Nearly all categories of financial investments produced positive returns during the January-March period. Large-company U.S. stocks gained around 6%, while small caps, taking a breather after sprinting ahead to end 2016, rose about 2%. Overseas stocks generally out-performed, with developing and frontier markets gaining around 7%, and emerging markets surging more than 11%. Real-estate investments recorded low-single-digit gains, on average. Most industrial commodity prices declined (oil was off -7%), though precious metals jumped (gold: +8%). Benchmark interest rates were nearly unchanged (the 10-year Treasury Note began the period yielding 2.44% and ended at 2.40%), resulting in modestly positive returns from investment-grade bonds; high-yield (‘junk’) bonds did somewhat better, on average.
Among large-company U.S. stocks, those in the Basic Materials, Technology and Consumer Staples sectors produced relatively strong three-month results, while Capital Goods, Consumer Cyclicals, Energy and Financial Services names lagged. Reversing a recent trend, growth-oriented stocks outperformed their value counterparts.
Benchmark Performance – Equities
|First Quarter 2017||Last Twelve Months|
|S&P 500 Index||+6.1%||+17.2%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||+5.8%||+16.0%|
|Small-Cap Stocks (Russell 2000)||+2.5%||+26.2%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||+7.4%||+12.3%|
|Non-U.S. Stocks (Emerging – MSCI EM)||+11.5%||+17.6%|
Benchmark Performance – Fixed Income
|First Quarter 2017||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||+0.8%||+0.4%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||+1.0%||-0.5%|
Strong first-quarter investment results were fueled by improving global economic growth, receding fears of deflation, and healthy gains in corporate profits. These solid fundamentals were more than sufficient to offset a rocky start by the incoming Trump administration and GOP-dominated Congress.
The U.S. economy appeared to be on sound footing. Though the latest read on overall growth, covering the final quarter of 2016, showed GDP advancing at an annualized rate of just +2.1%, more timely data largely exceeded expectations: both consumer-confidence and purchasing-managers surveys were at multiyear highs; monthly job growth accelerated from an already healthy pace (allowing unemployment to drop to just 4.7%); and wage gains picked up to near +3%. Financial and residential real-estate markets remained buoyant, pushing the ratio of household wealth to disposable income to an all-time high.
Overseas developments were also positive. In Europe, purchasing managers’ surveys and business confidence reached six-year highs, credit growth accelerated, and consumer confidence rose. In Japan, business sentiment improved, as did manufacturing- and export-sector growth. Particularly salutary news came from China, where a noteworthy turnaround continued. Following a prolonged slowdown that sowed widespread fear of a ‘hard landing’ early last year, the world’s second-largest economy expanded at an accelerating rate over the past 10 months. Research firm Capital Economics estimates actual growth at the turn of the year was in-line with usually-inflated government statistics for the first time in years – having accelerated from under 4% to nearly 7%. Reviving Chinese growth boosted the industrial sectors of other East Asian markets, and continued to support industrial commodity prices, helping ease recessions in Brazil and Russia.
One of the most notable recent macro-economic developments has been an unambiguous improvement in the global inflation environment. In February, average headline consumer-price inflation across the U.S., the Euro-zone and Japan was +1.7%, compared with just +0.2% a year ago. In China, producer-prices surged from a deflationary -5% to inflation of nearly +7%. Implied future inflation rates discernible within bond markets also improved. These developments prompted European Central Bank (ECB) president Mario Draghi to declare in early March that “the risks of deflation have largely disappeared.”
Against a backdrop of improving economic growth and rising, though still tame, inflation, the Federal Reserve raised short-term interest rates for the second time in three months at its March policy-setting meeting. Post-meeting communications and the so-called ‘dot plots’ indicating the likely future course of short-term rates were interpreted as marginally dovish: longer-term Treasury yields and the foreign-exchange value of the dollar fell back from near-term peaks.
Corporate profits reported during the period, generally covering the final three months of 2016, continued the marked improvement we noted last quarter, coming in more than 20% above the figure from a year earlier; the trailing-twelve-month tally showed a more muted but still healthy gain of 6%. Wall Street analysts expect another 20%+ improvement for the January-March quarter, and a similarly robust increase for the full calendar year.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the +6.1% S&P 500 total return?
|First Quarter (January – March) 2017|
|+ Change in Earnings||+2.5%|
|+ Change in Valuation||+3.1%|
|= Total Return||+6.1%|
Our read: Though year-ahead earnings rose, the market’s advance was greater; valuation near the top of its historical range leaves scant margin for error (and ample scope for disappointment).
Though growth will likely remain below average, 2017 could mark the first measurable acceleration in global economic activity since 2010. The American economy looks set to expand at the 2%-2.5% pace seen in the second half of last year, with a chance for upside if tax reform and/or an infrastructure-spending boost occur sooner than we anticipate. Europe and Japan, benefiting from weaker currencies and better export demand, should grow between 1% and 1.5%. Russia and Brazil will add to global growth for the first time in several years, while the Indian economy is seen notching another year of growth above 7%. As so often in recent years, China is a potential wild card: after contributing greatly to stabilizing the global economy over the past year, growth may be peaking; but we believe Beijing will do what it takes to avoid a meaningful slow-down prior to November’s important Communist Party Congress.
