Economics

As Volatility Spikes, Watch The Economy, Not The Market

The tremors that have battered financial markets recently have been nerve-wracking. But remember, the market is not the economy. Economic growth can persist even when markets decline, and that growth can eventually help to stop the slide.

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Economic Uncertainty And Increased Volatility

Over the last week, US equities have surrendered their gains for the year and then some, volatility has spiked, and interest rates have jumped amid worries that the US economy may be overheating. This is all unsettling for investors, and it’s not easy to see things in perspective in the heat of the moment.

But it’s worth remembering that the US economy is still performing well and is likely to continue to shine over the next few quarters. Market volatility of this degree certainly doesn’t guarantee that we’re headed for a recession. The 1987 stock market crash was far more severe, but it didn’t lead to a recession. In fact, the market regained and surpassed its precrisis high within two years.

It’s also important to put the recent moves in context. Sure, the stock market is down about 2% so far this year. But it’s still up almost 15% over the last 12 months and roughly 40% over the last two years. That’s a stellar performance by almost any standard.

Volatility: The New (Old) Normal

What’s more, it’s normal for markets to be volatile. The 10% decline in the S&P 500 Index from its recent peak isn’t unique even within this cycle. We experienced similar declines in 2015 and 2016. It was the absence of a significant pullback in 2017 that was unusual by historical standards. Against that background, the recent pullback is not necessarily cause for alarm.

So what does the recent burst of market volatility mean? Well, pretty much what we’ve been saying in our recent economic forecasts: inflation and interest rates are likely to rise in 2018, which should limit the scope of future equity market gains. In other words, investors shouldn’t expect an indefinite continuation of the large and uninterrupted stock increases they enjoyed in 2017.

Now, it’s true that we didn’t expect recent market trends to reverse quite as rapidly as they have. Nor do we think markets will keep this pace up. But the basic direction does makes sense.

Price Pressures Rise, Fiscal Discipline Fades

Let’s take a moment to dig a little more deeply into what we consider the fundamental causes of the market turmoil:

1. Rising cyclical inflation pressures. The proximate trigger for the volatility was an unexpectedly sharp increase in wages in January, which was reported on February 2. Rising wages suggest that the labor market is tight, meaning that inflationary pressures are more likely to persist as the year progresses. With core inflation already running above 2% on an annualized basis over the last six months, the wage data for January were just more evidence that price pressures are going to stick around for a while.

That said, the wage gains last month were likely exaggerated by several states adopting new minimum wages and by bonus payments associated with the new tax law. We expect wages to rise, but at a more moderate pace than the 4.1% annualized rate we saw over the last three months.

2. Deteriorating fiscal discipline. As we have previously noted, last year’s tax cut is likely to increase government deficits and debt. Congress’ recent budget agreement, which involves about $300 billion in additional government spending over the next two years, will do the same. Such aggressive fiscal stimulus at a time when unemployment is already low and inflation is rising is highly unusual and, in our view, imprudent.

We’re not saying a government debt crisis is imminent. But the government will have to increase borrowing to fund the spending increases and make up for the lost tax revenue. That means the Treasury will issue more bonds, and investors will demand higher yields to buy those bonds. The upshot: interest rates should rise. We still expect the 10-year US Treasury yield to hit 3.25% this year. After the last week’s events, other market participants are starting to forecast similar increases.

Don’t Panic. Do Be Prudent.

None of this is reason to panic. The US economy remains strong and the Federal Reserve is likely to continue along the path to higher rates (we expect four rate hikes this year). That should, over time, help to slow the economy and reduce the risk of overheating.

However, it is time to be prudent. A key aspect of our 2018 outlook has been that investors should expect lower absolute returns and higher volatility across asset classes. That has certainly been the case this week. We don’t expect it to be quite this volatile throughout the year. But here’s something we’ve all forgotten recently: some volatility in markets is normal.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Article by Eric Winograd, AllianceBernstein