We are two months into 2018 and so far it has been just about everything that 2017 wasn’t. Higher interest rates, higher inflation expectations, more stock market volatility, new tax laws, the list goes on and on. I usually have to wait for an entire year to go by before having enough to do a full recap – this year I get to do it in the first days of March.
Ryan Craft and David Ott have both written great pieces on different implications of the new tax law, (Dave’s here & Ryan’s here). Without repeating too much of what Dave and Ryan said I wanted to start here because the changes in 2018 so far have so much to do with expectations and a lot of people’s expectations are related to what changed tax wise.
Of course the real effect is hard to calculate. So many people moving to the standard deduction is likely to affect how people think about their mortgage interest expense, but how much? The large corporate tax cut is expected to be a boost to the bottom line, but what will companies do with those extra profits? Lower tax rates for individuals and businesses change the value of tax exempt interest and that should cause ripples in municipal finance, but the reality is that markets aren’t perfectly efficient and those effects can take time or not even happen at all.
I won’t go as far as to say that there’s consensus on this front, but the business and investing world viewed the tax cut as a positive in the near-term. But sometimes good news can be bad news.
At the end of 2017 the market was expecting 2 rate hikes in 2018, but was only assigning a 35% probability of a third. As of now, the market is almost certain that we will get three and think there is a 35% chance we get 4. This is a large change in a short amount of time and there is one main culprit… inflation.
Not real inflation per se, but the expectation for inflation. Inflation expectations can be measured different ways, but they have all moved higher.
The 5-year breakeven yield is up to 2.10% versus 1.90% in December, and the 10-year has made a similar move. (Breakeven yields are calculated by subtracting the yield on an inflation protected Treasury bond from a nominal Treasury.)
U.S. 5-year 5-year Forward Breakeven yields are up around 2.20% versus a mark of 1.90% in December. Fed officials favor this measure so it’s worth noting that the move here has been a little more dramatic.
Surveys of private economists tell a similar story. Bloomberg tracks CPI expectations from about 70 economist with an average of 2.3% for 2018 and 2.2% for 2019 and a range that tops out at 3.2% and 3.7% respectively. These expectations for higher inflation are causing people to wonder how aggressive the Fed might get in raising Fed Funds. Add in another unknown of a new Fed Chair and expectations be even more scattered.
The one factor missing from all of this is actual inflation. Year on Year CPI did jump up in late 2017, but it was even higher in 2016. The headline figure tends to be more volatile because of how food and energy prices can change so fast. Those are excluded in Core CPI, which stands at 1.8% as of the last reading.
Volatility returned to the stock market in February, with the Dow being down 4.60% on Feb 5th and 4.15% on the 8th. Down 4.60% in one day isn’t very common, but down 1,175 points marked the largest single down day on record. The S&P 500, a much broader measure, was down 4.10% and 3.75% on those days.
From the closing peak on January 26th to the bottom on February 8th we just barely crossed the correction threshold, finishing at down 10.16%. Some interesting facts about the move. It was the first correction in about 2-years, which is an unusually long time to go without a down 10% move. It also happened extremely fast, happening over just 13 days (only 9 trading days). Depending on how want to measure your corrections it was the quickest down 10% move that didn’t result in a bear market going back to 1929. But then again, we haven’t set new highs so the bear market door isn’t shut quite yet.
The worst of the volatility appears to be behind us but markets continue to be choppy. Already this year we have had 16 days of up 1% or down 1% – for some context we had 8 in all of 2017. If we continue at our current pace of 8 per month we would finish the year at 96, which is just about the average going back to 1999. Again, maybe not ideal, but certainly not unprecedented.
I know banks aren’t directly exposed to the stock market, but it is a good barometer of risk and stock returns do have some flow through to other markets including credit. It’s important to keep the proper perspective and understand that movements like this are a sign of a normally functioning market attempting to do its job to price risk. Interest rates are an important input into things like margin in brokerage accounts and the ratio of household debt to disposable income – both of which are at post crisis highs.
As for the rest of the year…
Overall, most of what has developed over the first two months of the year is positive. Of course some days didn’t feel that way, but the broad macro picture is trending in the right direction.
The Fed being mindful of an overheating economy is also a good thing. Moderate inflation usually accompanies a growing economy, but central banks can also leave easy money policy in place for too long and overshoot. The turning point for the Fed to get serious about interest rates requires a period of adjustment, and we may not be through it all.
Regardless, a long-term strategy can weather much worse than what we’ve experienced so far in 2018. The trick isn’t to try and anticipate the timing of the moves, but instead understand enough about the risks you have so you aren’t surprised when it rears its ugly head.