Global economic growth is improving and synchronizing, and corporate profits are generally up throughout the world. In the U.S., wages are up, unemployment is down, and recently passed tax reform legislation means many individuals and corporations have more money to spend.
Why, then, in the wake of this positive news are U.S. and global stock markets deep into negative territory?
U.S. Inflation Fears
Much of the recent sell-off stems from inflation concerns in the U.S., which have caused U.S. Treasury yields to increase rapidly. Inflation worries intensified Friday, following the U.S. Labor Department’s January jobs report, which showed wages posted their strongest year-over-year gain in nearly nine years. Rising wages have emerged as a serious threat to investors’ “goldilocks” scenario of gross domestic product (GDP) growth without the pain of inflation.
If inflation picks up, investors fear the Federal Reserve (the Fed) will raise interest rates more aggressively than expected, which potentially could lead to a slowdown in the economy. This sentiment not only sank U.S. stocks, but it also troubled stocks overseas, as global markets worried about a potential U.S. slowdown. European and Asian markets also came under pressure when, as in the U.S., rates moved higher.
What Goes Up…
As with any broad market sell-off, context is important. The two-day sell-off has pushed most major stock indices to their levels as of year-end 2017. It’s also worth noting annual stock returns in 2017 and monthly gains in January 2018 were among the best on record, so a pullback is not unusual.
On a positive note, there is no clear evidence that the underlying positive support for the stock market has changed. Employment and job growth remain strong, and recent corporate earnings reports continue to demonstrate steady growth. In fact, through Friday, 251 of the S&P 500® Index companies had reported fourth-quarter 2017 results. Of those companies, 77% beat earnings expectations. Should this level hold, it will be the highest “beat” rate since the second quarter of 2009.
Furthermore, it’s encouraging to note that rising earnings forecasts are not solely due to reduced U.S. corporate tax rates. S&P 500 revenues are soaring, too, totaling $10.74 trillion as of January—representing more than half the U.S. economy.
Positive Signs in Bonds
Regarding Treasury yields, we think 10-year Treasury bond yields are approaching their highs for the year. We believe they could climb as high as 3%, but it’s likely they will move lower by year-end. Inflation has inched up recently, but we do not believe it’s high enough to drive interest rates significantly higher, at least in the near term. Overall, we expect inflation to remain contained, which should give the Fed the ability to maintain its gradual rate-tightening strategy.
In addition, it’s important to note that credit spreads (the difference in yield between corporate bonds and U.S. Treasury securities of similar maturity) continue to tighten. This is a positive signal, as it suggests the recent stock market sell-off is not due to investor concerns about the financial health of corporations.
Finally, it’s important that we relate these market movements to individual investors’ goals and concerns. We understand that market volatility can be unsettling. At such times, we caution investors not to overreact to a single day’s headlines or market moves. Rather, it’s important to remember that volatility is a natural part of markets and investing.
We argue instead that most investing goals, such as saving for retirement or a child’s college education, are long-term exercises that may endure one or more complete market cycles—ups and downs, growth and recession, etc. Investors today have benefited from a remarkable period of market gains and historically low volatility, supported by positive economic growth and strong corporate earnings. But caution is warranted. We are likely in the late stages of the economic and market cycles in the U.S., and for those currently in or close to retirement or near other major financial goals, it may make sense to reduce risk.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of Dave MacEwen and Victor Zhang and are no guarantee of the future performance of any American Century Investments fund.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.