Following two years of remarkably steady gains, most major investment categories faltered during the first three months of 2018. Large-cap U.S. stock benchmarks fell 1% to 2%; small-caps were roughly flat. Overseas, developed-economy stock markets declined, though strengthening currencies cushioned losses recorded by U.S. investors; emerging- and frontier-market equities produced modestly positive returns. Commodity-related investments also eked out small gains, while real-estate investments mostly declined (though those linked to the value of timberland rose smartly). Benchmark bond yields rose: the 10-year U.S. Treasury Note finished the period at 2.74%, compared to 2.40% at the end of 2017; most fixed-income investments produced slightly negative total returns, as rising yields eroded their market value.
Among large-company U.S. stocks, above-benchmark returns came from companies in the Capital Goods/Business Services, Consumer Cyclicals and Technology sectors; returns lagged among Basic Materials, Communication Services, Consumer Staples, Energy and Utilities names. Growth-oriented stocks bested their value counterparts by an unusually wide margin (nearly seven percentage points, on average), a persistent pattern that has allowed large-cap growth to outpace large-cap value by a factor of four (+29% to +7%) over the past five quarters.
Benchmark Performance – Equities
|First Quarter 2018||Last Twelve Months|
|S&P 500 Index||-0.8%||+14.0%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||-3.0%||+10.5%|
|Small-Cap Stocks (Russell 2000)||-0.1%||+11.8%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||-1.6%||+15.2%|
|Non-U.S. Stocks (Emerging – MSCI EM)||+1.2%||+25.1%|
Benchmark Performance – Fixed Income
|First Quarter 2018||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||-1.0%||+0.4%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||-1.1%||+2.1%|
After an unusually smooth ascent dating from early 2016, volatility finally returned to global financial markets, as investors reacted erratically to hints of rising inflation, tightening monetary policy and rising bond yields, increasing political/regulatory scrutiny of some of the largest and/or most profitable tech-sector firms, and rising global trade tensions.
Data published during the quarter indicated continued strength in global growth, subdued inflation and robust corporate profitability. In the U.S., fourth-quarter 2017 GDP came in at +2.9%, a slight down-tick from the previous reading (+3.2%), but still well above the post-financial-crisis average. More timely data – including job growth, purchasing-managers indices, consumer- and business-confidence surveys, and real-estate market gauges – all indicated the expansion remained intact. The pattern was similar overseas: fourth-quarter growth was better than expected in the Euro zone, China, Japan and India; both Brazil and Russia continued to make progress following deep 2015-2016 recessions. Though reported inflation remained well below 2% across nearly all developed economies, evidence continued to accumulate that the post-financial-crisis period of worryingly low inflation was receding. Capping the solid fundamental news, earnings reported by U.S. publicly traded companies during the quarter (mostly covering the final three months of 2017) were 21% above the year-earlier period, bringing the calendar-year increase to 17.2%.
With economic activity maintaining a brisk pace and inflation stirring to life, global central banks continued down the path toward less accommodative monetary policies. In the U.S., the Federal Reserve, led by newly installed Chair Jerome Powell, raised short-term interest rates by 0.25% in March – the sixth such increase since late 2015 – bringing the target range to 1.50%-1.75%. Post-meeting communications signaled the likelihood of two additional quarter-percent hikes over the course of the year and three more in 2019 – a slightly more ‘hawkish’ view than previously. Benchmark bond yields rose rather abruptly early in the quarter – peaking near 2.95% in mid-February – before modestly softer growth and inflation data, combined with a flight-to-safety trade as stock markets swooned, allowed yields to subside later in the period.
Global political developments may have added to investors’ sense of unease. China announced the abandonment of presidential term limits – often cited as a key reform of the post-Mao Zedong era; populist, anti-establishment parties made surprising gains in Italian elections; and a Russian former espionage agent and his daughter were attacked in the U.K. using a sophisticated nerve agent of probable Russian origin. Meanwhile, the Trump administration continued to be distracted by investigation, innuendo and personnel turnover, and Republican candidates were defeated in several closely watched elections. In perhaps the biggest blow to investor sentiment, U.S. authorities demonstrated increased inclination to intervene in markets, first blocking Singapore-based Broadcom’s attempted takeover of U.S. chip-maker Qualcomm, and later announcing aggressive measures meant to protect U.S. industry from foreign competition.
With valuations stretched, the Fed raising interest rates, and political uncertainty burbling in the background, the U.S. stock market entered 2018 superbly positioned for a correction. The ‘melt-up’ phase that large-cap growth stocks entered in late 2017 continued into January, as major benchmarks repeatedly reached new highs, gaining nearly 8% in less than four weeks. Then, reality intruded, with volatility spiking and markets suffering a swift 10% decline – the first ‘correction’ in nearly two years. The proximate cause was a surprisingly large year-over-year increase in average hourly earnings, prompting fears that accelerating inflation would cause the Fed to slam on the monetary-policy brakes. The sudden rise in volatility, from abnormally low levels prevalent for the past two years, caused massive disruptions – and large losses – in a range of esoteric trading strategies (mostly employed by hedge funds and other institutional investors) closely linked to the level of volatility. Frantic efforts to ‘unwind’ or otherwise hedge suddenly wrong-footed positions added fuel to the fire. Markets calmed quickly, however, recouping most of their losses over the remainder of February, only to dive again into (and across) quarter-end, this time in response to announcements of protectionist and other market-unfriendly policies.
