February 2018 has brought us a stock market rout that has unnerved investors. Recent declines essentially erased year-to-date gains in the S&P 500, along with other indices. Energy shares led the selloff, since the sector’s Q4 2017 earnings have disappointed. However, earnings reports from other sectors have been robust and would indicate good growth prospects. US consumer confidence and spending have also been strong and recent wage data show growth at the fastest level since 2009. So what’s the problem?
In our Q1 2018 Economic Outlook, titled “The Rising Cost of Growth,” we indicated our concern regarding increasing interest rates due to higher expected inflation and a growing US deficit from tax policy changes. We think some of those risks are now being better recognized by investors. The yield on 10-year US Treasury bonds peaked at nearly 2.9% last Friday, up from less than 2.5% at the beginning of the year; yesterday, the yield closed 14 basis points lower as the S&P sold off by more than 4%. Inflation and interest rates are important to equity markets because they factor in the valuation of future earnings. In some ways, one can consider recent events a result of market forces functioning as expected, as equity prices begin to factor in higher borrowing costs. Looking forward, we will continue to focus on this relationship.
In our view, equity markets are resetting expectations for 2018 that were possibly too optimistic. We had already begun to shift allocations to navigate an environment marked by higher inflation, interest rates and volatility. Leading up to this recent selloff, we were holding higher-than-normal levels of cash. Further, we have for a while now maintained relatively low levels of interest rate exposure, thus minimizing the impact on our fixed-income holdings. Looking forward, we continue to look for opportunities that will benefit from higher levels of inflation and have lower correlation to public equity and fixed-income markets.