Three Questions on the Markets

The region’s leading wealth managers respond
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Each year in our Summer issue, we ask a group of the region’s leading financial experts to help our readers by responding to a question. This year, we’ve asked three. Part I of this four-​part series begins below.

Question 1: Why has market volatility spiked in 2018? Do you expect markets to remain volatile?

Linda Duessel


Volatility spiked almost as a payback from one of the least volatile years on record. Remember, equity markets in most years have several 5 percent pullbacks; the average year has one roughly 14 percent correction. 2017 had neither. It was the anomaly. Now volatility is back at relatively normal levels, historically speaking, and it’s likely to stick around. Inflation concerns are mounting, we are in the midst of Fed tightening and we are nine years into an economic recovery and expansion. We should expect increasing volatility as this very mature cycle ages. Every recession since 1950 was precipitated by a Fed that raised rates too much. Nine years ago, there was a lot of runway. Now, there’s not nearly as much.

Win Smathers


Let’s put context on the recent volatility. 2017 was one of the least volatile, one-​directional markets in history with 12 months of positive performance and not one drawdown worse than 3 percent. So, comparatively, 2018 appears to be off to a highly volatile start. The market corrected in February for the first time in two years. Again, a correction is a normal market-​clearing event historically occurring on average more than once per year. While there are reasons volatility may remain elevated, with higher interest rates, unpopular trade policy and Washington politics, higher inflation and tightening monetary policy, we believe volatility should dampen as investors shift their focus to very strong corporate earnings, supporting a continuation of the bull market in stocks.

Robert Y. Kopf Jr.


Accelerating uncertainty has contributed substantially to volatility in the equity markets in 2018. We have a political stalemate in Washington, especially over immigration, spending and trade matters, necessarily fueling domestic uncertainty, with little political will from either party to reduce entitlement spending in the face of a rising national debt with an increasing interest rate burden. Geopolitical tensions add to this miasma of uncertainty. We see little chance of a reduction of the factors contributing to volatility for the balance of 2018.

John Augustine


Markets arguably came under the spell of four new forces during the first quarter of 2018 — inflation concerns, a new central bank chair, trade worries and tech companies coming under fire. As a result, all four major asset groups that we track — stocks, bonds, commodities and currencies — experienced levels of volatility not seen since early 2016. In the end, all four groups saw negative total returns in the first quarter — which is fairly unusual. Going into the second quarter, tech and trade remain the dominant headlines. Markets are very lively from day to day. It will take a calming of the headlines to allow markets to calm. This could occur after technology company executives come public with their plans to protect client data, and as the US, EU and China start negotiating terms of trade for the their respective continents. Hence, volatility could be with us for some time. NOTE: It is important for long-​term investors to remember that investing on the emotions of headlines is generally not profitable. However, it can be profitable to invest into heightened market volatility that is not associated with a catastrophic event.

Thomas L. Wentling Jr.


Hopefully yes. When rhythmic spikes punctuating the flat line norm on an electrocardiograph stop, the family is informed the patient died. Volatility can spike on up-​or-​down market movements. Centrally planned economies never spike — they just flatly collapse from the inside of their insulated rot. Volatility signifies a vibrant system reacting minute by minute to external stimuli. To wish away volatility is to wish away life. The key is to discern whether those signals are good or bad. 2018 should see low-​teens S&P earnings growth. We believe when you add up all the positives and negatives in the economy here and abroad, you get a positive number, and until that math changes, we think investors should remain invested.

Thomas E. Crowley


Market volatility typically drops during the “sweet spot” of the economic cycle, after the public becomes confident of economic growth but before inflation raises the risk of higher interest rates. The low volatility of the last few years paralleled what we saw in previous cycles (e.g., 2005 to 2007 and 1993 through 1996). What has changed? A sharply higher wage report ignited fears of inflation. As labor markets tighten, accelerating wage increases put pressure on corporate profitability and eventually force the Federal Reserve to raise interest rates aggressively. Although inflation has remained contained to this point, inflationary pressures are rising and investors have become more sensitive to inflation. More recently, the risk of trade wars poses an entirely new threat to economic growth. The potential for investor surprise is rising, and that means volatility should remain elevated.

