Rebound Continues Helping Narrow Early-February Drawdown – Week Ended 2/23/18

Following what was easily the sharpest and most stressful drawdown the markets experienced in the last two years, foreign and domestic equity markets are managing to fight their way back in recent weeks, dramatically narrowing the loss that was built in early-February. Volatility, remains more elevated than witnessed during virtually all of 2017 due to bond yields that have risen materially on the worry about rising inflation. But since February 9, the S&P500 is up almost +5%. With the rebound so sharp though and the pullback relatively short-lived, the biggest questions in our mind are: was that really the extent of the correction (seemed too short, even if it was panicky and nerve wracking); and secondly, will the market actually manage to finish roughly flat for the month? Writing today with the markets again notably higher, it seems the race is on, but barring a sharp selling between here and Wednesday it would seem the market has achieved a highly unexpected and HUGE moral victory and seeming credibility to participants such as us who believe the pullback was largely an overdue technical correction rather than a meaningful change to the positive underlying economic fundamentals.

From an economic perspective, we continue to observe data supportive of firmly positive economic undertones. For example, throughout the recent earnings reporting season (4Q being reported now), 78% of S&P500 companies have beaten sales estimates; that is the highest beat percentage since FactSet first began tracking this data in 2008. Other more timely indicators such as company surveys suggest the robust pace of growth remains intact if not outright accelerating. Machine tool orders surged 48% in January over year-ago, and industrial orders were up +12.4% annually in Italy; just two examples that strength appears truly global. But it is in that regard where some participants continue to be troubled and highlights our writing two weeks ago (Is Good News now Bad?): faster growth should be expected to result in rising inflation and the data continues to stoke those fears and lead many traders to worry that the Fed will need to adopt a more aggressive pace of unwinding the historically accommodative stimulus that is a hallmark of the post-financial crisis period. The topic of monetary policy itself also poses a worry for some given a new Fed Chairman and a number of seats on the committee are new faces. Are their perspectives of policy normalization different than the outgoing committee? These last two points are ground-zero for why bond yields have surged since late-January creating headaches for holders of intermediate- to long-maturity debt.

With all the emphasis and attention being paid to the robust pace of growth and how that may prove inflationary and ultimately problematic, it remains important to consider that there are still significant headwinds to sharply higher or truly problematic inflation actually materializing. The reasons are numerous, but most notably are the deflationary themes of technology, the Amazon effect, and contained oil prices. Most notably, the Amazon effect and technology continue to flood abundant and cheap and competitive pricing on a huge range of consumer goods and prices putting a lid on how much pricing power there is. Some inflation is good; actually a goal central bankers have been pursuing for most of the last 9 years. The key is, can we continue to avoid significant wage-growth that begins to pressure corporate margins (a critical input to asset prices) and leads to broader inflation, even as officially reported unemployment rates are touching all-time historical low levels. Long-term, the answer probably still remains no but there are many reasons to believe that inflation inching higher is not a problem yet. Caution: perception can become reality and if the Fed perceives problematic inflation is developing they risk over-tightening. But in our view, there still remains fuel in the tank for this cycle.

Posted in Blog Post.