s civil war. Simmering tensions with China over the trade issue and territorial claims in the South China Sea added to the unsettled conditions.
As the quarter comes to an end, investors are left wondering if the bull market in equities will regain its legs, or if this is the beginning of a new normal. Certainly the prospects of higher interest rates will depress animal spirits in the equity world; on the other hand, declining bond yields may provide support. U.S. economic growth continues to be strong, with GDP growth for 2018 forecast to exceed 3.0%. However, concerns over the deficit resulting from the Trump tax cut and the recent omnibus spending package have lately increased investor caution. Perhaps reflecting this ambivalence, the dollar has traded sideways against both the euro and the pound sterling, two of its principal counterparts, through most of the quarter.
What seems indisputable is that the volatility genie has been let out of the bottle, and it will be difficult to stuff it back any time soon. The stock markets may resume their upward march, but it’s unlikely to be a smooth ride.