Is it time to worry about equities?

After a phenomenal 2018 start, U.S. equity markets caused a bit of a commotion in early February, giving up all gains to-date. By the end of the trading day on Feb. 8, the S&P 500 index, along with the Dow Jones Industrial Average, had fallen nearly 10 percent from their record highs. While declines of this magnitude are certainly not unprecedented, they create quite a frenzy when they have not been experienced for a relatively long period. We tend to forget that equity markets are inherently subject to corrections and bouts of volatility.

The culprit of this latest market correction was identified as investor fears of higher than expected inflation, with January hourly wages coming in higher than expected. The data suggested this unexpected pressure would compel the Fed to raise rates faster than initially intended. This further explains the ensuing increase in 10-year yields and the sell-off in equities, as equity investors became nervous of the adverse implications for equity valuations. Like a snowball rolling down the mountain, one event led to another, ultimately awakening market volatility from her deep sleep. The incredible spike in volatility was also evident in technical factors. As short volatility investors were forced to liquidate positions, market volatility increased even further, resulting in a negative feedback loop of increased selling pressure.

Although the February market turbulence is already in the rearview mirror, the question remains as to whether this is just the beginning of the end of the bull market.

Can equity markets hold on in 2018?

Admittedly, another correction in equity markets this year is highly likely, and so is increased volatility (relative to what investors have come to expect). Yet, the fundamentals, which have sustained the equity bull market still remain intact. Undoubtedly, U.S. equities are at all time high valuations and by many measures seem overvalued. Still, corporate earnings remain strong and continue to surprise to the upside. U.S. tax reform, coupled with additional fiscal spending approved by congress in February, are a welcome tailwind for economic growth and by extension equity markets.

Of course, the Fed’s actions are key in assessing the impact on risk assets. By and large, everyone expects monetary tightening, but it is the velocity of interest hikes that will influence asset values. Gradual measured rate hikes as forecasted by the Fed should not impair U.S. equity values, so long as economic growth and corporate earnings remain strong. If, however, the Fed is forced to hike rates more rapidly due to an overheating economy, equities are not expected to fare well.

There remains grave and well warranted concern that the next recession will be caused by the Fed in an attempt to quell an overheating economy from higher than expected inflation. As the Fed works feverishly to reign in the excessive stimulus, to which we have all become accustomed, the ability of the central bank to accomplish its dual mandate continues to raise doubt. While the Fed has been successful in achieving maximum employment, they are still working towards their elusive two percent inflation target. In his testimony to the House Financial Services Committee, newly minted Fed Chair Jerome Powell advised that the FOMC was anticipating a rise in inflation this year. He also reaffirmed the committee’s commitment to avoid an overheating economy whilst pursuing its 2 percent medium inflation target. Given that inflation is a lagging indicator, there is concern that by the time inflation is reflected in the data, the Fed would be behind the curve. In that environment, the Fed would be forced to hike rates much faster than expected, potentially pushing the economy into a recession. Ultimately, the impact of monetary policy on the economy can be characterized as a tug-of-war between interest rate expectations and growth expectations. Rapid moves in interest rates are not necessarily damaging if supported by higher than expected economic growth.

From a risk-reward perspective equities are currently a more attractive option than bonds. Moreover, against the recent backdrop of robust economic growth, equities are poised to continue on their bullish trek. Despite these encouraging fundamentals, 2018 will unquestionably be a year of elevated volatility. Consequently, whether you’re a bond or equity investor it’s important to keep an eye on the data and not take on excessive risk.

Sources: Bloomberg LP

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.