Highlights

Early last week, investors focused on new Federal Reserve Chair Jerome Powell’s congressional testimony in which he seemed to imply that the Fed would be more aggressive about raising rates. While he walked back some of his statements later in the week, stocks reacted negatively to his comments. Equity markets were further hurt when President Trump confirmed speculation that he would announce tariffs on steel and aluminum imports despite the objections of some of his leading policy advisors. The S&P 500 Index fell 2.0 percent for the week, with the materials and industrials sectors faring the worst.1 At the same time, Treasury yields declined as investors sought relative safe havens.1

Weekly Top Themes

1. President Trump’s tariff announcement triggers several concerns for investors. The main worry for financial markets is the prospect of retaliatory action from other countries that could trigger, in the president’s words, a trade war. From an economic perspective, investors are also concerned that such tariffs could cause price increases for a variety of products, including cars, construction materials and some consumer goods.

2. Fed Chair Powell’s comments raised the possibility that we could see four interest rate hikes in 2018. Powell highlighted the strength of U.S. economic data, confidence that inflation is firming and an overall favorable global macroeconomic backdrop.

3. A tightening labor market is likely to contribute to inflation fears. Last week, initial jobless claims fell by 10,000 to 210,000.2 This represents the lowest level since December 1969.2

4. We expect the February payrolls report to echo this theme. Current consensus estimates suggest that payrolls climbed 180,000 or higher and that the unemployment rate fell to 4.0 percent.3 In addition, average hourly earnings likely rose around 0.3 percent, keeping the year-over-year gain close to 2.9 percent.3

5. Rising deficits are likely to grow in importance in investors’ minds. Higher deficits would increase the supply of Treasuries, putting additional upward pressure on rates. Additionally, we think deficits will increasingly become a source of fiscal policy debate in the coming years.

We See Reasons For Optimism, But Also Several Rising Risks

Financial markets remain uneasy, and we believe the volatility that started in early February is not yet over. Bond yields remain in flux and prospects for sharp increases are keeping equity markets on edge. Investors are also anxious about a profound shift in the macro environment, as inflation pressures are on the rise. President Trump’s tariff announcement added fuel to the fire.

The pessimistic view of this transition is that a brewing trade war will cause a spike in inflation at the same time that deficits become a problem. Such an environment could result in central banks tightening more than anticipated while growth momentum slows. This would be a negative environment for equities.

The more optimistic view is that while inflation risks are rising, the macro backdrop is essentially unchanged: Real economic growth remains supportive of corporate earnings while inflation firms but remains at or slightly below central bank targets. Such an environment would allow central banks to keep policy accommodative while slowly normalizing rates. And while rising trade protectionism would represent a risk, it would be tempered by the fact that fiscal and debt ceiling battles appear to be over.

We acknowledge the downside risks, but lean slightly more toward the optimistic camp, especially over a longer time horizon. We think volatility is likely to continue, but see little that would suggest a major decline in equity markets. Until bond yield volatility calms down and the inflation picture becomes clearer, we think stock markets are likely to remain uneven and trade sideways. As such, it is possible that we have already seen the low (around 2,225 for the S&P 500 Index)1 and the high (around 2,875)1 for all of 2018, or at least for the next several months.

On balance, we think it is important to acknowledge that a combination of rising rates, higher inflation and growing trade protectionism makes for a tough environment for stocks. But we also think a decent economic backdrop combined with strong corporate earnings and reasonable valuations suggests that the long-term path of equity prices is to the upside.

Robert C. Doll, CFA, is senior portfolio manager and chief equity strategist at Nuveen Asset Management.

1 Source: Morningstar Direct, Bloomberg and FactSet.
2 Source: Labor Department
3 Source: ISI Evercore