Elizabeth Genter


“Volatility gives the shrewd investor the opportunity to take advantage of price swings to buy when the stock price falls well below the value of a company and to sell when the price is well above the company’s intrinsic value.” —Ben Graham

There are many factors which contribute to stock market volatility, although the most significant is human emotion or fear. While the underlying causes differ, the reasons for volatility are usually similar. For example, the fear that China will impose tariffs or that the Federal Reserve will tighten monetary policy by raising interest rates. Even such events as the Congressional hearings with Facebook can unsettle the market. We, at Schenley, are long-​term investors and have strategies to thwart volatility. The markets will remain volatile in 2018 and we are prepared.

Question 2: Do you think the Trump Administration’s stimulus efforts — especially the tax cuts and regulatory reform — will have any long-​term effect on U.S. economic growth?

Gregory J. Sorce


In a vacuum, the Administration’s tax cuts and regulatory reform should boost long-​term economic growth in the U.S. Some estimates have indicated that the Tax Cuts and Jobs Act may provide an increase of after-​tax corporate earnings of more than 20 percent. Also, the provision that permits the immediate expensing of capital investments will likely provide a boost to GDP. However, companies in certain sectors such as technology, financials, and energy will benefit more than companies in other sectors. Also, the increase in growth may be offset if the Federal Reserve raises rates very aggressively.

Alison Fox Wertz


Since 2008, countries have been reducing their corporate tax rates to compete for capital investment to rekindle their growth. Global corporate tax rates declined over the last decade from 35 percent to 28 percent while U.S. corporate rates have remained unchanged at 39 percent (federal, state & local). This disparity has driven corporations to make decisions that avoid taxes (moving headquarters overseas or leaving billions of dollars overseas) to the detriment of long-​term growth. With tax avoidance a diminished concern, corporate decisions will be driven by how best to tap innovation. The most likely outcome being more domestic investment and higher long-​term U.S. economic growth.

Edward M. Gallagher III


Our wealth management investment team is watching this closely, and time will tell after passing arguably the largest tax overhaul in the past 30 years. However, numerous provisions potentially sunset down the road. One immediate result is that corporations will be keeping more of the money they make. We have already seen some of that passed on to employees in terms of increased wages and bonus payments. That cash can also potentially be deployed in numerous other positive ways: increased capital expenditures, new growth initiatives, research and development, mergers and acquisitions, dividend increases and stock buybacks to benefit shareholders. Numerous families will also see money in their pockets from tax refunds and higher paychecks, as a result of lower taxes and therefore lower withholding on their earnings. These developments should have positive effects to the economy in the short term. The long term remains to be seen. Our elected officials still need to get a handle on government spending and the budget deficit.

Joseph Scarpo


Tax cuts and regulatory reforms have been implemented in the past 15 months. The clear and immediate impact of these reforms is an increase in corporate profitability and some easing — provided you are in a favored industry — in the ability for business to get things done. It is difficult to assess the long-​term effect on economic growth. The economy is cyclical. Positive long-​term economic impact will occur if the economic expansion results in higher wages, higher profits, a broader tax base and ultimately, a declining federal debt load. If the expansion is tepid and the debt balloons, not only will we lose the positive impacts of these decisions, but we indeed may be in a more difficult position.

David B. Ellwood


Economic momentum was strong prior to the signing of the Tax Cuts and Jobs Act, and the changes in the tax code will provide a long-​term benefit to the economic environment, corporate profitability and consumer spending. The flow through was quickly felt with a significant number of employee bonus payments and wage increases as well as announcements of plans to increase capital spending. We expect that the early indications that the consumer was saving a large proportion of the tax cut will subside and spending will increase. The less-​recognized regulatory reforms have been quietly providing an improving operating environment, especially in the areas of finance, health care and energy. While it is too early to determine the impact, the recent announcement of tariffs could slow economic growth.

Jack Kraus


The corporate tax cuts, which will be especially beneficial to smaller and mid-​sized companies, will have the longest-​lasting impact on long-​term U.S. economic growth. The change to individual tax policies will have a much smaller impact and are scheduled to reverse in 2026 unless made permanent. Infrastructure spending is typically viewed as the longest-​lasting stimulus, and that has not gotten off the ground yet. Regulatory reform, which has been valued at various amounts, is a net positive, but how much it will add to an $18 trillion economy is up for debate.

Jeff Muhlenkamp


We don’t view what the administration has done as stimulus; we view it more as correcting past government excesses. In our opinion, high taxes and burdensome regulations were impeding business formation and growth and, in some highly publicized instances, prompted corporations to move overseas to better business environments. Once the problem was identified, the sooner those impediments to growth were removed, the better. Our expectation is that, over the long term, lower taxes and a saner regulatory environment will create a better business environment in the U.S. and allow for higher growth than would have occurred absent those changes.

