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The Economy and the Markets | First quarter 2018

Volatility makes a comeback

While nothing seemed to rattle the markets in 2017, volatility made a return in 2018’s first quarter.

The U.S. equity markets fell almost 10 percent in February, over worries inflation would flare up. The Dow also lost 400 points on March 1, and more than 700 points on March 22. Both drops followed the Trump administration’s tariff announcements. With this rocky start, we expect volatility to be a continued presence in 2018. 

Expect more market ups and downs in 2018

Graph: CBOE volatility index

Source: Bloomberg. From 10/04/2017-3/29/2018.

We expect the Federal Reserve (Fed) will be an important force in 2018. A new Fed chair and an environment favoring interest rate increases could be critical in the year ahead. In addition, the recent tax bill will begin to demonstrate its potential impact.

Trade: A war or a skirmish? 

International trade became a concern when President Trump announced tariffs on steel and aluminum produced overseas. Later in March, he stepped back from those plans, but announced new tariffs on China. The markets recovered from the decline following the first tariff announcement. However, the Dow dropped again in late March with the announcement of tariffs on Chinese goods.

We don’t expect trade to pose major risks to the economy or the markets. We may experience short-term ups and downs over trade negotiations, but revising previous trade agreements could be positive for the economy over the long term. U.S. trade with Mexico had a smaller economic impact when North American Free Trade Agreement (NAFTA) was originally negotiated, and it may merit a new look.

According to the Bank of America Merrill Lynch Global Fund Manager Survey released in March, 30 percent of investment fund managers saw a trade war as the greatest risk to the market. We do expect more market volatility around this issue. However, we think the markets in 2018 will be most affected by corporate earnings, which we expect to be strong.

Strong job market

The employment market grew stronger during the first quarter. The U.S. Bureau of Labor Statistics’ Employment Situation reported February’s 313,000 new jobs ranked as the best month in two years. The unemployment rate remained at 4.1 percent, and could soon fall below 4 percent, a level last reached in December 2000. 

Markets are watching for signs that high employment is driving up wages. Wages grew at a 2.9 percent rate in January, which drove stocks down sharply with worries about inflation. But wage growth came in at 2.6 percent in February, easing those fears. The market remains nervous about inflation,* and continues to view every economic statistic in light of what it indicates for higher prices.

Job creation remains strong, but wages remain muted

Graph: Nonfarm payroll employment and U.S. average hourly earnings

Source: Bloomberg. From 10/04/2017-3/29/2018.

Looking closer, we see strength in employment bringing more people back into the job market and moderating wage gains. We project workers who were discouraged or dropped out of the job market are returning. That eases the pressure on employers to increase wages to fill jobs, and lowers the likelihood that hikes in pay will bring hikes in prices. We believe wage growth would have to reach and then stay at 4 percent to significantly increase inflation.

Investors are also closely watching the Fed under its new chairman, Jerome Powell. Observers had anticipated three interest rate increases in 2018. Powell, during his first press conference in March, confirmed the Fed plans to follow that script. Powell also indicated that the Fed plans three increases in 2019. His words were reassuring for markets worried about a spike in inflation, but any signs the Fed and Powell will become more aggressive could spark a swift negative market reaction.

Who said “recession”?

The U.S. economy is now into its tenth consecutive year of growth. Though inflation has remained below 2.0 percent over the last three years, some observers are forecasting a recession for 2020. Higher inflation can prompt the Fed and European and other central banks to raise interest rates, which could in turn slow global growth. This, combined with conflicts over trade and tariffs, could contribute to global economies falling into recession.

Inflation still below target

Gaph: U.S. personal consumption expenditures and Federal Reserve inflation target

Source: Bloomberg, Advantus Capital Management. From 1/30/2015 – 3/31/2018. The Personal Consumption 
Expenditures Core is the Fed’s preferred measure of inflation.

