The first quarter of 2018 saw a significant pick-up in volatility both in its own right and certainly relative to the calm seen in 2017. January began very strongly for markets; S&P500 had its strongest start to the year since 1997 (+5.7%), as the themes present in 2017 of strong economic growth, moderate inflation and accommodative central banks continued to drive markets. However significant volatility ensued, initially on inflationary fears as job data in the US continued to be strong, then also with strong fiscal stimulus from the Trump tax plan. Later in the quarter, volatility was centred around different concerns, most notably the potential escalation of a trade war between the US and China (with the impact on economic growth). Increased levels of regulation on technology firms following Trump’s tweets on Amazon shipping costs and then, more significantly, breaches of data privacy by Facebook also added to volatility. The VIX hit an intra-day high of 50.3 and remained elevated for the remainder of the quarter. The change in regime can be illustrated by the volatility of volatility index (‘VVIX’) reaching an all-time high, surpassing levels seen during the financial crisis. Ultimately there was a material sell-off in equities and most developed markets were negative for the quarter; MSCI World returned -1.7%, S&P500 -1.2% and Eurostoxx 600 -4.7%, whilst emerging markets fared slightly better (MSCI EM +0.4%). Government bonds saw losses as interest rates rose most clearly in the US though all developed markets were impacted; US 10yr increased by 33bps to 2.74% whilst the German 10yr rose by 7bps to 0.49%. The more rate sensitive investment grade market (iBoxx IG -3.0%) performed more poorly than high yield (iBoxx HY -1.0%) though both were negative. Currency markets saw continued weakness of the USD (DXY -2.3%).
The key risk to markets remains inflation and the potential rise in interest rates to counteract inflation, leading to a slow-down in the economy but also re-pricing of risk. The February monthly CPI increase of 0.5% in the US caught most unaware and led to high volatility in both bond and equity markets. The pace of increase of inflation has since moderated but the direction is certainly upwards. Core CPI in the US is now above 2%. The Fed’s preferred measure of PCE remains <2%, increasing modestly to 1.7% by end-Q1. We are not talking about hyper inflation or 1970s style high single digits, but just a normalisation which will lead central banks to exit their extreme policies.
Global growth generally remains robust and labour markets increasingly tight. The tax reform and fiscal spending package in the US also indicates a significant expansion in the fiscal deficit at a time of overall constrained excess capacity. This is somewhat counterintuitive and unprecedented. Increased fiscal spending typically and historically has occurred during and coming out of a recession, to increase demand as that of the private sector declines and reduce excess capacity, acting as something of a stabiliser on economic activity. This is the reverse with the real potential to cause accelerating inflation. The overall debt dynamics are also important. In a buoyant economy, the budget deficit is forecast to reach 7% GDP. One can only assume that this would be materially worse in the event of a recession or slow-down in economic activity.