Compared to last year’s unique calm, 2018 has seen a distinct change in stock market behavior. Record highs in the beginning of the year were followed by significant interest rate-induced drops in February. Then, after a rather tranquil spring and summer, investors saw the Dow Jones drop nearly 400 points in October.1 Why has market volatility returned?
The increasing threat of rising interest rates
Over the last 10 years, the U.S. has experienced historically low interest rates and relatively easy monetary policy. As a result, companies had easy access to borrow and fund growth, and equities experienced near record-high performance.2
U.S. Treasuries, viewed as the global benchmark for interest rates, recently topped three percent for the first time in four years. Historically, rates that move too quickly have negatively impacted stock indices for two reasons. First, investors react by moving money from stock into fixed-income investments. Secondly, increased interest rates mean increased expenses, and that has the potential to reduce company profits – a negative for stocks.2,3
The increasing threat of a global trade war
Since President Donald Trump first declared that the U.S. would impose 25 percent tariffs on steel and 10 percent on aluminum earlier this year, fear of a looming trade war has left its mark on the stock market.4 According to UBS Strategies, “An escalation into a trade war could reduce future growth expectations and equity valuations, and has particularly taken a toll on specific industries, such as machinery companies and automakers, due to the potential rise in cost.”5
Consequently, investors have reacted by moving their money into U.S. small-cap stocks. Since late February, the small-cap Russell 2000 has climbed about four percent compared with a nearly one percent rise for the S&P 500.
And while it’s important to note that the tariffs that have been enforced haven’t yet had an impact on the economy, if pending and potential tariffs are imposed, the impact on GDP could be significant.
Inflation is looming
Although inflation is still relatively low, investors are concerned that it’s beginning to accelerate once again. There are signs popping up everywhere. Businesses are paying the most for raw materials since 2011, and PCE (core benchmark for Personal Consumption Expenditures) is hovering around its two percent target.6
Another factor causing concern – tightening labor markets. Recently, the number of available jobs outpaced the number of available workers by more than 900,000. As a result, companies may need to increase wages, once again increasing operating costs and reducing company profits. This may lead many to reassess the value of their equities.6
Keeping long-term goals in mind
During market volatility, it’s important to not chase the market’s ups and downs, and keep your long-term investment goals in mind. Implementing a diversified portfolio strategy that has the potential to hedge against market volatility is important in today’s environment.