There is a market adage that states, “As goes January, so goes the year.” We certainly should hope this is the case for 2018, as January was another month of great stock market returns. The U.S. indices were up by 5 percent or more, while international markets—both developed and emerging—did the same. The news was not all good, of course, as markets pulled back at month's end. Given the strong gains up to that point, however, it looks likely to be just profit taking, rather than a harbinger of something worse.
Worried About Bonds?
Fixed income (which is to say bonds) didn’t do so well, as most indices lost money as rates went up. The U.S. Treasury 10-year rate rose from 2.465 percent to 2.743 percent, the highest level since early 2014. This may well have been part of what pulled the stock market back at the end of the month, so should we be worried? Not yet, as previous interest rate peaks have turned back down.
And why would we be concerned at all? Higher rates mean lower values for bonds. But as investors, we need to be aware that they also mean higher returns on reinvested income. Over time, Commonwealth research has shown, investors can actually come out ahead. Therefore, the risk to fixed income from higher rates going forward is something we are watching, but we're not worrying about it at this point.
The Good News About Rising Rates
For stock markets, the effect of rising rates depends on why rates are rising. Here, the news is good. The economic data continues to be strong, with consumer and business confidence at very high levels. Manufacturing is doing particularly well, benefiting from a cheap dollar—which makes U.S. goods more competitive—and strong growth around the world. Both business investment and consumer spending also remain at high levels.
Higher interest rates are normal and expected in this kind of growth environment. So, the rise in rates, rather than being a bad thing, is actually ratifying the improved economic conditions. Better economic conditions lead to higher profits, which in turn lead to higher stock prices. In this case, then, higher rates are good for markets. That won’t always be the case, as when rates get too high they start to choke growth off. But we are not there yet.
The Risks
January, then, leaves us with a solid economic foundation for financial markets. Of course, there are risks out there. One of the biggest—and certainly most immediate—is the pending need to approve federal government spending once again. The most probable case, as we saw last month, is that a deal will be cut before any damage is done, but that is not a certainty. If there were a prolonged standoff, it could rattle the markets and even the economy. North Korea also remains a concern, although it has moved out of the headlines.
Even with these risks, the fact is that the economy and markets are well positioned, on the fundamentals, to ride out any turbulence. As I pointed out yesterday in my post about the Dow, the conditions for a sustained market drawdown are simply not there, per history.