Equity markets underwent a significant transformation during the first quarter. Volatility increased markedly after an extended period of calm as investors became increasingly concerned about rising interest rates and a potential trade war. This led to the cessation of the sustained market uptrend and a severe correction. A high level of complacency also contributed to the stock price vulnerability. The US stock market declined 1.2%, while the Canadian market declined 5.2%. Bond markets also fell as interest rates rose on inflation fears. Bond markets were responding to improving economic conditions and Central Banks removing previously injected monetary stimulus.
The recent rise in volatility and the stock market correction coincided with a changing of the guard at the Fed as Janet Yellen concluded her term as Fed chair. This should not be too surprising as the markets also experienced increased volatility when the previous Fed chair retired. The incoming fed chair, Jerome Powell, has signaled a continuation of the current policy of gradually raising interest rates. The economy is at a critical juncture due accelerating growth, near capacity employment and accommodative interest rates. Investors are fearful of a resurgence of inflation due to the government's tax cuts. Although it was Janet Yellen who began this tightening cycle, it will be Jerome Powell's Fed that does the heavy lifting with regards to monetary tightening. The trick will be to raise interest rates just enough to return interest rate policy to neutral (vs. the current accommodative stance) while at the same time not raising them too far or too fast and snuffing out the economic expansion. Federal Reserve tightening cycles always tend to be messy, and this one should be no different.
President Trump has been making a lot of noise of late about increasing tariffs on US trading partners and winning a trade war. Optimistically, his bluster is only a negotiating strategy to get US trade partners (and specifically China) to negotiate more balanced trade agreements. Unfortunately, the market has been focussing on the negative consequences of a potential trade war, and the theoretical impact on the economy. Investors are keying in on the tail risk that negotiations are unlikely to be successful which would lead to a full out trade war. This would obviously be negative for the global economy. Contrary to President Trump's recent statements, there are never any real winners in a trade war. While we believe a full blown trade war is unlikely, President Trump has created ambiguity as to the eventual outcome, and the market abhors uncertainty. Increased uncertainty implies lower valuations, which results in increased volatility.
As the market has recently been focused on issues that could derail the bull market and the economy (trade and interest rates), earnings estimates have continued to creep upwards. Positive estimate revisions are based on increased capital spending, benefits from the recently enacted tax cuts and better foreign earnings due to a weaker US dollar. This has translated into 2018 earnings estimates that are 16% higher than 2017, with a further 10% increase projected for 2019. Valuations towards the end of 2017 appeared expensive when in reality stock investors were anticipating the acceleration in earnings. With rising earnings estimates, we now have a market that is reasonably priced based on historical valuations.
We continue to prefer equities over bonds. Although bond yields have improved, bond yields are still only returning low single digits. US equities are trading at 15 times next year's earnings which is pretty close to the historical norm. While the Canadian market is a little cheaper than the US market, we continue to prefer the US market due to its diversity, higher growth profile and lower cyclicality. With the Fed tightening and with the current, uncertain political climate, we expect volatility to remain elevated.
By providing strategic portfolio diversification, Condor's client returns have significantly outperformed Canadian stock and bond markets over the last five years. As always we welcome your thoughts and comments.
