QUARTER 2 2017 COMMENTARY
Global risk assets remained strong for the first half of 2017. Emerging markets, developed international stock and international real estate stayed in front of the global market. Domestically, large cap and specifically growth-oriented segments of the U.S. market led the way. The tech-heavy NASDAQ 100 grew 16.8% during the first half of 2017 posting the index’s best start to a year since 2009. Low interest rates and strong year-over-year earnings growth were the key drivers to the NASDAQ’s strength.
During the second quarter, the divergence between survey-based (soft) measures of economic growth, which surged after the U.S. presidential election, and quantifiable (hard) data, which remained stubbornly pessimistic, finally subsided. The two measures moved together as soft data declined and hard data improved modestly.
To illustrate this convergence, consider the Atlanta Fed’s GDPNow, which predicts second-quarter growth of 2.7% – a drop from the more than 4% growth rate it was predicting just three months ago. Consumer spending also fell slightly as real personal consumption expenditures grew by just 2.7% year-over-year.
Despite modest economic improvement, corporate earnings had solid growth. They were helped by favorable earnings comparisons to this time last year. Recall that second quarter 2016 was the last of five consecutive quarters with earnings decline. Prior to that, the most recent time we experienced five quarters of earnings decline was Q3 2008 - Q3 2009. According to Standard & Poor’s, the S&P 500 operating earnings were up 20% year-over-year in the first quarter of 2017. Second-quarter earnings growth is expected to be as robust at 21% year-over-year. However, expectations for the full year have declined slightly to $128 per share from $130. The CBOE’s Volatility Index has remained muted, meaning that except for two small spikes this quarter, investors did not see volatile portfolio fluctuation.
Inflation trended lower during the quarter after hitting a high of 2.8% in February. Wage pressure has remained low despite a flat participation rate and low unemployment.
Labor markets remained healthy as initial jobless claims continued to move lower. The four-week moving average dropped below 240,000 and initial claims have now remained below 300,000 for the longest time since the 1970s. Non-farm payroll additions moderated over the past three months, averaging just 121,000, while the unemployment rate plummeted to 4.3%. The labor force participation rate stabilized at what appears to be a structurally lower level of less than 63%.
Gridlock in Washington continues, raising doubts about what can be accomplished by the end of the year. According to a recent poll by Bloomberg, 27% of economists now expect slower growth in 2017 due to the new administration’s economic agenda, up from 14% in March. Zero percent of respondents expect higher growth this year, down from 31% in March.
Washington remains in the spotlight over two key topics: 1) the debt ceiling debate and 2) the Fed’s plan to unwind its balance sheet. On the first issue, the U.S. Treasury expects it will run out of cash by October. This will provide a target date for Washington to work toward some policy action. The second issue surrounds the Federal Reserve, mentioning in June, their plan to start reducing its $4 trillion balance sheet while possibly raising interest rates further even in the face of weakening inflation the first half of 2017.
Growth stocks significantly outperformed value stocks, giving them a commanding lead this year. Larger companies materially outperformed their smaller peers partially because of massive inflows to passive investments like index funds and ETFs. According to Bloomberg and ICI data, nearly $500 billion flowed from active to passive investment vehicles in the first half of the year. Initial reactions to the Department of Labor Fiduciary Rule suggest this trend could get worse before it gets better. Additionally, Ameriprise recently decided to cut 1,500 funds from its offerings, based on short-term performance, assets and costs. Should other brokerage firms follow suit, passive strategies could enjoy even greater inflows, further benefitting large- and mega-cap stocks, which represent the greatest share of popular benchmarks and so receive the majority of passive investment dollars.
In the S&P 500 Index, Energy was the only sector with negative returns for the quarter (-6.6%), primarily due to crude oil’s continued price decline. Crude oil fell 10.5% over the quarter, dropping from the mid-$50s per barrel down to the mid-$40s. This comes at a time when U.S. crude oil production is just 6% off its all-time highs, according to data from the U.S. Energy Information Administration. Year to date, the energy sector is lower by 12.7%. Utilities and Consumer Staples trailed other sectors, returning 1.5% and 2.2%, respectively. Thanks to a late quarter rally, Financials managed a respectable 4.4% gain, even as the yield curve flattened. Health Care and Technology, both growth sectors, were up 7.1% and 3.1%, respectively—although Technology suffered a late quarter dive that sapped 3.5% from what would have been another blockbuster quarter for the sector.
Despite the unpredictable landscape, bonds also produced solid absolute returns, helped by the decline in inflation. U.S. Treasury note issuance was just $73 billion in the quarter, down 14% from last year. Consequently, the Bloomberg BarCap Aggregate Bond Index increased by 1.4%. The 10-year U.S. Treasury note yield declined roughly 13 basis points over the quarter, falling to 2.3%, while the yield curve (as measured by the yield spread between the two-year and 10-year Treasury) flattened 21 basis points, to end at 0.93%.
Foreign assets led global stock markets again this quarter. The 4.8% drop in the U.S dollar for the quarter, its worst since 2010, was the primary driver. Emerging markets rallied 6.3%, up by almost 19% through the first half of the year. From a country standpoint, China was the winner, earning a low double-digit return for the quarter and up over 20% for the year. Developed markets, proxied by the MSCI EAFE Index, increased 6.1%. For the year, the EAFE benchmark is higher by 13.8%. Europe was higher by a consistent 7.4%, bringing the year-to-date return to an impressive 15.4%. Euro-area inflation declined on a year-over-year basis to 1.3%, but has made significant “progress” since the near-zero levels in 2016. First-quarter GDP for the Eurozone was 1.9%. Japanese stocks approached a two-year high towards the end of June after the market was up 5.2% in the quarter, leaving it up 9.9% so far in 2017. Consumer prices in Japan came in at 0.4% year-over-year and have been stable for several months now.
While the trade-weighted dollar index had a poor quarter, most of the currency movement was focused on the euro cross rate, where the dollar depreciated 7%. Most of this move happened late in the quarter, on the heels of European Central Bank President Mario Draghi’s speech at the ECB Forum on Central Banking. Investors paid particular attention to this portion of his remarks:
“monetary policy is working to build up reflationary pressures, but this process is being slowed by a combination of external price shocks, more slack in the labour market and a changing relationship between slack and inflation. The past period of low inflation is also perpetuating these dynamics. These effects, however, are on the whole temporary and should not cause inflation to deviate from its trend over the medium term, so long as monetary policy continues to maintain the solid anchoring of inflation expectations.”
Although the market took these comments to be hawkish, some noted they were taken out of context. The ECB is unlikely to take substantial action prior to observing how the initial unwind of securities from the Federal Reserve’s balance sheet (and one of largest monetary policy experiments in history) impacts global markets.