What might cause volatility in the second half of 2018?
Stock markets had an extraordinary run here, from the lows at the beginning of April through recent market highs in June and early July. The S&P 500's up about 9% or 10%. We are nervous about heightened volatility here, and there are a number of issues that fundamentally make us nervous. Now corporate earnings, we think, are going to be very strong but we think the guidance could be very tepid given these concerns. The Federal Reserve, what is the pace of interest rate increases we're going to see over the balance of this year and into next? The trade and tariff issues are ramping up here. The risk of a blue wave in the mid-term elections in November, investors are very nervous about the narrowing of the yield curve and whether or not that yield curve will invert and signal an imminent recession. Inflationary forces are increasing. Does that result in a spike in inflation? Oil prices are up 75% or so over the last year. Does that begin to crimp consumer spending? When will the Mueller investigation be released? Will it come out before the mid-terms this year, and is there a smoking gun in there? And then, geopolitical risk. Brexit, the Italian elections, Iran, North Korea. There's any number of things the market could focus on, and for all those reasons we felt the likelihood is that we're looking at increased volatility and perhaps a 5% to 8% correction in large cap stocks over the course of the third quarter.
How are small caps likely to perform when volatility rises?
We're expecting a choppy summer. We think large cap stocks, the S&P 500, have the potential to perhaps give up some of their profits and decline by 5 to 8% or so over the course of the third quarter due to concerns about Fed policy, these trade and tariff situations, and the upcoming midterm elections. But we do believe that small caps will perform relatively better than the large caps. Small caps are enjoying a stronger earnings growth, they are more insulated from the trade pressures that are impacting the larger cap companies, and there is an M&A put. The merger and acquisition activity is providing some support for the small caps. Any correction that we see in small caps over the course of the summer, in our view, would represent an attractive buying opportunity, and we do expect that small caps and large caps will enjoy a powerful fourth quarter rally into year-end.
Views are as of July 11, 2018 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Small company stocks may be less liquid and subject to greater price volatility than large company stocks. Federated Advisory Services Company 18-75139 (7/18)