The April-June period saw further gains accrue to most categories of financial assets. Large-company U.S. stocks advanced around 3%, marginally outpacing their smaller-company counterparts. Non-U.S. stocks bested domestic equities for the third consecutive quarter; both developed- and emerging-market categories notched gains greater than 6%. Real-estate investments, too, posted mid-single digit returns. Industrial commodity prices declined for a second-straight period (oil dipped -13%); gold was roughly flat. Despite another short-term rate hike by the Federal Reserve, benchmark yields declined slightly (the 10-year Treasury began the period at 2.40% and ended at 2.30%), resulting in positive returns from investment-grade fixed-income; high-yield (‘junk’) bonds again posted somewhat larger gains, on average.
Among large-company U.S. stocks, those in the Capital Goods, Health Care, Technology and Utilities sectors produced relatively strong three-month results, while Basic Materials, Consumer Cyclicals (other than Amazon!), Energy and Financial Services were weaker, on average. Growth-oriented stocks again substantially outperformed those in the value category.
Benchmark Performance – Equities
|Second Quarter 2017||Last Twelve Months|
|S&P 500 Index||+3.1%||+17.9%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||+2.9%||+17.1%|
|Small-Cap Stocks (Russell 2000)||+2.5%||+24.6%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||+6.3%||+20.9%|
|Non-U.S. Stocks (Emerging – MSCI EM)||+6.4%||+24.1%|
Benchmark Performance – Fixed Income
|Second Quarter 2017||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||+1.1%||-0.2%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||+1.7%||-0.8%|
An expanding global economy, rising corporate profits, and falling bond yields – perhaps aided by signs that populist/nationalist political turbulence could be on the wane – produced a generally conducive environment for financial investments during the April-June period.
Though the U.S. economy experienced another early-year slow-down (first-quarter GDP expanded just +1.2% – roughly half the pace of late-2016), numerous indicators of better growth remained intact. An average of nearly 150,000 net jobs was created each month, bringing the unemployment rate to a 10-year low of 4.3% (though wage growth remained subdued); purchasing-managers surveys were solidly in expansion territory; and the housing market remained buoyant, with prices advancing nearly 6% over the past year. Political dysfunction/scandals dominating headlines for much of the quarter may have dented consumer confidence, which backed off multiyear highs reached earlier in the year. Retail sales, especially of cars and light trucks, were also somewhat disappointing. Of note, both reported inflation measures and indicators of future inflation expectations fell back after an early-year acceleration (always-influential gasoline prices dropped precipitously during the quarter).
Overseas economic developments continued to underpin the notion that 2017 will likely see the first meaningful acceleration of global growth since 2010. The Eurozone economy, in particular, seemed to be firing on all cylinders: first-quarter GDP growth came in above 2%, while gauges of both business and consumer confidence reaching multi-year highs encouraged economists to raise their outlook for both this year and next. Japan, too, turned in a stronger performance, though a blow-out initial first-quarter report was later revised to a more modest but still above-trend expansion. Brazil and Russia continued to dig out from deep recessions; with inflation falling, both countries’ central banks cut interest rates sharply. And despite the removal of 85% of bank notes (by value) from circulation early in the year, India continued to set a blistering pace with growth above 7%. Statistics from China moderated somewhat from the above-trend pace seen around the turn of the year, though activity remained healthy ahead of the important Communist Party Congress in the fall; other East Asian economies continued to benefit from the rebound in China following last year’s ‘hard-landing’ scare.
Despite generally sturdy global growth, commodity prices were under pressure for a second-straight quarter. Industrial commodities fell more than 10% from their February peak (though most remained well above year-ago levels), responding to moderating activity in China and fading hopes for a ramp-up in U.S. infrastructure spending. The decline in energy prices was even more pronounced (though prices stabilized somewhat late in the period), as market participants continued to assess the interplay between OPEC supply discipline (resulting in higher prices) and quick-response production increases from U.S. shale fields (depressing prices).
Global central bankers took their cue from improving economic statistics and inched gradually toward a more normal monetary policy regime. The U.S. Federal Reserve raised short-term interest rates for the third time in just over six months (the fourth hike since late 2015), and also began publicly discussing plans for reducing the enormous inventory of Treasury and mortgage bonds the central bank has acquired via ‘quantitative easing’ since the end of 2008.
Even as heavily Fed-influenced short-term Treasury rates headed higher, longer-term bond yields fell over much of the period. This so-called flattening of the yield curve – a classic recession-warning signal – received widespread coverage in the popular financial press. However, the recent decline in longer-term yields seemed mostly to reflect declining inflation expectations, which had spiked in previous months, rather than a drop in ‘real’ interest rates (which would more clearly indicate expectations of slowing growth).
As the quarter drew to a close, a spate of unexpectedly up-beat comments by global central bankers was widely interpreted as indicating that the European, U.K., Canadian and Australian central banks were all beginning to prepare investors for a gradual tightening of monetary conditions in coming months. This shift caused quite a stir, especially in European bond and currency markets, where sovereign yields jumped 20 basis points (0.20 percentage points) or more and currencies surged in value against the U.S. dollar. Longer-term U.S. yields, held down in recent years partly by exceptionally low (even negative) yields on European and Japanese bonds, also bounced.
Corporate profits continued to recover from the strong-dollar/energy-sector-collapse ‘earnings recession’ of 2015-2016. Large-company results reported during the period (generally covering the first three months of the year) came in 20% above the year-ago figure; the less volatile trailing-twelve-month tally advanced nearly 13%. Of note, Wall Street analysts trimmed estimates for second-quarter profits by the smallest amount in two and a half years; they see trailing-twelve-month gains accelerating to nearly 20% as 2017 progresses.
