Volatility Spikes Amid Rising Inflation and the Threat of a Trade War | Capital Group

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Volatility Spikes Amid Rising Inflation and the Threat of a Trade War

The low volatility that’s been a trademark element of the stock market in recent years was always a bit of a double-edged sword. Though it was a symbol of economic optimism, it carried the risk of investors being caught off-guard when turbulence returned to historical norms. That scenario has played out twice in the early stages of this year, with stocks gored first by concerns about inflation and later by the specter of a trade war. Economic reality is far more promising, as the global expansion remains on track. Still, the undulations in stock prices highlight the risks facing the market in the 10th year of a bull run.

Inflation worries spiked after a government report showed wages jumping as employers scrambled for workers. The news shouldn’t have been surprising given the ongoing drop in unemployment. But it startled investors nonetheless, and the S&P 500 tumbled 10%, the traditional definition of a correction. Subsequent data indicated that inflation remains under control and that investors’ initial agitation was overblown. Consumer prices are likely to rise this year, but at a restrained pace that is not expected to undermine the equity market. Capital Group economist Darrell Spence addresses this in greater detail here.

The prospect of higher inflation rattled the bond market, with the 10-year Treasury yield briefly threatening to exceed 3%. Though that would still be low by historical standards, it stirred debate about whether the era of low interest rates was drawing to a close. The Federal Reserve has raised rates six times since late 2015, and two additional hikes are expected this year. Investors are on the lookout for any signs of an overheating economy that could prompt the central bank to tighten more vigorously. The immediate pressure on bonds eased as anxiety about inflation receded, and the 10-year Treasury finished the quarter at 2.74%. Mike Gitlin, Capital Group’s head of fixed income, offers a detailed outlook for bonds here.

Given that rising rates often precede recessions, the Fed moves have raised questions about whether an economic downturn may be in the offing. Capital Group research suggests otherwise. An analysis of past rate hikes shows that the speed with which the Fed acts can play a role in the timing of contractions. In general, recessions take far longer to develop when the central bank moves gradually, as it is today. As a result, a recession is very unlikely before late 2019 or early 2020 at the soonest, according to our analysis. Our research also found that the stock market peaks an average of nine months before the start of an economic contraction, suggesting that a bear market is unlikely for at least an additional 12 months.

The specter of a trade war has unnerved investors.

Of course, other forces can chill the market, including the outbreak of a pernicious trade war between the U.S. and China. President Trump’s threat to slap $60 billion in tariffs on Chinese-made goods — which came barely a week after the announcement of tariffs on foreign-made of steel and aluminum — raised the prospect that the U.S. would retreat from its once-inviolable commitment to unfettered trade.

The immediate impact of escalating trade friction is likely to be limited, according to one estimate. The announced tariffs could shave an estimated $82 billion from U.S. growth this year, which is minor compared with the $800 billion in stimulus money funneling into the economy from tax cuts and other fiscal measures. 

However, the long-run fallout is unclear, as deeper tensions have percolated for some time. The antagonism stems from many factors, including the impact of Chinese exports on U.S. manufacturing jobs and long-standing complaints that China is expropriating American technology through lopsided trade deals. The Asian giant’s abolition of term limits, which effectively installed President Xi Jinping in power indefinitely, has aggravated the situation given his determination to make China a dominant force in areas such as advanced semiconductors, robotics and artificial intelligence. That has fanned worries that China is less likely than ever to move toward a market-based economy, as the U.S. has long sought.

An all-out trade war is doubtful because of the economic dangers it would pose to both countries, according to an internal analysis. But smaller skirmishes and tit-for-tat retaliatory measures are possible as the U.S. and China recalibrate their relationship amid a broader debate about global integration and the decades-long dismantling of trade barriers.

The trade clash has overshadowed the robust economic picture around the world. Global growth is projected to edge up this year, thanks partly to continued improvement in emerging economies. Corporate earnings are likely to ease back from their feverish pace of 2017, but U.S. and foreign companies are still expected to achieve double-digit profit growth this year. With the U.S. in the late stage of the economic cycle, indicators such as increased merger activity and a rise in inflation-adjusted interest rates have begun to flash cautionary signs. However, other signals that typically foreshadow market breaks are not present, including a weakening of earnings upgrades and a shift to defensively oriented stocks.

Our portfolio managers have selectively deployed capital into sectors with promising long-term outlooks while seeking to minimize downside volatility in industries with high valuations. For example, some added to exposure in the energy sector through positions in oilfield services and drilling companies. Demand for oil is strong amid the global economic upswing, and exploration projects are slowly ticking up after a lengthy hibernation. The increasing number of rigs in operation bodes favorably for companies offering oilfield services.

Opportunities are also being created by artificial intelligence. The technology industry is working furiously to develop AI in the belief that it will have applicability across many industries in coming years. In what amounts to an arms race for talent, leading companies have rushed to scoop up engineers and programmers.

Our managers also have been drawn to select health care businesses.The combination of faster regulatory approvals and more-efficient research is helping to lower the cost and speed the development of new medicines. That’s increased the willingness of companies to devote research to so-called orphan diseases, which afflict a relatively small number of patients compared with more-common ailments. The limited potential audience for orphan drugs has made it financially infeasible for drug companies to pursue remedies. But the streamlined research process has altered that calculus, as quicker and cheaper clinical development opens new markets for companies while providing a source of potential cures for patients.

The rise in interest rates took a toll on bonds.

Increasing yields weighed on fixed-income returns around the world, with bonds suffering a down quarter. The movement in rates has caused a flattening of the yield curve in the U.S., which measures the relationship between short and long rates. That has increased the risk of a so-called inversion, in which short rates exceed long rates. (By virtue of the greater risk inherent in holding bonds over extended periods, long bonds typically carry higher rates.)

Historically, inversions have preceded market downturns by an average of nine months. However, an inversion is likely to be a less reliable indicator in the current market cycle because a number of factors are artificially depressing bond yields. These include the Fed’s unwinding of its balance sheet, ongoing quantitative easing programs outside the U.S. and the savings glut in Asia.

After a years-long rally in the bond market, credit spreads have tightened as investors have stretched for yield in a low-rate environment. Our managers have been careful not to take such undue risk. As a result, our exposure to investment-grade corporate bonds is below the benchmark, providing a potential cushion if spreads on these securities tighten further. Meanwhile, the possibility that inflation could exceed current market estimates has caused our fixed-income team to favor Treasury Inflation-Protected Securities, or TIPS, which could benefit in such a scenario.

Though rising rates can be unsettling to investors, the additional income generated by higher-yielding securities can more than offset short-term capital losses.

Regardless of short-term gyrations, bonds remain an essential component of broadly diversified portfolios. Aside from their income generation, bonds provide diversification from equities, and can be a safe haven during bouts of turbulence in the stock market. That’s particularly important now, given the heighted volatility in stocks after the lengthy advance of recent years.

The above article originally appeared in the Spring 2018 issue of Quarterly Insights magazine.