May Investment Comments


To date, one could make the case that the return of volatility is the market story of the year.  The Cboe Volatility Index, or VIX, spiked in February to a high of 50 before settling in at a level below 20. Despite the February surge, the current level of the VIX is roughly equivalent to its long-term average since it was created in 1993.  Current levels on the VIX are roughly double where they were a year ago, underscoring how tranquil the market was in 2017.  We are tracking in line with historical volatility despite the possibility of a trade war, missile strikes in Syria, and a steady stream of market-moving tweets from the President.  If the start to the year is any indication, a return to the abnormally low volatility we experienced a year ago appears unlikely.

When volatility first broke out in February, there was some thought it might help keep the Federal Reserve Board in check and prevent the three rate hikes initially anticipated for this year.  This does not seem to be the case.  The minutes from the March Fed meeting, where rates were raised by 0.25%, indicated a hawkish tilt.  The primary takeaway from the minutes was members’ belief in a stronger economic outlook and their increased confidence inflation would get back to 2% in the medium term.  As a result, the path for rate hikes would “likely be slightly steeper than previously expected.”  While the median policymaker at the Fed currently predicts a total of three rate hikes for the year, many analysts are now leaning toward four hikes as the more likely scenario.

Unsurprisingly, Fed policy has meaningful implications for short-term rates, though its ability to influence longer term interest rates via rate hikes alone is less clear-cut.  Long-term rates are generally driven by the economic outlook.  The current environment featuring an uncertain longer-term outlook, due in part to trade policy, combined with recent Fed rate increases bear this out, as short-term rates have increased in relation to long-term rates.

One indicator many investors closely monitor is the difference between the 2-year and 10-year Treasury bond yields.  This is because an inverted yield curve, where 2-year interest rates are higher than 10-year rates, has been a reliable indicator of a pending recession.  An inverted curve has predicted all nine U.S. recessions since 1955, with a lag of six to 24 months.  However, there have been false alarms as well.  The difference between U.S. short- and long-term bond yields has generally been declining since 2013 and at a current level of under 50 basis points (0.50%), it is at its lowest level since 2007.  The Fed is mindful of the relationship between an inverted yield curve and recessions and will undoubtedly maintain flexibility based on future developments.

Inflation will help determine the pace at which the Federal Reserve is likely to move.  Though inflation has been well-contained, it is uncertain how recent fiscal stimulus in the form of tax reform, along with the budget deal reached in March, will impact the rate of inflation going forward.  Former Federal Reserve Chair Janet Yellen co-wrote an opinion piece recently questioning the timing of tax reform, given the economy “was already at or close to full employment and did not need a boost.”  The piece went on to add, “This year’s bipartisan spending agreement contributed further to ill-timed stimulus.  The Federal Reserve will have to act to make sure the economy does not overheat.”  The timing of the article was somewhat interesting given the sensitivity of the subject and the fact former Fed Chairs have tended to maintain a low profile immediately after leaving the Chairmanship.

The former Chair and her co-authors may be correct, but it is worth highlighting that inflation measures to date haven’t hinted at an overheating economy.  The core PCE, which is the Fed’s preferred measure of inflation, continues to run below the Fed’s 2% target.  The most recent reading was up 1.6%, and the measure hasn’t been above 2% since April 2012.  However, perhaps in response to tax reform, the Fed minutes indicated that all participants expect inflation on a 12-month basis to move higher in coming months.  The 10-year implied breakeven inflation rate of 2.1% indicates the market concurs with this sentiment, though it hardly implies runaway inflation.

With an uptick in volatility and what appears to be a slightly more hawkish Federal Reserve, investors looking for more positive news can turn to what is expected to be a very strong Q1 earnings season.  Earnings in the first quarter are expected to increase more than 17%, representing the fastest growth since 2011.  In a reversal of the usual Wall Street dance, where analysts typically reduce earnings estimates as we get closer to the reported results—leading to the inevitable “surprise” beat when results are announced, consensus expectations for Q1 earnings have actually increased by more than 4% over the past three months.  This increase in estimates is the most for any quarter since the financial crisis and a positive sign.

Expected earnings growth of more than 17% in Q1 and 18.5% for the year is impressive but requires some context.  Approximately 7% of the expected growth this year comes from tax reform, leaving the core growth trend closer to 10%-12%, still a respectable number.  Growth is even higher if one chooses to also consider the 3% by which reported earnings typically exceed estimates.  Current estimates for 2019 earnings indicate 10.5% growth, a strong follow-up if 2018 delivers on expectations.  Q1 earnings have a welcome opportunity to take center stage over the next several weeks and reinforce the belief that in 2018 stocks are poised for their best earnings growth since 2010.  Risks abound, but then again, risks always exist.  The fundamental backdrop looks positive and it pays to maintain a long-term perspective.

James M. Skubik, CFA