It was both long overdue and arguably healthful that the market experienced a noticeable pullback last week (and that appears to be bleeding into another). The S&P500 skidded -2.1% on Friday and ended the week roughly -4% below its January 26 highpoint. In virtually all our writings and conversations over much of the last 6 months, we have conveyed that investors should at some point anticipate a rise in volatility as periods of extended calm like enjoyed since late-2016 are rare. But as much as one tried to emotionally condition themselves for the possibility, pullbacks are never fun, and the magnitude with which Friday capped an already difficult week likely creates anxiety for those who have enjoyed seeing their portfolio values steadily climbing to new heights on almost a daily basis in the early days of 2018. So what many may find most interesting then is that this overdue reversal comes amid economic news that is actually quite strong.
From an economic perspective, the news blamed for sending the market into its frenzy on Friday was the strength of the January employment report. Specifically, the report reveals that employment remains strong, the labor market tight, and finally wages rising at a more noticeable clip than to this point since the financial crisis concluded. This caused US Treasury bond yields to spike higher, which has implications for virtually every asset class. For literally years this stronger data is the type of development economists and central bankers have been hoping for. Yet as it is arriving, it seems markets now worry. They worry because wage growth is the breeding ground for rising inflation. And rising inflation is the reason that central bankers pursue less accommodative monetary policy. It is those policies that most attribute for powering the appreciation of financial assets like stocks and real estate rather than true economic growth. Interesting. Is good news, now bad news for the markets? Ultimately, we see little reason to believe that last week marks the end of the current economic expansion or bull market. Estimates for growth of both the economy and corporate earnings continue to rise; no recession has ever begun when corporate earnings were still climbing. Tax cuts, particularly corporate, also appear to be encouraging businesses to deploy capital into their businesses. These are blatant positives, and we believe the underlying fundamental case for both the economy and financial assets remains supportive. But it is these stronger data points, along with tax cuts, along with fiscal spending proposals, and a weaker dollar, that provoked us to suspect that inflation worries might begin to constrain the financial markets or give them pause in the short-run.
The recent spike in government bond yields is telling of the worry in the market. The selloff in bonds represents the most clear inflection point yet where the focus is shifting toward normalization of monetary policy in pursuit of avoiding too-hot inflation. And make no mistake, that is a risk to financial markets because the Fed and other central bankers are not immune to making mistakes via overtightening. But the yield curve has steeped in recent weeks; typically an inverted yield is an excellent predictor of economic recession, so the fact that is steepening lends itself to the idea that more time still remains this cycle. In fact, the recent selling pressure in the markets would be more worrisome from our perspective if it were accompanied by lower bond yields rather than higher ones. But in the nearest of timelines, we suspect this market hiccup may not yet be done. February is often a choppy month for returns. But a strong January as just witnessed, historically bodes well for full-year returns; when combined with an economic backdrop that appears to be accelerating and sentiments high, it is hard for us to get too negative or view the recent setback as anything other than overdue and a cleansing reminder that markets do not typically travel linearly upward and risk always exists.