06 Feb Market Volatility – What You Need to Know Now
Stocks have given up their 2018 gains after a few rough days in the market, with the S&P 500 dropping about 10% from the peak before stabilizing some this morning. We believe a primary driver of the sell-off is inflation fears, as wage inflation is starting to finally pick up. This creates concern the Fed will raise rates more aggressively. Higher rates act as brakes on the economy, making the cost of capital, mortgages, and credit more expensive. Further, the market has been going up in a straight line for an abnormally long time with very little volatility despite high valuations. Political gridlock and polarization doesn’t help either. Keep in mind that algorithmic and momentum trading likely played a role in exacerbating the volatility.
The good news is nothing has really changed fundamentally. The US and economies around the world continue to improve, almost in a synchronized fashion, with little risk of a recession on the horizon. The tax cuts are very constructive to earnings, which should help alleviate some of the overvaluation fears. Wages are likely increasing due to the low unemployment rate typical of this stage of the economic cycle. As things get better for Main Street, Wall Street worries an overheating economy might cause the Fed to apply the brakes too hard. Absent some geopolitical event, it would take a major increase in rates to upset this economy. While possible, we don’t think this is probable. It is more likely we will see a steady increase in rates over the coming years, which the economy will likely be able to absorb.
We haven’t really had a major fiscal policy (tax cuts) at this late of a stage in the economic cycle, so market participants are trying to sort out what that means. The bull case is companies will buy back stock, pay more in dividends, pay higher wages, make more capital investments, and this will all lead to strong GDP growth for many years. The bear case is lower taxes come at the expense of higher, unsustainable debt. Bears argue interest rates will increase not just due to a stronger economy, but due to concerns about US financial stability. There is also concern we won’t have much ammunition to fight the next recession, as we are spending it prematurely and unnecessarily now. If inflation becomes a problem, stocks eventually adapt more than most asset classes, as they can pass on higher prices to consumers. However, between now and then, things can get very volatile should that scenario occur. It’s too early to tell or make portfolio changes in anticipation.
Keep in mind volatility is normal and not unexpected. It would be abnormal if we don’t see more of this chop in the coming months. Highland has a goal-based approach to managing portfolios, meaning we allocate assets based on your goals, not what we think the market is going to do in the short term. Therefore, funds invested in stocks are generally thought of as assets you might spend 5+ years from now. Conversely, money invested in bonds or cash is there to serve as a stabilizer and to fund shorter-term spending needs. In most cases, our clients have anywhere from 5-10+ years of their spending needs in bonds, and our bond durations are shorter than the indexes as our investment committee has been concerned about the impact of rising rates. For our current client base, this means there’s no reason to worry or make any significant changes.
Highland makes the best of volatility by using it as an opportunity to rebalance and/or harvest tax losses when appropriate. The main thing investors can do right now is to review their anticipated cash needs and let their advisor know if they think their need is higher than originally planned. Additionally, times like this are always a good time to re-evaluate your risk tolerance. Absent a change in cash needs or risk tolerance, it is best to stay the course and not try to time the market. If putting cash to work, it may make sense to put a little more to work this month to take advantage of the dip.
As always, Highland stands by to help you make sense of the financial market noise and support our clients in the achievement of their long-term investment and personal goals. Please feel free to contact us if you have questions or need information about our investment approach or other services.