April 6th, 2018

Markets in 2017 were extremely calm, but that is clearly not the case in 2018. The volatility in the first quarter was high by historical standards. It was extremely high if you put it in the context of non-recessionary periods.

Most broad equity markets globally finished the first quarter with a negative return. In the US, returns were only slightly negative (S&P 500 -1%, Dow Jones Industrial -2%, Russell 2000 -0.2%). For comparison, much of the rest of the world was far worse (Japan -6%, Germany -6%, UK -8%).

Within the US market, the ability to generate positive returns was limited to only two of ten economic sectors, technology and consumer discretionary. Even within these sectors, the returns were driven by a narrow group such as Amazon (+25%) and Netflix (+50%). It’s not surprising that these high flying stocks started to come under material pressure as well as the market volatility picked up.

On the surface, it feels like the economy is chugging along nicely and corporate earnings are going to see large growth. So why the lack of return? Is this just an obvious buying opportunity?

It’s important to remember that markets feel like they are reacting to today’s headlines, but the overall trend is more about looking to the future. The current challenge is that markets through January had been looking ahead to very strong earnings (approx. 20% annual growth) and significant economic gains (early estimates were 4% GDP growth). These are very high hurdles even if everything goes well.

Besides having high expectations already “priced in” to the markets, there have been some cracks to emerge. First quarter economic growth in the US is likely the be around 2%, not bad but not exactly huge news. The new jobs created in March were only about 100,000, much less than expected and were again centered on part time jobs. Construction jobs actually declined for the first time in two years (although weather can play a big part from month to month).

The bond market is typically the first to react to economic divergences. Despite inflation concerns leading the Federal Reserve to continue raising short term rates, the difference between longer yields and shorter yields is converging. A ten year Treasury bond only yields about 0.5% more than a two year Treasury bond. If the market believed inflation was coming, there would be very little appetite for this sort of differential.