A risk-on mindset dominated with global equities surging and interest rate sensitive asset classes lagging.
The global economy is experiencing a synchronized mini-acceleration with emerging economies leading the way and the potential for the U.S. to follow if Washington can provide further policy support.
Survey-based (soft) measures of economic growth are running ahead of quantifiable (hard) data.
Heading into the summer, markets will be looking for a resolution to this disparity.
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.
Q1, 2017: Key Market Total Returns
After jumping at the end of 2016, inflation expectations moderated, removing the strong head-wind to bonds that prevailed in the fourth quarter. In addition, post-election optimism in the U.S. boosted survey-based economic measures. The U.S. Conference Board’s Consumer Confidence Index reached a 16-year high of 125.6 in March. Contributing to the optimism: strong labor markets, rising wages, 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 optimism, 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. Perhaps the most interesting theme to develop is that the positive outlook in survey-based (or “soft”) economic data has yet to transfer over to the real economy. By many accounts, there has never been so wide of a gap between quantifiable (hard) data and reports based on sentiment (soft). This gap caused a sharp divergence in expectations for first-quarter U.S. economic growth, as highlighted by the stark disparity between two widely quoted regional Fed growth models: the Atlanta Fed’s GDPNow measure is calling for first-quarter growth of just 0.9%, while the New York Fed’s Nowcast predicts first-quarter growth of 2.9%.
Washington sits at the epicenter of this growth conundrum. President Trump’s inauguration officially started the clock on the new administration’s goal to deliver on its pro-growth mandate. By late March, a bill to overhaul the Affordable Care Act had been shelved due to lack of support, and the House of Representatives subsequently moved on to tackle tax reform. In addition, 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.
Also in mid-March, the Federal Open Market Committee (FOMC) 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.
In January and February, U.S. equity markets pushed higher, continuing one of the calmest periods in stock market history. During the quarter, the CBOE’s Volatility Index even fell below 10, a level that had not been seen since 2007, and for 11 weeks before that, it had remained below 12. According to Charlie Bilello of Pension Partners, these were the lowest volatility readings since 1990. In March, however, volatility crept back in, and large cap stocks finally ended their epic 109-day run without a decline greater than 1%.
Stock returns were strongest in traditional growth sectors, such as technology, up 12.2%, and consumer discretionary, up 8.1%. The only sectors that declined were telecommunication (-5.1%) and energy (-7.3%), which was dragged lower by the 9% decline in crude oil prices. 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 their value counterparts. (The Russell 3000 Growth outperformed the Russell 3000 Value by 5.6%.) Large cap stocks also outperformed small caps for the quarter, though they trail them 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.
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. real 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 greenback against a basket of currencies added to these gains for U.S. 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, and the second and final round will occur in May. Currently, Le Pen is 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 be holding 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 that 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.
The SpringTide Investment Team
Disclosures & Footnotes
The indexes referred in the performance table are as follows: U.S. large cap stocks: S&P 500 Index; U.S. small cap stocks: Russell 2000 Index; International developed stocks: MSCI EAFE; emerging market stocks: MSCI Emerging Markets Index; U.S. taxable bonds: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. municipal bonds: S&P National Muni Bond Index; U.S. high yield bonds: Bloomberg Barclays High Yield Corporate Bond Index; international developed bonds: S&P/Citi International Bond Ex-U.S. Index; emerging market bonds: JP Morgan Emerging Market Bond Index Global; U.S. REITs: MSCI U.S. REIT Index; international real estate securities: S&P Global Ex-U.S. Property Index; commodities: Bloomberg Commodity Index; master limited partnerships: Alerian MLP Index.
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