Volatility returned to the markets in the first quarter as large intra-day swings replaced the relative calm of recent years. Stock markets started the year strongly, then sold off on concerns over inflation and rising interest rates. After a brief recovery, stocks sold off again in March due to worries over trade and the outlook for large technology stocks. Most stock indexes ended the quarter down slightly while still producing solid gains over the last twelve months. As expected, the Federal Reserve raised its target for short-term interest rates. Bond portfolios were down in value for the quarter as the yield on the 10-year U.S. Treasury rose 0.33 percentage points to 2.74%.
Economic data releases were generally positive, although a number of indicators softened as the quarter ended. It’s possible this was seasonal weakness similar to recent years where the first quarter was generally weaker but the following three quarters picked up. Many economists are expecting solid growth in 2018, helped by tax cuts, government spending, rising incomes, low unemployment and healthy growth overseas. Business and consumer confidence as well as the labor market remain strong. However, the housing market has been weakening while retail sales continue to disappoint. Overall consumer spending softened in the first quarter after a very strong fourth quarter.
As noted above, the Fed voted in March to increase its benchmark federal funds rate by a quarter percentage point to a range between 1.50% and 1.75%. The Fed also increased the monthly pace of reducing its balance sheet by not replacing bonds as they mature. Most economists expect the Fed to raise rates two or three more times this year. Combined with the balance sheet reduction, this could present a significant headwind for the economy and markets. The yield curve flattened, indicating that the bond market expects moderate growth and inflation beyond this year. The Fed is also projecting long-term economic growth below 2%.
Corporate earnings have continued to improve and analysts are estimating strong growth again in 2018. U.S.-based multinational companies continue to benefit from a weaker dollar and solid economic growth overseas. The underlying foundation of the U.S. economy remains solid. However, the market has likely already priced in expectations of strong earnings growth. Worries about broader issues like the economy, inflation and regulation of technology companies threaten to overwhelm earnings growth. A key question for the near term is whether we are entering a loud, but minor, trade skirmish or a full-fledged trade war. We expect markets to remain volatile in this environment of heighted uncertainty.