Investment Commentary - First Quarter 2018

Written by Don Wilson, CFA, CFP® on April 9, 2018
  • Volatility returned after an extraordinarily calm 2017
  • Stocks experienced first monthly decline after record 15 positive months in a row
  • Bonds declined as interest rates continued to rise
  • U.S. economy on solid footing, boosted by tax cuts

After a record fifteen positive months in a row, the S&P 500 posted negative returns in February and March, and experienced its first 10% correction in two years.  Despite the return of volatility, the S&P 500 finished the quarter down just -0.8% because of its strong start.  Although market pundits cited concerns of a potential trade war and the Federal Reserve’s tightening of monetary policy as catalysts for the drop, 10% corrections are a common occurrence.  After a couple of extraordinarily calm years, the market was overdue for a pullback.  While the stock market’s recent volatility may feel abnormal, this is closer to normal than last year’s extreme calm when the market rose every single month and never declined by more than 3%. 

During the quarter, the S&P 500 experienced 6 days when the index rose or fell by 2% or more (see chart below).  That’s significantly more than during the unusually calm 2017, when there were zero such days, but it is not unusual compared to previous years.

Daily Moves of 2% or More for the S&P 500 Index

Source: Standard & Poor’s, FactSet, J.P. Morgan Asset Management.  Data as of March 30, 2018.

While volatility can be unsettling, it is a normal part of investing in stocks. Since World War II, there have been twenty-seven corrections of between 10% and 20%, and eight bear markets, (defined as a 20% or greater decline). Nevertheless, long term investors have been rewarded for persevering through difficult periods.  Most investors don’t have the intestinal fortitude to invest 100% of their portfolio in stocks and watch their net worth fluctuate in lock step with the market.  Having a diversified portfolio that includes bonds and alternatives helps temper the volatility and allow investors to stick with their investment strategy during periods of turbulence. 

Developed international and small cap stocks also experienced small declines in the first quarter.  Developed international stocks as measured by the MSCI EAFE, returned -1.5%. Small Cap stocks performed slightly better than large caps, as the Russell 2000 was down just -0.1%.  The MSCI Emerging Market Stock Index gained 1.4%.

Growth stocks continued their outperformance against value stocks across the market cap spectrum. The Russell 3000 Growth rose 1.5% while the Russell 3000 Value returned -2.8%.  Despite elevated valuations, investors are still willing to pay significant premiums for faster growing companies. Technology was the strongest sector for the quarter up 3.5%. Consumer Staples (-7.1%) and Telecommunications (-7.5%) were the worst performing sectors.  These defensive sectors are made up of more stable, mature and often dividend paying stocks and tend to move inversely to interest rates which rose over the quarter.

Fixed Income
The broad U.S. bond market (Barclays Aggregate Bond Index) declined -1.5% as yields rose across maturities.  The benchmark 10-year U.S. Treasury Bond yield began the quarter at 2.40% and rose to 2.74% by the end of the quarter.  While the rise in interest rates negatively impacted bond investors this quarter, the higher yields increase expected bond returns going forward.  Interest rates increased sharply over a short period of time, especially given how low interest rates are.  We do not expect this to happen often over the next couple of years as we believe a slow rise in interest rates is more likely. 

At some point in the future, we will experience another recession. During that period, interest rates are likely to fall. This is one of the self-correcting features of capitalism.   Hence, our outlook for bonds remains little changed: we expect they will underperform stocks during economic expansions and outperform during recessions.  This is one of their functions in a well-diversified portfolio and we expect this will be the case when the next recession occurs.

Alternative Investments
The alternative investments are comprised of a diverse group of strategies we expect will generate solid long-term returns that are less directly tied to the moves of the traditional stock and bond markets.  During periods of market turmoil, we expect the alternative investments to be more stable than stocks and dampen overall portfolio volatility.  The equity drawdowns during the quarter provided a test of the alternatives strategy and we were pleased with how they held up.  After a prolonged period of unusually low volatility, higher volatility is likely as the Federal Reserve continues to raise interest rates.  We believe the alternatives strategy will be a valuable component of our clients’ portfolios through this environment.

Both the U.S. and global economy appear to be on solid footing.  The most recent Wall Street Journal economic forecasting survey of 60 economists, forecasts GDP growth of 2.5% for the first quarter followed by 3.2% and 3.1% for the next two quarters.  Tax cuts are expected to boost economic growth and earnings.  However, rising interest costs could be a headwind.  The job market is very strong and unemployment has dropped to 4.1% from 4.7% a year ago.  So far wage growth has been subdued and inflation remains low.  Consumer confidence is high and corporate earnings are strong.  Overall, the economic backdrop is solid.

One area that has raised concerns recently has been an increase in protectionist policies.  The U.S. recently announced tariffs on $50 billion worth of Chinese imports.  China retaliated with tariffs on a similar level of U.S. imports to its country.   Thus far, the tariffs would only affect about 3% of U.S. imports and equate to less than a 1% increase in the average U.S. tariff rate (see chart below).  In addition, the tariffs would not go into effect immediately, providing time for negotiations. If these tariffs do go into effect, the economic impact is expected to be small, but the risk is a substantial escalation in trade tensions that would more negatively impact the economy.

Announced Tariffs Are Small in Historical Context

Source: Irwin (2003), HSUS, USITC, Goldman Sachs Global Investment Research

After the last couple of years of unusual calm, volatility has returned to the markets.  This serves as a good reminder that the stock market does not always go up – something that can be easy to put out of one’s mind nine years into a bull market.  While the economic environment appears solid and the likelihood of a recession in the near term seems low, it’s important to maintain a disciplined investment strategy including rebalancing portfolios back to their target asset allocation weights. After last year’s strong stock market performance, rebalancing usually requires selling stocks, buying bonds and alternatives, and incurring gains.  While we try to minimize tax bills as much as possible, paying taxes on capital gains is a necessary part of making money.  Moreover, taking profits through rebalancing is an important discipline we exercise to manage risk as part of a successful long-term investment strategy.


The statements and opinions expressed herein are subject to change without notice based on market and other conditions.  The information provided is for informational purposes only and should not be construed as investment or legal opinion.  Please consult a tax or financial advisor with questions about your specific situation.

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