By Jeffrey Schulze, CFA, Investment Strategist at ClearBridge Investments
They only briefly dipped into "correction" territory, but this week's sharp equity sell-off stunned U.S. equity markets - and investors everywhere. Triggered by fears of higher inflation and higher interest rates, it was exacerbated by investor complacency: stocks cannot always go up.
But the selling was overdone, as Tuesday's rebound illustrated. Equity markets can handle higher rates from the U.S. Federal Reserve (Fed), assuming the ascent is not too rapid. Investors can overlook short-term price swings. Even with this dip, U.S. markets remain near record highs.
Everything worked for investors in 2017: President Donald J. Trump and the Republican-majority U.S. Congress enacted tax reform; the Fed continued to slowly tighten rates; credit spreads narrowed; and many stocks and bonds soared. For nearly every asset class, it was a "can't miss" environment. The S&P 500 made it to the end of January without a five percent decline, the longest stretch of positive market performance since the Great Depression.
Yet a sudden spike in interest rate volatility over the last two weeks, exacerbated by strong wage inflation data from the January jobs report, contributed to the largest equity sell-off in two years. Average hourly earnings increased 2.9 percent, the highest level since 2009. This raised concerns that inflationary pressures could be about to rise, and that the Fed may be behind the curve.
The markets overreacted to these events because of complacency. Prior to last week, the market had not seen consecutive daily declines for 310 days. The record streak of days without a five percent correction was broken Monday, February 5. These types of streaks are rare. They are typically followed by heightened volatility, as fear percolates back into investors' minds.
Notwithstanding the unexpected downturn, I continue to believe that:
- The positive momentum that has lifted equities will continue into 2018.
- Rising interest rates and inflation pose the biggest risks.
- The probability of a recession stands at less than 10 percent.
Business cycles need not die from exhaustion or old age. Australia is in the 26th consecutive year of expansion. Business cycles can end for many reasons: overly aggressive central banks; commodity price surges; and cyclical economic sectors overheating (often financed by asset bubbles). We see no strong evidence of any of these precursors to economic downturn.
ClearBridge Investments maintains a proprietary Recession Risk Dashboard, which evaluates 12 indicators that measure the four most vital fault lines upon which our economy rests: consumer health, business activity, inflation and financial markets. Analogized to a traffic light, as this is published, 11 of the 12 variables are flashing green.
Only one variable - corporate profit margins - flashes yellow. Even that is an improvement. Margins expanded in 2017 as revenue growth improved, while wages (the largest expense for many companies) were held in check. As a result, corporate profit margins moved up, from red to yellow. However, margins have most likely peaked for this cycle.
The economic backdrop outside the U.S. appears similarly supportive. For the first time in over a decade, the world is experiencing synchronized growth and improving corporate profits. The fewest number of countries will be in recession in 2019, ever, according to the International Monetary Fund. The 10-year recovery from the Global Financial Crisis was led by the U.S., and as our business cycle matures, better global growth should help offset any domestic slack.
Europe and many emerging markets are in earlier phases of their economic and monetary policy cycles. This should result in risk assets moving higher globally, enhancing opportunities.
Any other small pullbacks should also leave intact equity markets' primary drivers: the strengthening global economy, robust earnings growth and abundant liquidity. Consensus Bloomberg estimates point to well over 10 percent earnings per share (EPS) growth for the S&P 500 in 2018, in part due to benefits from tax reform. Since 1950, in years with 10-plus percent EPS growth, stocks have delivered an average return of 11 percent. That would be just fine.
Jeff Schulze is a Director and Investment Strategist at ClearBridge Investments, a Legg Mason affiliate. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
© 2017 Legg Mason Investor Services, LLC. Member FINRA, SIPC
