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WIA BELIEVES | Volatility Returns

| February 09, 2018
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We continue to believe all that we shared in our November 20th commentary - global economies are strong, equities have gotten ahead of themselves, volatility in both stocks and bonds is overdue and natural, and business/government strategies are pro-growth. But be prepared to hold onto your hat.

The equity markets officially entered into what is considered a market correction, after falling 10% below their peaks of January 26. Garnering most of the headlines, the Dow Jones Industrial average declined over 1,000 points in one day, which is the most points ever lost in a single day of trading. However, while a thousand points would have been big news in the 1980’s and 90’s, the index is at much higher levels now, so the decline only represented a 4.15% drop. While this pullback signals a return to higher volatility in the markets, a decline of this magnitude could be expected once or twice in a calendar year. In comparison, on October 19, 1987, known as Black Monday, the Dow lost 22.6% in one day. While this was only a 508-point drop, the index lost nearly a quarter of its value in a single day.

The recent fall in stocks comes after an unusually long period of calm, and therefore has many investors on edge. While The Great Recession was ten years ago, the scars are still fresh in many investors’ minds and they do not want to live through another major selloff. While this is a fear, most economists would say that the U.S economy is definitely not entering a recession. It can be hard to believe, but the news causing the current pullback is actually positive for the economy.

The equity markets are reacting to higher growth prospects in the United States caused by low unemployment and, in part, by the recent tax reform. The tax reform is adding stimulus to an economy that arguably does not need it. Economists estimate the GDP for the United States could be 0.2% to 0.5% higher over the next couple years as people spend more money from their temporary tax cuts, while corporations could potentially expand production as their corporate tax rates were permanently reduced. In addition, companies doing business abroad can repatriate cash at lower tax rates. And, all this is happening while unemployment rates are at a very low at 4.1%, arguably close to full employment. The Labor Department recently reported that average hourly earnings for all private-sector workers increased by 2.9% in January from a year earlier. This is the biggest gain since 2009 and comes even before the impacts of the tax reforms can truly be felt. There is a concern companies will have to bid even higher for qualified labor as companies compete for workers. This will cause even more wage growth and potentially add to inflation, which eats into corporations earnings.

In addition to equity investors taking notice, fixed income investors are also reacting. Treasury bonds have sold off, causing the yield on the 10-year Treasury bonds to approach 2.9%, a level not seen since early 2014. Bond investors want more yield to compensate them for more expected inflation. In turn, the higher yields impact mortgage rates and corporate borrowing costs and generally slow down the economy.

However, at current mortgage rates and yields, we think the fears related to runaway inflation are premature. The Federal Reserve and other central banks around the world, especially Japan, have desperately been seeking higher inflation to normalize short-term interest rates, which will help savers earn more interest and give the central banks more tools for when the next recession begins.

We seem to be in another period where good news is perceived as bad news. As economic growth picks up, investors are worried about the consequences of higher growth. Until this recent sell-off, we had gone the longest period of time ever without a 3% drawdown from a peak in the S&P 500, so investors had grown accustomed to this low volatility anomaly we have been experiencing.

We continue to stress that market fundamentals remain positive due to strong corporate earnings, tax reform benefits for both the consumer and business, and moderate amounts of inflation, which we expect can be good for the economy as companies can raise prices.

While economic growth prospects look positive, investors are reacting to the potential for modestly higher inflation caused by such growth. As we mentioned in our 2018 Market Outlook, equity valuations were high entering the year, so we could see more price volatility as valuations adjust to higher interest rates and inflation expectations.

Diversification is even more important during times of market volatility. There are risks in both bonds and equities, so diversifying within and amongst different asset classes is important. One way to diversify overall portfolio risk is to use alternative investments, which tend to have low correlations to these traditional asset classes. Commodities are also a good diversifier as their value may rise in inflationary periods. Because markets are concerned with the sharp jump in bond yields, having lower duration exposure (interest rate sensitivity) makes sense. However, since yields have risen so fast and domestic yields trade much higher than other developed nations, we would not eliminate all duration in your portfolio. Furthermore, it is important to diversify the types of exposure within fixed income while retaining high-grade bonds in a portfolio, which increases the diversification benefits from owning bonds.

In summary, keep calm and carry-on.  The robust economy is creating expected volatility in stocks and bonds as interest rates meander back towards normal levels.  We do not see a recession in the offing, and consumer spending, corporate profits, broad deregulation and advantageous tax changes all make for healthy stock opportunities in the weeks and months ahead.

* Statistics and figures cited in this material is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.

Investing involves risks including the potential loss of principal. No strategy, such as diversification, or product can assure success or protect against loss. Past performance is no guarantee of future result.

Investing in alternative investments may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, potentially illiquidity. There is no assurance that the investment objective will be attained.

The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

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