After becoming accustomed to consistently robust equity returns throughout 2017, the first quarter of 2018 ushered in a bout of volatility unlike the low volatility of 2017, with the markets experiencing two 10% drops and ending the quarter about where they started. In our judgement, the playing field in 2018 has changed. We are now in a rising interest rate and potentially rising inflation environment.
The recent Federal Reserve minutes indicate that the Fed is on a fairly aggressive path of hiking interest rates. It should be noted that one of their main mandates is to control inflation and with the recent rise in oil and gasoline prices, as well as the CRB Broad Commodity Index, it appears that inflation is rising. Thus, it is quite possible we will see four rate hikes from the Federal Reserve in 2018. In addition, it is quite possible that the 10-year bond yield will creep up to 3.2% by the end of the year.
The recent passage of the tax bill and the continued de-regulation across many industries have been a tailwind for corporate earnings and equity prices. However, higher levels of inflation and higher interest rates represent a possible risk for equities, creating a sort of tug-a-war between the two.
One concern we have is that the U.S. market generally is a discounting mechanism. It is quite possible that the tax cut and enhanced earnings projections were discounted and paid for in 2017. Evidence of this can be seen from 2016 to January 2018, when the market was up 44% versus 14% growth in earnings thus, market gains may be muted until it is possible to see continued future earnings gains.
That being said, we have always been proponents of global diversification and this year is no exception, where we see international markets, both developed and emerging, as well as other asset classes like international real estate, commodities, and certain hedge fund type strategies, as being a complement to our existing portfolios.
As for bonds, while the siren call for a bond bear market continues, the Fed’s recent move to raise interest rates, and the flattening of the yield curve, all are signals to us to position our portfolios in a conservative risk posture, maintaining a focus on short maturities, as well as investments in rising interest rate vehicles like floating rate bonds.
As always, we think that a well-diversified portfolio in line with your long term goals should allow you to participate in upside potential as well as serve as a ballast for any short term volatility that may arise in the coming months.