The stock market started off 2018 on a strong note. The 5.73 percent return of the S&P 500 was the largest monthly gain since March of 2016, which came after the last stock market correction, and the best January return since 1997 when the S&P finished positive by 6.25 percent. There is an old Wall Street adage that says, “As goes January, so goes the year.” This is also sometimes referred to as the January effect. A good January has historically been a positive sign for the year. But it does not mean there won’t be any volatility. The best January return since 1950 was in 1987 when the S&P 500 returned 13.47 percent; the market finished positive for the year, but thanks to Black Monday, which contributed to a 21.5 percent drop in October, the market had a negative return from February through December. These historical numbers are fun to look at but they should not be viewed as a strong indicator for what is to come. Every year has its own set of conditions and circumstances that need to be considered.

The optimism was mostly driven by the expected benefits of tax reform which will go into the effect in 2018. Some individuals will begin to see the benefits with larger take home pays as earlier as February but the real benefit will be seen by corporations. Some companies have announced they will pay one-time employee bonuses or raise wages, but the long-term plans for use of this excess money remains to be seen. Analysts are expecting better earnings this year, which makes sense: if your tax expense is lower, your earnings should be higher. However, it is also possible that companies will use the tax cut as an opportunity to cut prices on their products and services in order to improve their competitiveness. If this happens it will be another source of downward pressure on inflation.

With about a quarter of companies in the S&P 500 having reported Q4 earnings, about 76 percent of those companies have reported positive earnings per share surprises and 81 percent reported positive sales surprises, according to FactSet. The expected earnings growth rate for Q4 2017 is 11 percent but as tax reform benefits begin to kick-in earnings growth is expected to accelerate. Analysts are expecting Q1 2018 and Q2 2018 earnings growth to be 16 percent and moving to 17 and 28 percent for the third and fourth quarter, respectively. FactSet also reports that analysts are expecting 2018 earnings growth of 16.3 percent and revenue growth of 6 percent.

The Federal Reserve acted as expected by not increasing interest rates during their January meeting. They continued to be bullish and sounded a little more hawkish in their statement. Current Fed Chair Janet Yellen will be finishing her term and Jerome Powell will be sworn in on the first Monday in February. The Fed will need to continue to strike a balance between normalizing interest rates and its balance sheet while also not acting too aggressive which could ultimately push the economy into recession. The yield curve continues to be an indicator to keep an eye on. The 2-year and 10-year interest rate spread has increased slightly since the beginning of the year, from 52 basis points to about 57 basis points; however the 10-year to 30-year spread has tightened from 33 basis points at the beginning of the year to 22 basis points at the end of January. As discussed in previous Investor Insights, a tightening yield curve is not bearish, but once it inverts, it has been a reliable indicator of recession. We will be watching closely to see upcoming inflation readings and the impact they will have on the longer end of the yield curve. The Fed may want to get more aggressive with interest rate increases and normalization but without higher inflation the Fed will need to decide between keeping the status quo or risk pushing the economy into a recession. The market continues to expect three rate increases with the possibility of a fourth during 2018.

Despite all the market talk about the risk of an inverted yield pushing us into a recession, the less discussed scenario could bring the opposite: an overheating economy and a more aggressive Fed. Some employees are receiving higher wages or bonuses, while tariffs are being introduced on certain imports which will push prices higher. With oil prices steadily climbing as well, it’s not difficult to see an environment that could quickly turn more inflationary. Higher inflation, not to mention the net new Treasury issuance resulting from tax cuts, could push longer-term interest rates higher. If interest rates move too fast either from the Fed or as a result of market conditions this could act as a stranglehold on the economy and ultimately push it into a recession. The Fed is in a really difficult spot in 2018, and it will be interesting to see how to new Fed Chair responds.

With expectations for Fed rate increases growing, shorter-term interest rates were on the move in January. The 2-year moved 26 basis points higher and the 10-year moved 34 basis points higher. The swift move resulted in losses for many bond benchmarks. The Barclays Aggregate Index lost 1.15 percent for the month of January. This should not cause investors to get nervous or panic, rather they should keep in mind that it has only been one month. In this environment of rising interest rates, a majority of a fixed income investment’s return comes from monthly interest payments, so as the rate movement settles down and interest payments catch up, returns may look better. Fixed income is often used a diversifier or a hedge against market volatility, so don’t forget why you own it and move to shorter duration bonds or bond funds if you would like less interest rate sensitivity. 

In addition to the strong economy and high expectations in the U.S., the global synchronized growth story remains intact and international markets continue to perform well. International developed markets had a strong month, just slightly behind the S&P 500 but emerging markets performed very well, returning 8.34 percent which outpace the S&P 500 by over 250 basis points.

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