The salutary impact of an improved global inflation outlook is difficult to overstate. For most of the post-financial-crisis period, the specter of deflation (that is, broadly falling prices) has haunted the global economy and financial markets. Along with sluggish growth, fear of deflation kept unconventional monetary policies, including near-zero and even negative interest rates, in place for eight years. If the recent improvement holds, central bankers will be able to move more purposefully to normalize policies, which if handled deftly would be a boon to many: savers, investors, retirees, and financial services firms top the list. A return to a gradually-rising price environment would also reduce the real value of debts (deflation does the opposite) and, importantly, allow business managers to worry less about survival and start looking for growth opportunities, potentially unleashing long delayed investments in new plants, equipment and labor.
Global central bankers, carefully monitoring the improvement in economic conditions, appear ready to begin a more broad-based normalization of monetary policies. Though the Fed has indicated it expects to hike short-term rates at least two more times this year, it remains in no hurry to see rates at levels that prevailed prior to 2008: the ‘dot plots’ suggest a late-2019 reading below 3%. Elsewhere, the ECB has begun hinting that its super-accommodative policies may soon begin to be scaled back, and even the Bank of Japan has recently adopted a somewhat brighter view. While the Fed is clearly ahead of its peers in this process, the degree of divergence among major central bank policies seems likely to be on the wane for the first time in several years.
Following a fifteen-month ‘earnings recession,’ corporate profits are likely to be supportive. The fading impact of the dollar’s abrupt appreciation after mid-2014, and roughly coincident collapse in commodity prices, will continue to provide a tail-wind for the energy, basic materials, and capital-goods sectors. (The North American oil-drilling ‘rig count’ has more than doubled from its mid-2016 trough, though it remains some 65% below the late-2014 peak.) Incrementally better global growth, as well as higher inflation, will boost top-line growth across many industries, while higher interest rates will support results in the financial-services sector. At the same time, however, rising interest costs and wage gains are likely to temper profitability. All in, we are skeptical of Wall Street’s anticipation of a 20% gain, but would not be shocked to see a final 2017 tally in the double digits.
While heartened by supportive fundamentals, we believe recent gains in financial asset prices already discount a lot of good news, leaving ample scope for disappointment. First, political and policy uncertainty abounds. Botched efforts to limit immigration and ‘repeal and replace’ Obama-era health care legislation have diminished optimism that the new Administration and Congress can work together to enact investor-friendly initiatives (tax reform, regulatory roll-back, infrastructure spending). Meanwhile, as investigations of Russian election interference loom, China, North Korea, ISIS/Iran/Syria (and even Canada, Mexico and NATO!) will pose foreign-policy challenges to the fledgling Administration. Overseas, notwithstanding the relatively benign outcome of the recent Dutch vote, the next twelve months hold a number of potential pitfalls: elections in France, Germany and Italy and the beginning of Brexit negotiations, to start.
Valuation also remains problematic. After another increase during the January-March period, the aggregate valuation of U.S. stocks remains near historic highs – some 15% to 30% above historical averages, depending on the measure applied. Happily, recent earnings strength, if played out over several more quarters, would eliminate a reasonable amount of this gap (if stock prices remained unchanged, that is). In any case, as we have noted previously, high valuation is rarely a catalyst for a sell-off, though it generally has a depressing effect on future returns.
Finally, we have begun to note unsettling trends in investor sentiment. On one hand, bullishness is on the rise among both individual and institutional investors, many of whom had been quite skeptical during much of the current bull market. On the other, a widely watched survey by the Yale School of Management indicates a near-record percentage of investors believe stocks are overvalued. Meanwhile, volatility has been exceptionally low: the S&P 500 recently ended a near-record 109-day run without a 1% daily decline; the VIX ‘fear gauge’ hovers at historically low levels. While the meaning of these observations is far from unambiguous, we feel in combination they suggest growing investor complacency, often an important precondition for a market correction.
Facing a combination of political uncertainty, stretched valuation and growing complacency, we are inclined to remain somewhat cautious, especially with regard to U.S. stocks. We expect the prospective ‘mature bull market’ environment to be characterized by increasing performance divergence among industries and individual companies – an environment where active security selection will provide increasing value. We also note (again) that, after under-performing in six of the past eight years, many non-U.S. markets remain meaningfully cheaper than their domestic counterparts. Moreover, fundamental developments (improving trade, more competitive currencies, lower debt) appear particularly supportive of emerging- and frontier-market investments. Finally, we welcome the prospect of (gradually) rising interest rates, which would allow us to invest incremental cash reserves (‘dry powder’), as well as proceeds from maturing bonds, at more attractive rates.
We encourage your questions and comments regarding our management of your investments.
Alan Purintun, CFA Robert W. Phelps, CFA
Principal & Portfolio Manager Principal & Portfolio Manager