We believe tax reform could make corporate earnings, solid in 2017, even stronger in 2018. Based on our review of financial earnings calls, corporations, on average, have been paying taxes at a 27-percent rate, which are likely to fall to 21-22 percent. Tax reform and the potential for increased government spending on defense and other programs could increase economic growth by one-half of one percent, which is a significant boost. The Atlanta Fed feels confident of continued growth, with an April 5 estimate for first quarter gross domestic product (GDP) of 2.3 percent.

Our view is strong earnings growth and business investment will keep the economy expanding for at least two to three more years.

Our review of company earnings reports indicate they are using stronger earnings to hire more employees and invest in their businesses. Our sense is that business confidence remains strong, and the tax law’s favorable treatment of cash repatriated from overseas, gives companies more money for capital expenditures, hiring, share buybacks, and mergers and acquisitions.

Two views of real estate

The public and private markets see real estate investing through a different lens. Our research indicates the public markets sold off Real Estate Investment Trusts (REITs), utilities, dividend-paying stocks and other income-paying equities in a wave of concern over potentially rising inflation and interest rates.

However, in the private markets, our research tracks buyers pouring money into commercial real estate investments that may produce sustainable income growth. Sovereign wealth funds and domestic pension funds in search of returns are actively buying self-storage facilities, apartments and hotels. In the industrial sector, rent growth has kept up with rising construction costs. E-commerce is driving demand for more distribution facilities, as companies work to get closer to and deliver sooner to online customers.

Even if inflation increases, we forecast commercial real estate will be a good investment. For much of the period following the financial crisis, builders have been able to pass on increased costs, and we expect them to retain that ability.

Office building dynamics are changing, as companies look to squeeze more employees into less office space. While areas like Seattle and San Francisco are seeing new office construction, rising construction costs mean fewer speculative office building projects elsewhere.

For bonds, the good times roll

Low interest rates make this a good time for companies to borrow money. While some bond market analysts expect a drop in new issues, we take an opposite view. Mergers and acquisitions, and the repatriation of overseas dollars, should spur companies to issue more bonds and keep the new issues market humming.

The market for corporate bonds has been almost insatiable. Our traders indicate that Japanese and Asian buyers are buying about 40 percent of new bond issues. European investors may become more active. Non-investment grade bonds appear to remain volatile, as tax reform has reduced the ability of these companies to deduct interest expenses.

We expect the 10-year Treasury rate to trend toward 3 percent, unless the market perceives the Fed is behind the curve on inflation.

What could possibly go wrong?

We expect 2018 to bring solid economic growth and good investment returns. But there’s the potential for “black swans,” unexpected events that rattle the markets. A few possibilities include the November mid-term elections, North Korea, the Russia investigation, oil prices, and China’s economic growth rate.

We’re keeping a watchful eye on three potential disrupters: (1) the possibility that protectionism grows and sets off a trade war; (2) the prospect of the Fed raising interest rates at a faster pace than expected; and (3) earnings either growing much faster (thanks to rising employment and consumer spending) than expected, or much slower (if tax reform doesn’t have the expected impact) than hoped. Regardless of whether any of these events occur, we expect ongoing market volatility in 2018.

Source is Bloomberg for all information, unless noted otherwise. Investment risks associated with international investing, in addition to other risks, generally will include currency fluctuations, political, social and economic instability and differences in accounting standards when investing in foreign markets. Fixed income securities are subject to credit and interest rate risk and, as such, values generally will fall as interest rates rise.

The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The Dow Jones Industrial Average is a stock market index that shows the price-weighted average of 30 large and well-known U.S. companies.

*U.S. average hourly earnings, all employees total private yearly percent change SA report published by the U.S. Bureau of Labor Statistics.

Investments will fluctuate and when redeemed may be worth more or less than originally invested. Past performance is not indicative of future results. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

This commentary should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. Opinions expressed herein are those of Advantus only. Investors should keep in mind that markets are volatile and unpredictable. Past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested.

This article contains forward-looking statements based on expectations and assumptions. Actual results could differ materially because of changes to these expectations and assumptions. The Economy and the Markets has been prepared for informational purposes only and is the opinion of Advantus Capital Management, Inc., a registered investment advisor.

Investment risks associated with real estate investing, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes, and differences in real estate market values

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