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First Quarter 2018

The only thing more volatile than the New England weather during the first months of 2018 may have been global financial markets. Volatility returned with a vengeance, first in February, and then again in late March. With US equity markets experiencing selloffs not seen in years, the complacency that defined 2017 came to an abrupt end. 

The S&P 500 posted a negative return of -0.76% for the first quarter of 2018. Despite the marked increase in volatility in US equity markets, global equities, as measured by the MSCI ACWI Index, fared slightly worse than the S&P 500, returning -0.96% for the quarter.  While returns on both equity indices were only slightly negative, the last two months of the quarter more than offset the red-hot start the markets got off to in January.

On the fixed income side, the Bloomberg Barclays US Aggregate Bond index returned -1.46%, reflecting concerns of higher rates and higher inflation in the US. The Bloomberg Barclays Global Aggregate Bond Index posted a positive return for the quarter of 1.36%.  With increased angst related to the inflation and interest rate environment in the US in addition to a weakening dollar, global bonds outperformed their domestic counterpart by 282 basis points during the first three months of 2018.

There were several points last year where it appeared the stock market was willing to shrug off anything and everything and continue its upward ascent. This type of undisturbed momentum seems to have come to an end this past quarter though. Central bankers continue to remove crisis-era accommodation—adding another variable for investors to contemplate, one that for years had been much more predictable.  A boost from the tax cuts enacted at the end of 2017 could be the one prevailing force that helps the bull market continue forward. Although politically tenuous, the tax cuts in the US could certainly be a tailwind if consumer spending and business investment remain strong for the rest of 2018. Any boost from the tax cuts though could be complicated by the negative effects from potential trade conflicts however. Higher prices mean higher inflation, and the Fed may be forced to raise interest rates faster, or more frequently, than currently anticipated in the event of higher inflation.  Under its new Chairman Jerome Powell, the Fed raised its benchmark interest rate 0.25% in March, the first of an expected three rate increases this year. Powell will likely take a similar approach to his predecessor of gradual normalization, but concerns surrounding increased inflation pressure will remain top of mind for Powell and his Fed colleagues. 

At the beginning of 2017, investors were optimistic as they looked ahead at what were three potentially bullish developments in the near-term under the new administration: tax cuts, deregulation and expansionary fiscal policy, most notably through an infrastructure spending plan. Tax legislation was passed at the end of the year, capping off a very strong 12 months for US equity markets. 

With the tax cut in the rearview mirror, regulations being pared back and virtually no consensus on an infrastructure plan, a lack of optimism on the horizon may put a damper on equity markets moving forward.

In last quarter’s letter we highlighted President Trump’s desire to shake up Washington and how, strictly from a markets’ perspective, the response was positive for the most part. We also noted that geopolitical tensions, although high at times in 2017, were largely ignored by financial markets. While only a quarter of the way through the year, it appears these assumptions regarding developments in Washington may not hold true any longer. The most notable example on the economic front relates to trade relations with China and the United States’ NAFTA partners, Canada and Mexico.  A real trade war could severely disrupt the global economy, likely taking financial markets down with it. Whether simply a negotiating tactic or the actual start to a trade conflict with a major trading partner, markets have certainly taken notice of the increasingly harsh rhetoric. It will be interesting to watch over the course of the year how markets react to more potentially disruptive events and changes in the global status quo.

Our belief is that US equity markets remain overvalued, even if forward P/E ratios look attractive at the moment, because the tax cut will only provide a one-time boost to earnings. In addition, fixed income markets will face increasing pressure as accommodative policy is scaled back and disruptive political and economic events could have tangible effects on financial markets in 2018.  Normalization of interest rate policy has been the focus, but in this past quarter we saw some normalization in equity markets with a return of volatility.  The day-to-day swings in the market can be nauseating to watch but a reemergence of volatility could provide new opportunities to find value in both domestic and foreign equities.

As always, please do not hesitate to contact us if you have any questions.


Sincerely,

Carl R. Hall, CFA
Chief Investment Officer

Wealth Management at Century Bank logo.

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