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As expected (and stated in our Q4 2017 report) volatility has made its presence known as stock and bond markets around the world suffered losses during the first quarter of 2018. The S&P 500 had a 1% single day swing 23 times during Q1. This occurred only 8 times in total during 2017. The CBOE Volatility index (VIX) catapulted 81% during the first quarter and posted a 20% plus jump during 6 trading days – the most ever for a quarter. A strong start to the year, in the U.S. equity markets, with a string of record high closing prices in January quickly retracted to end the quarter in negative territory with the S&P 500 index down 0.8% and the Russell 2000 down 0.1%. The only two equity market sectors to post positive Q1 returns were Technology (+3.53%) and Consumer Discretionary (+3.10%). Fixed Income markets suffered similar results with the Bloomberg Barclays U.S. Aggregate Bond Index down 1.46% and the ICE U.S. Treasury 20+ year Bond Index down 3.36%.

Several factors were responsible for this return to volatility during the quarter, including:

1. Signs of rising wage inflation. Data released in early February showed that workers’ wages the previous month rose at the fastest pace in 8 years. That likely made investors nervous that an inflation spike was possible which could then lead to the Fed aggressively raising interest rates to cap rising prices.
2. Concerns about tariffs and trade wars. The Trump administration’s announcement in March that it would implement stiff tariffs on certain imports fueled fears of a trade war that could hobble the global economy and consumer spending.
3. Trouble in the Tech Sector. Near the end of Q1 2018, concern that Facebook may have allowed its users’ data to be accessed inappropriately by political campaigns made investors leery of the once red-hot technology sector. Selling pressure among Facebook and other tech names created additional volatility.

It is very important to note that, despite rising volatility and the many headlines about it, during the quarter the VIX’s average was 17. While that is significantly higher than where the VIX started the year (around 10), it’s still below its long-term average level of around 20. What we experienced during the quarter was a return to a much more historically normal level of market volatility and not an environment of record high or even excessive volatility.

It was very easy for investors to focus on the above and overlook the fact that many key fundamentals underpinning both the economy and the markets, remained strong;

1. The U.S. economy in the fourth quarter of 2017 grew by 2.9%, driven by robust consumer spending and business investment.
2. Consumer confidence hit an 18 year high in February.
3. Inflation remained relatively tame, with the Fed’s preferred inflation gauge (core PCE) up 1.6% in February, on a year over year basis.
4. Jobless claims sank to their lowest level since 1973.
5. Q4 corporate earnings were strong and exceeded expectations.

The noise of the markets during the quarter muffled the fact that the economy remains healthy going into the second quarter.

Within the fixed income markets, expectations for bonds in the current rising rate environment remained muted. Investment grade credit under-performed government issues in the quarter while high yield corporates outperformed the investment grade universe. Municipal bonds continued to keep pace with the taxable part of the market, despite lower tax rates for many Americans following last year’s tax reform passage. By mid-February, yields on some U.S. government debt hit their highest levels since 2014. Bond markets also had to contend with a new Federal Reserve Board Chairman. As expected, the Fed raised a key short-term interest rate at its March meeting, marking the 6th rate hike since December 2015.

As bond yields rose, the yield curve flattened. This happened for two main reasons:

1. Shorter-term bond yields, which are influenced heavily by the Fed’s monetary policy decisions, increased steadily during the quarter. The yield on the 2-year Treasury note ended the quarter at 2.27%, up from 1.88% at the start.
2. Longer-term bond yields rose more slowly. Rising interest rates and inflation fears would typically cause long-term yields to spike. However, strong demand for these bonds (especially from foreign buyers) in the wake of stock market volatility helped to tamp down their yields somewhat. The yield on the 10-year Treasury bill ended the quarter at 2.74%, up from 2.41% at the start (the largest quarterly rise since 2016).

Ultimately, the key driver of bond market returns during the quarter was duration: The longer a bond’s duration, the worse its return; the shorter a bond’s duration, the better it did. Duration is a big reason why both high-yield bonds and preferred stocks, which tend to have relatively short durations, performed relatively well during the quarter.

A Look Ahead: A strong U.S. economy, continued global growth improvement, a concerted effort by global central banks to remain accommodative as long as possible, and a general sense of complacency about valuations in the equity markets provided the backdrop for 2017’s wins. Globally diversified portfolios performed well, as international and emerging markets contributed meaningfully to returns. Many of the same forces are at work in 2018, although risks have certainly increased. Investors appear less complacent , which has led to greater volatility in asset prices; however, this may lead to a renewed focus on fundamentals and valuation, which could drive upside in portions of the market which have not participated as fully in the run.