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 -0.8% S&P 500 total return
|First Quarter (January-March) 2018|
|+ Change in Earnings||+10.6%|
|+ Change in Valuation||-11.9%|
|= Total Return||-0.8%|
Our read: A tax-reform-induced step-up in expected earnings provided some welcome relief on the valuation front
In hindsight, it seems clear that 2016-2017 was a period of large forces moving, at the margin, in favor of financial-market investments: global economic activity was strengthening; deflation fears were waning but central bank policies remained maximally accommodative; pro-market/pro-business political and policy developments were in the vanguard; and investors finally emerged from the protective crouch assumed during the financial crisis and maintained through the less-than-certain 2010-2015 period. The market perturbations of the past ten weeks suggest investors sense an important shift may be in the offing: slowing – or at least no longer accelerating – global growth; tightening monetary policies and rising bond yields; and a more populist, anti-establishment and, on balance, less market-friendly policy environment.
The up-shift in global economic activity that began in 2016 seems intact, though recent data hint at a nascent deceleration abroad. In the U.S., the boost provided by last year’s tax reform and recently passed spending legislation will add substantially to GDP well into 2019. The combination of tax cuts, solid jobs growth, and healthy household balance sheets should also permit an up-tick in consumer spending, which has lately been somewhat disappointing. Though the latest OECD projection calls for global growth to accelerate from last-year’s above-average rate (+3.3%), recent industrial-production and purchasing-managers reports from China, the Euro zone and Japan suggest growth may have peaked around the beginning of 2018. We will watch the news carefully in this regard, as it might not take much additional soft data to kindle a ‘growth scare’ that could quickly sap investor confidence.
Likewise, corporate profits look set to remain supportive. Wall Street analysts expect a combination of healthy economic activity and the large one-time effects of recent tax changes to cause a substantial step-up in earnings, with growth rising from last year’s very healthy +17% rate to an eye-watering +25% clip by the time 2018 is in the books. Overseas, modest currency headwinds should be more than offset by solid global demand, relatively steady commodity prices, and profit margins that are generally less elevated than in the U.S., leaving room for expansion.
Monetary policy and bond yields present something of a half-full glass. For much of the past several years, the Treasury yield curve (the interest-rate differentials among bills, notes and bonds of various maturities) indicated investors doubted the Fed’s resolve to raise rates as rapidly as indicated in post-FOMC-meeting communications (the so-called ‘dot plots’ indicating where each FOMC member expects the Fed Funds rate to be at various future dates). Lately, however, investor views are broadly in agreement with the dot plots, indicating (at least marginally) less risk of a sudden surge in bond yields. That said, if growth stays above trend and unemployment continues to fall through the remainder of 2018 – both of which currently seem probable – the Fed will likely begin focusing in earnest on averting a rise in inflation. History has taught investors that whenever it tries to nudge growth lower to head off inflation the Fed is at great risk of instead tipping the economy into recession.
Recent market volatility suggests shifting U.S. policy stances may pose substantial near-term risk to investors. The Trump administration seems to be undergoing a dramatic pivot, leaving behind a first year characterized by traditionally conservative, pro-business and investor-friendly policies, and embarking on a new phase promising more populist, anti-establishment, and in many cases less business- and market-friendly themes. Potential trouble spots include (in increasing order of concern) the review of the Iran nuclear agreement; renegotiation of NAFTA, simmering immigration/border-security issues, and July’s presidential election in Mexico; rapidly evolving antitrust and consumer-data-protection policies that pose unquantifiable threats to tech giants like Amazon, Facebook, and Google-parent Alphabet; and finally, politically popular but market-anathema protectionist initiatives, in particular those aimed at ‘correcting’ the trade imbalance with China, which risk escalating tit-for-tat measures that could be extremely disruptive to global commerce and economic growth.
Despite the improvement noted in our ‘What’s Changed?’ box above, valuation remains challenging. While the S&P 500 price/earnings ratio based on expected profits over the next twelve months fell substantially, the ‘normalized’ measure, using an average of reported profits over the past 10 years, is still very elevated. According to JPMorgan research, by the first gauge, U.S. stocks are now below their median post-1990 valuation; but analysts at Leuthold Group counter that, by the latter, valuation remains in the 95th percentile. In any case, average valuation is currently being pushed meaningfully higher by the truly ample valuations of a handful of extremely large-capitalization technology stocks (the so-called FANG group: Facebook, Amazon, Netflix and Google-parent, Alphabet – plus Microsoft and a few others). Many stocks – including a large number held in Oarsman client portfolios – trade at far lower multiples (closer to 10-times earnings than 20 to 25), indicating substantially better value and, we would argue, superior prospective returns. Such gaping valuation discrepancies are not characteristic of a balanced, healthy market, and (though less extreme) remind us of 1999-2000 – the peak of the last large-cap growth/tech-stock mania. That episode ushered in a seven-year period during which large-cap growth and technology stocks massively underperformed nearly all other investment categories.
On a final note, we draw attention to the cumulative effect of Fed-engineered interest-rate hikes since the end of 2015: near-zero-risk, near-cash-equivalent investments now yield almost 2%, compared with essentially zero for most of the nine years since the financial crisis. And with high-quality longer-term bond yields also moving (more modestly) higher, the expected ‘opportunity cost’ of shifting incremental investment dollars from potentially risky stocks to much safer cash and bonds is as low as it has been in years. We may be witnessing the end of ‘TINA’ – There Is No Alternative (to stocks) – if so, not a moment too soon.
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