Why volatility shouldn’t scare investors—and what should

U.S. markets may be experiencing more volatility, but that doesn’t mean we’re at the beginning of a bear market.

Read: Where bearish advisors can look for opportunity

Richard Turnill, BlackRock global chief investment strategist, says in weekly market commentary that he expects markets to return to normal this year. That means “lower returns and higher vol[atility] amid rising economic uncertainty and less room for growth to top expectations.”

Economic uncertainty is the result of “U.S. stimulus and trade policy actions, [which] have broadened the range of possible outcomes compared with 2017,” he says.

Though markets could be bumpy ahead, Turnill isn’t calling for the end of the equity bull market just yet. “We prefer to take risk in equities over credit,” he says. “We see market returns being driven by earnings growth, dividends and coupons, rather than rising valuations.”

Read: What investors can learn from Q1 results

For higher earnings growth, he looks to equity markets in the U.S. and emerging markets. In fixed income, he prefers emerging market debt and short-duration U.S. bonds. “The latter’s recent yield increases reflect anticipated Fed hikes and make for an attractive risk-reward tradeoff,” he says.

Read: Market moves that capitalize on rising rates

Tom Elliott, deVere Group’s international investment strategist, says recent Wall Street volatility is the result of three factors: Treasury yields approaching 3%, sentiment that the U.S. economy is peaking and headwinds faced by tech firms.

That the economy is peaking is illustrated in Caterpillar’s earnings statement this week, says Elliott. The company said Q1 would be “a high-water mark” for the year.

For tech, greater regulation on privacy issues and lacklustre sales, for example, are headwinds.

But any market sell-off is likely to be “noise that we will forget about soon,” says Elliott. “Fundamentals of strong corporate earnings growth, possibly growing over the coming 12 months thanks to Trump’s tax cuts, is very supportive.”

U.S. debt isn’t a problem—yet

When it comes to tax cuts and U.S. spending, however, economists have been ringing warning bells, saying that now—as the economy continues to recover—isn’t the time for fiscal stimulus.

“With its latest decisions on tax cuts and higher spending, the U.S. federal government has put itself in a situation of procyclical deterioration in public finances,” say Desjardins vice-president and chief economist François Dupuis, and senior economist Francis Généreux, in a report on the U.S. budget.

Eroding public finances will persist in coming years, explains the report, as the U.S. deficit balloons to more than US$1,000 billion as of fiscal 2020 (using projections from the Congressional Budget Office). Expenditures for Social Security and old age pensions are expected to increase significantly due to population aging.

Adding to the problem is that federal revenue from taxes will increase only slightly relative to expenditures, thanks to tax reform. And economic activity is forecast to increase in the short term only, in 2018 and 2019.

“What remains to be seen is whether the gamble is justified, or whether the erosion of public finances will come back to haunt the economy later,” says Généreux in the report’s conclusion. “At this stage in the economic cycle, the aim should be to capitalize on economic growth to decrease budgetary shortfalls; this would help deal with eventual cyclical shocks.”

Debt consequences

Ballooning annual deficits will have a direct impact on U.S. federal government debt, says the report, and could trigger new battles over the legal debt ceiling. (For now the 2018 bipartisan budget agreement has suspended the debt ceiling until March 1, 2019.)

Of note is that the erosion of U.S. public finances is in contrast with improvement seen in several other countries.

Says the report: “According to the International Monetary Fund’s forecasts, the euro zone could reach a balanced budget at the start of the next decade, and Canada and even Japan will be close, while the United States will slide deeper. Only U.S. debt will continue to worsen.”

The outcome of the situation remains to be seen. Will demand for U.S. bonds be enough to meet the supply resulting from higher U.S. debt, without taking interest rates up sharply?

“The baseline scenarios are banking on some continuity with bond yields, which are primarily subject to movement by the economy and inflation,” says the report. “However, some [yield] pressure could eventually be felt on the cost of financing the debt.”

Servicing the federal debt will be increasingly expensive for the government. The CBO expects 10-year bond yields to go from 2.3% in 2017 to 4.2% in 2022. Short-term rates will rise from 0.7% to 3.8% over the same period.

For full U.S. debt analysis, read the full report from Desjardins.

For more investing details, read the full BlackRock report.

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