Key Market and Economic Themes to Watch in Q2
Tim Courtney, Chief Investment Officer, CIMA®
In the first quarter of 2018, we finally saw the long awaited correction1 in stock market prices. While the correction was not unexpected, it still caused unease among investors. In the end, it was a healthy move for the markets in which prices were tested and then rebounded2.
Economic growth, both globally and within the U.S., has continued to look solid3 despite the bumpy ride in markets in the first quarter. As we move into the second quarter, we’re watching for a few potential disrupters.
1. Inflation/interest rates. Inflation has been a key player throughout the first quarter, linking itself to a hike in interest rates4, showing strengthening global demand and making many of the bond index returns negative5. The Federal Reserve’s target for inflation is 2 percent6, and inflation has been testing this level and popping above it periodically for a few months now7.
Inflation below 2 percent has been great for the stock market, encouraging a steady climb in valuations, but talk of rising wages sparked fears of accelerated inflation8. While rising inflation is not necessarily a bad thing, it can certainly cause waves throughout the economy after investors have been accustomed to lower rates. When the inflation rate is high (4 percent or higher), real stock market returns have historically been lower9. Also, buyers may start front-loading purchases, which can further spur inflation and put a strain on resources. We are expecting a more gradual increase in inflation10 and interest rates rather than a quick move higher, which would allow markets more time to adjust. We’ll be monitoring this.
2. Undervalued assets. Last quarter, we discussed undervalued assets, which may have recently underperformed but historically have higher expected returns in the long run. Unfortunately, these assets have been disappointing so far in 2018. Our main focus in this category, U.S. small caps, have not moved much11 since the end of 2016. While it is not unusual for underperformance to persist for some time, we’re watching what environment small companies may find themselves in as global competitors become larger. We believe that we will be rewarded for investing in this area – much like we were for our international exposure last year and in emerging markets in the last two years12 – but we’re watching how prices are reacting to news.
3. Volatility. Five years ago, bad news didn’t yield much reaction from the markets, because the markets were at lower prices12. Now that they are more expensive, any deviation from the expected script triggers concern – and with it, more volatility. When the markets were less expensive, investors expected bumps here and there. Now, they expect the numbers to come in line with expectations and if they don’t, money can flow fast as shown by February’s correction.
Additionally, an election year, the announcement of tariffs13 and a potential trade war14 have triggered even more uncertainty within the market.
The underlying fundamentals of the economy continue to appear firm, but we expect more volatility than we have grown accustomed to over the last few years because of changing inflation and interest rates and potentially surprising news.
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