Question 3: What effect do you expect higher inflation to have on stock prices?

James Armstrong


Higher inflation has different effects on different businesses. A company that sells a commodity or generic product will find it difficult to raise prices, even as its input costs of production (materials, energy, capital equipment, labor) rise with inflation. Accordingly, its profit margins may be squeezed and its profits may decline. By contrast, a company with a strong market position and brand name, unique product, and less exposure to rising input costs (think Microsoft, Google, Facebook) will have more ability to raise its prices as inflation occurs and thus generate rising profits. Generally, over the long term, stock prices tend to rise for companies with growing earnings and fall for companies with shrinking earnings. But if interest rates rise along with inflation, as often happens, they will create a headwind against rising stock prices in general.

Henry S. Beukema III


Higher inflation will cause the Fed to continue to raise interest rates. Historically, when the 10-​year Treasury yields are below 5 percent (currently at less than 3 percent), rising interest rates have been associated with rising stock prices. With equities trading at approximately 1617 times forward earnings vs. the historical average of 16 times, modest inflation that does not cause the Fed to become too hawkish and make a policy mistake should allow the equity markets to continue to perform as long as earnings growth continues.

Kim Craig


Just the mention of the word “inflation” conjures up the ghosts of the 1970s, including soaring consumer prices and mortgage rates, the OPEC oil embargo and a plummeting stock market. Given this background, it is understandable that any hint of inflation can cause market jitters. However, to analyze the effect of inflation on stock prices, it is imperative to evaluate the type of inflation at play. In the ‘70s, commodity and wage inflation pushed through to impact consumer prices. While we are seeing growing commodity prices and wages today, mitigating factors should keep inflation on a more moderate trajectory. First, the emergence of the U.S. shale industry has propelled us into a position as one of the top oil producers in the world, which should partially keep the commodity index in check. Second, the generational transition of the workforce is enabling companies to increase staffing while holding wage growth at a reasonable level, given that millennials are replacing retiring baby boomers at approximately 60 to 70 percent of the cost. These unique circumstances work together to keep commodity and wage inflation from pushing consumer prices significantly higher, contributing instead to the controlled increase in prices that is associated with the growth phase of the economic cycle and a positive environment for stocks.

H. Scott Cunningham


Most investors’ biggest fear is another market crash like the 2008 Financial Market Crisis or 2000 Tech Wreck. For now, however, they should be afraid of losing purchasing power due to inflation. Over the last 50 years, the value of a dollar has plummeted more than 86 percent. It now takes $7.15 to purchase the same amount $1.00 would have bought back in 1968. Stocks, on the other hand, have been able to keep pace with and even grow their purchasing power after accounting for taxes and inflation. While inflation could cause some turbulence for the markets, or even cause stocks to pull back significantly in the next few years, it won’t spell doom and gloom for investors over longer horizons.

Greg Curtis


Inflation is a negative for stock prices for simple mathematical reasons. When you buy a stock you are really buying a future stream of dividends (or cash flows reinvested in the business). Since that money will be received in the future, its value has to be discounted back to today to ascertain the present value. When inflation is low, the discount is modest, but as inflation rises the discount factor goes up — dividends received in the future are worth much less. Notice that this doesn’t mean that stocks will be hurt more than other assets. Many companies are able to pass inflationary cost increases on to their customers, so equity prices often hold up better than (for example) bond prices.

Peter F. Mathieson


As experienced in the decade of the 1970s, higher inflation has a distinctly negative impact on the valuations of financial assets. The combination of upward wage pressures and rising commodity prices will squeeze corporate profit margins, negating much of the benefits seen in the recently legislated corporate tax rate reduction. Rising inflation and interest rates could particularly impact the valuations of the large and rapidly growing technology companies, and the imposition of a higher discount rate will reduce the present value of future earnings and negatively impact share values.

Michael R. Foster


Modest, expected inflation is actually good for equity markets, as it allows companies to grow revenues, increase worker pay, and manage input costs and margins. But as we saw earlier in the year, an unanticipated spike in inflation can be detrimental to stock prices as that can cause the Fed to raise rates faster than expected to combat inflationary pressures. Ever since the financial crisis, inflation has generally been below the Fed’s 2 percent target, but data have suggested consumer prices and producer prices seem to be normalizing back toward that target. We believe inflation will likely only drift higher and that this backdrop provides a supportive environment for stocks, but with increased volatility.

PQ Staff

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