U.S. equity markets started the year on a hot streak, extending 2017’s gains and recording the strongest January performance since 1997. However, after 15 consecutive months of positive returns, markets ran out of steam in February and March, closing down both months. The S&P 500® Index ended the quarter down -1.22% and the Dow Jones Industrial Average finished down -2.49%, marking the first quarterly decline for each index since the third quarter of 2015. The fear of rising inflation and interest rates — both normal at this point in the cycle but not seen in a decade — were the initial catalysts for the decline. While both the S&P 500 and Dow Jones briefly entered correction territory in February, the bull market continued through the first three months of the year, turning nine years old in March and further extending a run that began in 2009. Interestingly, if the bull market perseveres through August 21, it will become the longest on record since World War II.
The first quarter also saw a meaningful uptick in volatility, as the VIX more than doubled from last year’s historic lows and S&P 500 3-month realized volatility ended at levels not seen in over two years. While this newfound volatility is simply a return to historically normal levels, it is an indicator that investor risk appetite may be on the decline.
Both the Bloomberg Barclays U.S. Aggregate Index (-1.46%) and Bloomberg Barclays U.S. High Yield – Corporate Index (-0.86%) produced negative returns for the quarter, driven down primarily by an increase in interest rates across the yield curve. In commodities markets, WTI crude finished the quarter up over 7%, closing at nearly $65 per barrel on optimism about Chinese demand for oil and continued strength in the global economy. Gold also ended the quarter in positive territory, gaining over 3%.
As expected, the Fed raised the Federal Funds rate at its March meeting, increasing it by 0.25% to a new target of 1.50% to 1.75%. While the Fed maintained its official projection of three total rate hikes in 2018, expectations of economic strength prompted it to raise its estimate for 2019 from two to three rate increases. As mentioned in our fourth quarter 2017 review, the Fed is currently in uncharted territory, as it has never before tightened monetary policy after such a prolonged period of quantitative easing and zero interest rates. New chairman Jerome Powell will be heavily scrutinized as he leads the Fed through the continued process of interest rate normalization — investors are fearful of a Fed mistake and are watching closely to determine whether the central bank will “stay the course” charted by former chair Janet Yellen or accelerate the pace of rate increases in a quicker-than-expected manner.
Tariffs and trade policy were prominent news topics during the quarter. In late March, President Trump announced tariffs on approximately $50 billion of Chinese imports — “the first of many” trade actions against China, according to the president. This action followed broader tariffs on steel and aluminum that were enacted earlier in March. Investors reacted negatively to this news, fearing a potential trade war that could lead to increased inflation and slower economic growth.
In our opinion, there is no reason to panic, as the economy and earnings growth both remain solid and should be buoyed by the recent tax cuts and continued global economic expansion. Volatility is likely to continue, however, and additional market drawdowns are possible as the year progresses. As a reminder, declines in the 10% range are very normal and are often considered healthy developments for markets that have produced outsized gains. Now may be a good time to evaluate portfolio allocations and consider whether an opportunity exists to de-risk into asset classes that perform better in a more volatile environment. In times of uncertainty, it is important for investors to be appropriately diversified and remain committed to their long-term investing strategy. As always, we do not recommend trying to time the market.
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