Key Points:
- January was a strong month for stock returns, today not so much
- Interest rates have gone up rather quickly so far in 2018
- With years of stable prices, inflation is starting to rear its ugly head
As I am sitting here in my office writing how great stock returns were in January (the S&P500 was up 5.73%), ready to start my weekend and watch the Eagles march into the “big game,” the market is selling off 2.5% today. So instead of talking about how great January was, I decided it’s probably more important to talk about what is going on.
On the one hand, I feel comforted that the market is healthy, going down instead of straight up (which honestly has been making me a bit cautious lately). On the other hand, a 2-3% selloff may lead investors to get nervous and continue the route next week and potentially beyond. So exactly what happened? Earnings have been good. Sentiment is strong. We had a good jobs report this morning, gaining 200,000 jobs in January. However, the report indicated that wages picked up. Wage inflation tends to be the big driver of price increases in the United States. We earn more, we spend more. We spend more, demand goes up along with corresponding prices.
The increase in expected inflation we have seen has caused the bond market to reprice itself, with rates increasing rather quickly this year. The 10-year Treasury yield has increased from 2.45% to 2.85%, as of today. Interest rates tend to go up when expected inflation increases because investors require higher yields to lend their money. This higher yield compensates for the fact that purchasing power will likely be less when their money is returned. Wage inflation, along with expected growth in GDP from the tax package, could cause the Fed to raise interest rates at a faster pace this year in an effort to keep inflation in check. Bond investors don’t wait for the Fed to move and expect 3-4 rate increases in 2018.
We are still constructive on the market and would have preferred this decline to have taken place over the course of a few days/weeks instead of today. Part of this may have been investors just waiting for a down day to take profits. We haven’t seen a negative return in the equity markets like this in some time. As of now we don’t think this is part of some larger selloff but will keep our eye on what is transpiring in the market and continue to manage our risks accordingly.