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 +3.1% S&P 500 total return
|Second Quarter (April – June) 2017|
|+ Change in Earnings||+2.6%|
|+ Change in Valuation||0.0%|
|= Total Return||+3.1%|
Our read: In a statistical fluke, the market’s three-month gain was exactly equal to expected earnings growth plus dividend income. The ‘change-in-earnings’ component is likely to remain positive, providing much-needed support for the market’s above-average valuation.
As we enter the second half of 2017, the backdrop for financial market investments seems reassuringly benign. Global economic conditions are supportive; profits are expanding; and bond yields remain near historic lows even as global central banks cautiously begin to normalize monetary policy. However, the low-volatility gains of the past several years, exacerbated by the ‘TINA” effect (ultra-low cash and bond yields leading investors to conclude ‘There Is No Alternative’ to owning stocks), have herded incremental dollars into the equity markets. Valuations are high compared to historical averages; and tentative signs have emerged of investor complacency, if not greed. These worrisome features represent ‘tinder’ that could fuel the next meaningful market downturn (the last decline we would characterize as more than a ‘dip’ was in mid-2011). But as we have noted before, they seem unlikely to be the ‘spark’ that ignites an overdue correction.
So, what could provide the catalyst for a downturn, and what should we be watching for to stay ahead of such a change? Our first concern would be an unexpected deterioration in global growth. Happily, few of the preconditions for recession are evident in the developed economies of North America, Europe and Japan. Likewise, away from China (and perhaps a handful of smaller Asian and Latin American markets that are particularly dependent on Chinese growth), developing economies look set to accelerate further in coming months. Surely the biggest wild card is China (a recurring theme in recent years), where the worrisome accumulation of corporate and local-government debt since 2008/9 could easily end badly before long. However, we believe the authorities in Beijing will do all they can to keep growth on track ahead of the fall Party Congress, with impactful reforms coming no earlier than 2018.
A second worry would be a reversal of the profit expansion underway the past several quarters. The run-up in stock prices since mid-2016 can be largely explained as discounting healthy gains in profits this year and next, driven by improving global growth, a weaker U.S. currency, and – especially – the bottoming and gradual recovery of energy/mining and related manufacturing sectors. Of the factors driving the current profit expansion, the improvement in the energy/commodity/ industrial complex seems most vulnerable to a negative surprise. An unexpected decline in the U.S. oil and gas ‘rig count’ on the last day of the quarter – following 23 consecutive weekly rises – was a salutary development on this front (a rising count indicates growing supply, which tends to depress prices).
The monetary-policy/bond-yield backdrop is probably the most precarious prop to current market conditions. In recent months, economic activity seemed to be in a ‘Goldilocks’ zone – with growth improving even as inflation settled back – prompting investors to temper their expectations regarding the aggressiveness of near-term monetary policy. The market turbulence triggered by recent global central bank commentary showed how quickly complacency can turn to angst. In this regard, a particularly worrisome development would be a meaningful rise in inflation measures, which could lead investors to fear that policymakers had ‘fallen behind the curve’ and would need to ratchet rates higher sooner than expected. As we have noted repeatedly, the hugely unorthodox monetary policies of the past nine years will be tricky to unwind without incident.
Before closing, two additional market developments warrant comment: strong returns being posted by a handful of ‘mega-cap’ technology companies – the so-called ‘FANG’ stocks (Facebook, Amazon, Apple, Netflix/Microsoft and Google); and continuing, broad-based outperformance by non-U.S. equities. Large gains by the FANGs – compounded by the (related) fact that the NASDAQ market is trading very near the level it reached in early 2000 – have led to inevitable comparisons with the late-1990s tech-stock/dot-com bubble. Though we acknowledge some discomfort with current stock-market valuation, such alarm seems misplaced. As noted in the Leuthold Group’s June market commentary, since the prior peak, tech company revenues have increased 130% and profits have risen nearly five-fold; as a result, the median P/E ratio of the 100 largest NASDAQ stocks is below 25 today, compared to nearly 80(!) in early 2000. And though the FANGs have contributed meaningfully to the latest leg of the eight-year bull market, a number of disparate market sectors have participated as well (in contrast to 1998-2000): small-caps, mid-caps, utilities and a number of economy-sensitive market sub-indices have all recently traded within a percentage point or two of all-time highs. So, while the large-cap tech sector has clearly asserted leadership in recent months, the current market advance has been nowhere near as narrow as that of the late-1990s.
As for the durability of non-U.S. stock performance, we believe conditions remain supportive. Many overseas markets remain considerably cheaper than their U.S. counterparts, either absolutely or in relation to historical ranges. Moreover, the earnings environment is arguably more conducive, especially in Europe, where profit margins remain depressed and labor-market slack plentiful compared with domestic conditions. Finally, though meaningful differences exist among countries, many developing-market economies, having weathered numerous trials over the past two decades, today feature improved public and private-sector finances and increasingly vibrant domestic-consumer-driven sources of aggregate demand. That emerging and frontier markets have rallied in recent months despite Federal Reserve monetary tightening stands in stark contrast to the sharp sell-off that accompanied a much more timid shift in Fed policy in 2013 (the so-called ‘taper-tantrum’), and we believe attests to these markets’ underlying health.
To sum up: supportive economic trends and robust earnings seem capable of supporting further stock-market gains in coming months. But we admit to having difficulty finding value, especially among U.S. stocks: many companies we do or would like to own trade at valuations that seem likely to compress future returns at some point. And with bond yields lower than late last year (though higher than a few weeks ago), we are less enthusiastic about incremental fixed-income investments than we had hoped to be at this point. Accordingly, we believe a modest portfolio tilt toward non-U.S. equities and an above-average level of cash reserves remain prudent near-term positions.
We hope you are enjoying the summer. As always, please let us know if you have questions, comments or suggestions regarding the management of your investments.