The first three months of 2018 saw twenty-three 1% daily moves by the S&P 500, compared to just eight such days in all of 2017, giving you some perspective on how volatility jumped in the first quarter (Q1). CBOE’s volatility index, the VIX, spiked 177% to 37.32, even as the S&P 500 fell -8.5% over a five-day period. Equity markets fell into correction territory, with peak drawdowns larger than -10%, recovered and then fell again toward the end of the quarter.
The rise in volatility in Q1 can be attributed to four causes. Two were fairly predictable – a surge in interest rates that saw the yield on US ten-year Treasury bonds rise from 2.40 to 2.90 over the first three weeks of the year, followed by an employment report on February 5th that showed wages grew 2.8% year-over-year in January. A tightening labor market should naturally see wage growth rising, but at the time of the report’s release we discussed how the market was over-reacting to a single data point that was likely to be smoothed as more numbers came in. This turned out to be the case as inflation reports over the next couple of months suggested that inflation is not accelerating, yet.
The two other drivers of higher volatility in Q1 were curveballs. It started with President Trump’s announcement of across the board steel and aluminum tariffs on March 1st, raising fears of a trade war between America and its largest trading partners. The other driver that took everyone by surprise was the Facebook privacy scandal that erupted on March 17th, followed by President Trump’s tweets against Amazon, suggesting that the US Postal Service was getting a raw deal from the company.
The big questions for the second quarter essentially focus on where these issues move from here, and that is where we start.
1. Will the trade spat with China, and others, escalate?
Trade is on everyone’s mind and a recap of what we have seen to date would be useful.
In the weeks following the initial announcement of broad steel and aluminum tariffs, the Trump administration temporarily excluded Canada, Mexico and other allies in Europe, Latin America and Asia. Notably, China was not granted an exemption and on April 2nd they retaliated with tariffs on US imports worth $3 billion. The very next day the US trade representative (USTR) threatened to target almost $50 billion worth of Chinese goods – proposing a 25% tariff on more than 1300 goods, mostly hitting machinery, mechanical appliances, and electrical equipment. China was quick to respond, proposing their own 25% tariffs on $50 billion worth of US goods. These would mostly hit US transportation (vehicles and aircrafts) and agricultural sectors, shrewdly chosen to put maximum political pressure on President Trump.The tit-for-tat continued with the President immediately counter-punching, threatening to target an additional $100 billion of Chinese imports.
On April 10th China filed a trade case at WTO against the original steel aluminum tariffs. However, the same day saw Chinese Premier Xi Jingping lowering the temperature at the Boao Forum for Asia. He urged “dialogue, not confrontation” and outlined plans to to reduce tariffs on imported vehicles, open up financial services and automotive joint ventures, reduce restriction on foreign investment, strengthen intellectual property protections, and expand imports. All of these are essentially recycled proposals that have been made in the past but it did appear to give both sides a way to back out of their respective corners, with President Trump reacting positively.
At the same time, the Chinese Commerce Ministry said that these proposals have been in the works for a while and should not be seen as concessions. The USTR is also proceeding with public hearings and a comment process on proposed tariffs on $50 billion in Chinese goods, which will end on May 22nd. So it may be late May at the earliest before a final decision is reached, giving both sides ample time to negotiate/de-escalate. The administration will also have to decide whether or not to permanently exclude its allies from the steel and aluminum tariffs.
With the US-China spat dominating headlines, it was easy to forget that NAFTA negotiations continue to proceed without agreement on key issues like dispute settlements, rules of origin on vehicles, the sunset clause and major market access rules. All sides would like NAFTA negotiations to conclude in the second quarter, to avoid running up against Mexico’s presidential election in July (a leftist, nationalist candidate is the current front-runner) and to allow the US Congress to ratify the treaty before midterm elections in November.
A full-blown trade war is not imminent at this time. Right now the various sides are playing a game of chicken and waiting to see who blinks first. As we have written before, the most likely scenario is a proportional tit-for-tat that eventually ends. However, the risk of escalation remains a possibility, especially if President Trump feels that America’s trading partners have not ceded enough ground and significant tariffs actually go into force.
2. Will the yield curve continue to flatten?
The positive string of economic data in Q1 made the Federal Reserve’s (Fed) March meeting a mere formality with respect to market expectations for yet another rate increase. More eyes were focused on whether the Fed would project an extra, fourth rate hike in 2018. While the median consensus amongst officials did not shift from three rate hikes, several participants shifted toward the more hawkish scenario. This was reflected in the fact that the market implied probability of four rate hikes in 2018 rose to 38% after their meeting (the probability was as low as 10% at the beginning of the quarter).
However, despite all the positive data and surge in long-term yields at the beginning of Q1, the yield curve ended the quarter slightly flatter than it was at the end of 2017. The spread between yields on ten-year and two-year treasury bonds fell 4 basis points (bps) over the quarter, while the spread between thirty-year and five-year yields compressed by 13 bps. Given that the US has been growing above its post-recession trend over the past three quarters, and expected to do so this year (especially in the face of stimulus from tax cuts), one would have expected the yield curve to steepen. The opposite has happened.
Nominal and real US treasury yields, as of December 31, 2017 and March 29, 2018. Source: US Treasury.
Market odds of another rate hike in June is higher than 95% as of this writing, but if long-term yields do not move higher, we could see yet more flattening. A flattening yield curve (both nominal and real) by itself is not indicative of a recession – only an inverted one is – but it does suggest that the bond market is growing pessimistic about the growth outlook in the US. One way to square this circle is to assume that markets believe the Federal Reserve will explicitly turn toward restrictive policy in the next couple of years to intentionally slow the economy.
3. Will the downshift in economic momentum in Europe be temporary?
Another unexpected development that occurred during the first quarter was the marked downshift in economic momentum in Europe. Economic data consistently came in on the softer side in Q1 and Convex’s proprietary risk rating for the region fell from Hold to Caution-Hold by the end of the quarter. Manufacturing PMIs fell across the board, with PMI for the entire Euro Area falling to an eight-month low of 56.6, down from 60.6 in December. Business confidence also steadily declined across the quarter while core inflation refused to budge higher than 1% year-over-year. Economic data could only tear higher for so long but the extent of the softening is puzzling.
All of this comes as the European Central Bank (ECB) hints at cutting its crisis-era stimulus program sooner rather than later. Expectations are for the ECB’s bond-buying program to end in September. However, the ECB’s current plans are conditioned on upgraded growth forecasts that were made at the end of 2017. The question is whether the recent data, along with stubbornly low inflation, will be seen as a temporary blip, or as a sign of a more protracted slowdown.
As the second quarter gets underway, we are closely monitoring the situation for any fundamental shifts that can have a significant adverse impact on the global economy, and lead to a sustained bear market.
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