Commentary | 1Q 2018

Economic conditions in the first quarter of 2018, as exhibited by readings on the Institute of Supply Management’s Purchasing Manager’s Index (PMI®) and the year-over-year growth rate of the Conference Board’s Leading Economic Index®, remained consistent with increases in corporate profits. The Atlanta Fed’s GDPNow economic model is forecasting real economic growth during the first quarter to be 2.5%, and this growth rate is expected to continue for the foreseeable future. The increase in corporate profits for the whole year is expected to be close to 10%.  Despite these favorable circumstances, the market produced a minor decline in the quarter. Within the quarter, the market exhibited a high level of volatility. By the end of the period, a popular measure of market volatility approximately doubled and was far higher at times during the quarter. Certain inverse-volatility funds suffered spectacular losses as volatility spiked. The increase in volatility was a reflection of policy innovations which were perceived to be destabilizing with respect to future economic growth, future increases in corporate profits, and investors’ confidence.  While the expectations for economic growth and increases in profits remained positive, the range of possible outcomes increased.

Uncertainty about the Fed’s monetary policy under a new Chair, as well as the prospect of trade wars were two primary concerns of investors during the quarter. The Fed announced that it was planning to raise short-term rates further, and expected short rates to be about 2.9% by the end of 2019. Thus far, as the Fed has raised rates the yield curve has flattened. The spread between the 3-month T-bill and the 10-year T-note touched 100 bps, while that between the 10-year T-note and 30-year T-note fell below 25 bps. While many market analysts have ascribed this to strong demand (especially from abroad) for the long bond, it could also be a sign that the bond market expects inflation and real growth to be lower than previously thought. If inflation and real growth were expected to rise, then rates at the long end ought to have increased. Prior recessions have always been preceded by an inversion of the yield curve – a condition where short-term rates are higher than long-term rates. The slope of the yield curve gained prominence among investors as the quarter progressed.

The prospect of possible trade wars between the US and China loomed over the market as the quarter came to an end. The announcement of 25% tariffs on steel and 10% on aluminum came on the heels of policy moves such as withdrawal from the Trans-Pacific Partnership, and renegotiation of NAFTA. China, Canada, and the EU signaled retaliatory measures on US-made products. Historical evidence indicates that trade wars generally slow down economic growth and produce winners and losers in an unpredictable manner. The market will not establish a clear trend, either up or down, until the policy initiatives are set firmly.