All About The Fed
We’ve been getting some questions from clients recently about market fundamentals in light of the recent stock market correction. We noted in our January comment that we expected volatility to pick up this year and the market obliged in February with our first real “correction” (a decline of over 10%) in over 17 months (a rather long time without a correction, BTW, given that the long term average is about once every 12 months). Has the recent correction removed the risk of further volatility? Probably not. And as with any market correction, there will most likely be a period of backing and filling of the sharp technical decline if not a re-test of the February 9 bottom. That would be a normal process for any corrective phase.
There is some good news to come from the correction. Corrections are a normal part of the market cycle and help to contain excessive speculative trading activity, normalize valuations, and maintain a more balanced market. As we stated in our January comment, we expect stock market volatility to remain elevated primarily because of investor uncertainty over Federal Reserve policy: how many times will the Fed raise rates this year? New Fed Chair Jerome Powell’s testimony this week also brought the Fed into sharper view, which may have added to market volatility this week. Interest rates and Fed policy are important in the valuation of all financial assets. The good news is we believe the backup in bond yields over the past several months has gone a long way towards adjusting (or normalizing) yields for Fed policy steps of what we believe will most likely be three or four rate hikes this year.
In terms of answering client questions about “the fundamentals”, as of now, they remain good for stocks. Corporate earnings fundamentals remain strong driven by corporate tax reform, increased capital spending, as well as synchronized global economic growth. Corporate earnings should be strong both this year and next. The economy remains strong. Valuation remains reasonable at about 17x forward earnings, and the recent correction helped to temper valuation which had gotten somewhat stretched. Inflation, another factor that can affect stock valuations, remains constructive. While we do see inflation rising somewhat this year, a moderate 2-2.5% inflation environment should be viewed as positive and should not be deleterious to stock valuations, in our opinion.
One client asked “if the tax windfall is 'used up' in 2018, what does that mean for 2019?”. It is a good question. At this point, it appears 2019 should be another good year for the U.S. economy due to the positive lag effect on capital spending and continued strong employment. We think the fears over some great slowdown or dropping off the (economic) cliff in 2019, as some have suggested, are overblown. And given the below average growth of the early part of this cycle, it is entirely possible that this recovery could extend for a longer period than most now believe.
The recent market volatility has not materially changed our investment strategy and we have continued to recommend that clients stay the course and remain invested. Diversification of client portfolios by asset class is a cornerstone of our investment policy. We do this because we believe it helps to mitigate portfolio volatility and essentially “prepare” for inevitable increased market volatility. We will be holding our quarterly investment strategy meeting at the end of this month. I suspect there may be a bit more discussion about inflation, or potential for rising inflation, and U.S. stock valuation in light of rising interest rates. As long as inflation remains moderate and Fed policy remains steady, a moderately rising rate environment should not derail the bull market in stocks.
Robert Toomey, CFA/CFP
Vice President, Research