February 13, 2018
Written by Nathan Erickson, CFA®, CAIA, Partner and Chief Investment Officer
One of the most popular commencement speeches of all time is David Foster Wallace’s titled “This is Water” to the Class of 2005 at Kenyon College in Ohio. Wallace begins the speech with a short story about two young fish swimming along, who happen to meet an older fish swimming the other way. The older fish nods at them and says “Morning, boys. How’s the water?” The two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”
While Wallace’s speech goes on to recommend to young graduates that they look beyond their own circle at the world around them, we see applicability of the fish story to the current market environment. For over a year many market “fishes” have been swimming along, comfortable and confident, unaware of their surroundings. For them, last week seemed abnormal, but in reality, it was normal.
As we said in our year-end commentary, 2017 was an unprecedented year for low volatility. Markets were calm based on a Republican led house, senate, and White House; a Federal Reserve Board that remained cautious with fiscal policy; positive economic data; and the eventual passing of a stimulative tax bill. However, Mr. Market can be fickle in the short term, and sometimes good news can be interpreted as bad news.
We believe the primary cause of the market’s change of direction over the past two weeks was a fear that the economy may grow too quickly, resulting in the Fed adjusting monetary policy to slow it down. In particular, strong wage growth numbers, low unemployment claims, and strong manufacturing data were interpreted to lead to higher inflation. While the Fed has stated that they expect to raise short-term rates three times next year, this positive data resulted in increased expectations that the Fed will raise rates four times. In addition, longer-term interest rates rose for a variety of reasons, including higher inflation expectations and the Fed buying less of the new Treasuries issued by the government. A sharp rise in yields, and fear that the Fed may put the brakes on economic growth, led to the wild market ride over the past couple weeks and a rare moment where investors experienced negative stock and bond returns at the same time.
To the young market “fishes,” this may have caught them by surprise. It may have resulted in an urge to act or a feeling that this is the beginning of the next big downturn. To the older fish(es), this is water. Market volatility is normal. Furthermore, experienced investors know that the Fed increasing rate hikes from three to four will have little-to-no long-term effects on their portfolio returns and that diversified portfolios are well equipped to handle many different types of market volatility. Our clients may have noticed that diversifying investments in their portfolios were unaffected by the last two weeks of volatility, including reinsurance and several others. Those investments are unrelated to economic data points, the level of interest rates, and most importantly, the short-term emotions of market participants.
2018 may see even more volatility, but we remind our clients that this is normal. As we mentioned in our year-end commentary, too little volatility can lead to excess risk taking. When asset classes exhibit a normal level of volatility, investors are more cautious and aware of the risk required to earn returns. Equity markets are unlikely to repeat last year’s performance in 2018, and traditional bond markets may struggle as well. If that is the case, we remain confident that portfolios are well constructed to handle a more “normal” year.