By Alex Oliver, Investment Advisor, First National Corporation
Volatility returned to the markets this past quarter as fears of inflation, trade wars, and privacy issues with technology companies flooded the headlines. The S&P 500 fell as much as 10%, the first time in fifteen months this has happened. After the steep rise in stocks with just a 3% “pull-back” during the 2017 calendar year, some investors may have forgotten that 10% drawdowns are very normal and typical, usually happening at least once per year. For the quarter, the S&P 500 Index declined less than 1%, while the Russell 2000 Index of small U.S. stocks was essentially unchanged, though it sure felt worse than that due to the volatility.
The market is trying to decide if we are currently entering a trade “war,” or simply witnessing a trade “skirmish.” To summarize, President Trump is hoping to reduce the current trade imbalance with China by installing tariffs on steel and aluminum imports, which is noteworthy because the United States is the world’s largest importer of steel. A tariff is a tax on an imported good, making the product more expensive in hopes that domestic steel would see increased demand. One concern would be whether domestic manufacturers have the capacity to keep up with increased demand which could result in a price spike. A second and greater concern would be the “tit-for-tat” war it could start, as seen by China’s announced tariffs on American imported goods such as soybeans, cars and whiskey. However, some analysts speculate that Trump is trying to weaken the U.S. dollar with his rhetoric, which would be good for the trade deficit and make American exports more competitive on the foreign market as they become cheaper for offshore buyers. The MSCI EAFE Index of foreign stocks declined 1.5% for the quarter as a result of the uncertainty surrounding trade.
Rather than over-react to normal market volatility, we try to stay focused on the economic and market fundamentals. In January, the S&P 500’s price to earnings ratio was about 14% more expensive than the 25-year average, implying that we were paying a small premium for U.S. stocks. As of the close of the first quarter, the S&P 500 lost 6% while the price to earnings ratio actually fell by 12%, bringing it almost in line with the 25-year average. With corporate profits expected to increase a whopping 25% from 2017 to 2018, U.S. stock valuations seem very reasonable.
It’s not just the U.S. economy that is rebounding though. Economic data around the world is looking much better. Thus, all eyes are on the Federal Reserve, the European Central Bank, and the Bank of Japan to continue tightening their monetary policies by raising interest rates to avoid an overheating global economy. On March 21st, the Federal Reserve raised the benchmark to a range of 1.5% to 1.75% in the first of three expected rate hikes for 2018. This hurts real estate investments and bonds values which are sensitive to interest rate increases. For the quarter, real estate declined 7%, while the Barclay’s Aggregate Bond Index lost 1.5%.
As we will continue to emphasize, we encourage all investors to keep a long-term view and ignore the headlines. Bouts of volatility are healthy to ensure that irrational exuberance is tempered, providing positive returns for the patient investor. For those who sat in cash for too long and felt like they missed the boat on stocks, keep in mind that international equities have still yet to have an American-style run up and could be ripe with opportunities.