QUARTER 1 2017 COMMENTARY
During the first quarter of 2017, global stock markets performed well, supported by accommodative central banks and the first synchronized, albeit modest, acceleration in world economic growth since 2010.
After jumping at the end of 2016, the inflation outlook moderated, removing the strong head-wind to bonds that prevailed in the fourth quarter. Post-election optimism in the U.S. boosted survey-based economic Confidence Index which reached a 16-year high of 125.6 in March. Contributing to the optimism: strong labor markets, rising wages and home prices, lofty stock markets and cheap gasoline. Janet Yellen, chair of the U.S. Federal Reserve, summed up the quarter after the Fed’s decision to raise rates in mid-March: “the simple message is the economy is doing well.”
Despite this overly optimistic sentiment, there remain pockets of concern. We are in the midst of an aging economic cycle and the second longest bull market in the post-war era. The health care repeal and replace bill was paused at quarter end causing the market to work off some positive sentiment.
The U.S. equity markets pushed higher in January and February maintaining one of the calmest periods in stock market history. The CBOE’s Volatility Index (VIX), an index used to measure price volatility of the S&P 500, fell below 10 on February 1st. This marks the lowest reading of the VIX in a decade. Prior to that, the VIX remained below 12 for the previous 11 weeks confirming the absence of price volatility in the S&P 500. Volatility crept back on March 21st as the S&P 500 lost 29 points or 1.2% finally ending an epic 109-day run without a 1% decline.
Stock returns were strongest in traditional growth sectors like technology, up 12.2%, and consumer discretionary, up 8.1%. Telecommunication and energy showed weakness down -5.1% and -7.3% respectively. Crude oil prices fell by 9% as oversupply concerns caused prices to fall. According to Baker Hughes, rig count in the U.S. this quarter grew at its highest level since September 2015, an echo of the supply dynamics that led to the global glut of two years ago.
Growth stocks significantly outperformed value and large cap outperformed small cap for the quarter, though large cap continue to trail small cap over the past 12 months by nearly 10%.
According to Standard & Poor’s analyst estimates, S&P 500 earnings are expected to rise 22% on a year-over-year basis to $130 per share for 2017. The price-to-trailing twelve-month operating earnings multiple of the S&P 500 now stands at 22.2 times, the highest reading outside of a recession since 1998. The price-to-forward 12-month operating earnings ratio is a more reasonable 17.6 times, but this reading is also at a decade-long high.
The markets have focused on Washington and politics as the inauguration of President Trump officially started the new administration’s goal to deliver on its pro-growth mandate. By late March, a bill to overhaul the Affordable Care Act was shelved due to lack of support, and the House of Representatives subsequently moved on to tackle tax reform. The Congressional Budget Office (CBO) announced on March 16 that the U.S. Treasury had reached its statutory borrowing limit and therefore will need to use “extraordinary measures” to raise cash. The CBO expects those measures to exhaust themselves this fall.
The Federal Open Market Committee (FOMC) in mid-March raised interest rates for the second time in three months, citing moderate economic conditions and rising inflation. In its statement, the FOMC reaffirmed its desire to maintain the size of its balance sheet, currently sitting at $4.2 trillion, by continuing to reinvest the proceeds of maturing mortgage-backed securities and Treasury securities.
Bonds produced meager gains as signs of inflation increased and investors sought greater risk-reward opportunities. In addition, modest economic growth, the threat of further interest rate hikes and a host of policy unknowns from Washington also dogged the fixed income markets. The 10-year U.S. Treasury note yield declined roughly five basis points over the quarter, falling to 2.4%, while the yield curve (as measured by the spread between the two-year and 10-year Treasury yield) declined 11 basis points, falling to 1.07%. High-yield bonds outperformed safer sectors, and spreads declined 37 basis points to end the quarter at 3.9%. Interest-rate sensitive REITs navigated these headwinds and rose a modest 1%.
U.S. gross domestic product (GDP) was announced at 2.1% for the fourth quarter, giving the economy a 2.0% growth rate for 2016. Most recent inflation, as measured by the consumer price index (CPI), came in at 2.8% year over year. Increases in shelter, energy and medical services were the main drivers. Job gains also remained strong. Non-farm payrolls additions averaged just over 230,000 per month to start the year, and the unemployment rate was a mere 4.7%. Wage growth still appears to be subdued, though, as average hourly earnings increased 2.8% year over year.
Foreign markets experienced strong gains in the quarter, led by low double-digit returns in emerging markets. The average 1.8% decline in the U.S. dollar against a basket of currencies added to these gains for investors. Emerging markets are expected to lead the globe in economic growth in 2017. According to the International Monetary Fund (IMF), developing economies are estimated to grow by 4.5% after growing by 4.1% in 2016.
Developed markets, proxied by the MSCI EAFE Index, increased 7.4% in dollar terms. Although global economic growth remained subdued in 2016, the prospects of a synchronized uptick in growth across Europe and Japan, alongside attractive valuations and continued central bank asset purchases, helped both stocks and bonds. According to the IMF, advanced economies experienced real GDP growth of only about 1.6%, but this is expected to pick up in 2017.
As markets in the U.S. focus on Washington, Europe is focused on Paris. Marine Le Pen seeks the first presidential win for the far-right French party her father founded in 1972. Le Pen has reshaped the party to become more anti-establishment and to cater more to working-class voters as well as those who are anti-immigrant, anti-EU and "French-first" voters. The first round of the election is April 23, with the second and final round occurring in May. Le Pen is currently polling reasonably well which concerns the EU establishment as evidenced by EU President Jean-Claude Juncker’s recent comments:
“The European Union will survive Marine Le Pen because she won’t become president. And even if she did, it would not be the end of the European project. But it will certainly rock the boat. So I hope that pro-European forces will win in France.”
Germany will also hold federal elections in late September which puts Chancellor Angela Merkel up for re-election. Her popularity has waned due to her controversial support of the country’s open-door migration policy.
Leading into the summer, we expect political events around the globe will continue to dominate investors’ attention. Analysts will also monitor the U.S. stock market to see if it can maintain its robust performance, as well as economic indicators for signs of inflation.