06 Apr Cross-Currents
The rally from 2017 continued into late January as a strong earnings backdrop and optimism surrounding tax reform drove record inflows to stock mutual funds and ETFs.
Record-high optimism was met with a swift reversal in markets, sentiment and flows late in January as concerns about higher interest rates, deficits and a budding trade war stole the headlines.
U.S. stocks and bonds ended the quarter negative, a dynamic which has not occurred since 2008.
Investors will need to navigate these volatile cross-currents amid a deluge of positive and negative news.
The year began where 2017 left off—with a powerful rally in stocks, driven by strong earnings growth and optimism related to tax cuts. Equity mutual funds and ETFs experienced a record $58 billion of inflows in the first three weeks of the year. That trend, however, came to an abrupt end late in January and was followed by a swift reversal as the S&P 500 Index lost over 10% in just nine sessions. Markets then whirled frantically for the rest of the quarter as investors wrestled with a strong economic backdrop, rising rates, ballooning deficits and increasing risks of a trade war. Yet, despite all the churn, stocks ended the quarter down just -0.8%. U.S. bonds, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, also declined (-1.5%), marking the first time since the third quarter of 2008 that both asset classes dropped together. Trends that continued from 2017 included REITs underperforming broad equities, U.S. dollar weakness and emerging markets posting positive returns.
The selling that started in January intensified after the non-farm payrolls report on February 2 showed a bump in year-over-year growth in average hourly earnings to 2.9%, a post-recession high. Although the news was positive, the number generated concern that the Federal Reserve may need to raise interest rates four times in 2018, instead of the three times expected coming into the year. The selling caused investors to bid up the price of portfolio protection (put options). The CBOE Volatility Index—a measure of the cost of options on the S&P 500 index—surged far above the near-record lows it had hovered around for most of 2017. After hitting an intra-day high of over 50, it settled down and ended the quarter a tick below 20. Interestingly, U.S. Treasuries did not offer investors safe-haven protection. From the start of the equity sell-off through mid-February, the ten-year Treasury yield rose from 2.63% to 2.95%.
Released on February 16, the Commerce Department’s 232 Reports on Steel & Aluminum also contributed to volatility. Secretary Wilbur Ross recommended tariffs of 24% on steel and 7.7% on aluminum. Starting in early March, President Trump spoke publicly about implementing even higher tariffs (25% on steel and 10% on aluminum), and he formally signed them into law on March 8. From the release of the Commerce Department’s report through the end of the quarter, the S&P 500 Index returned -3.2% while the Russell 2000 Index—a proxy for small cap stocks—returned -0.4%. As expected, the Federal Open Market Committee (FOMC) raised interest rates by 25 basis points in March from 1.50% to 1.75%, its sixth raise of this hiking cycle. The press conference that followed was Jerome (“Jay”) Powell’s first. In it, Chairman Powell seemed to downplay the importance of the FOMC’s forecast, leaving the market with more questions than answers:
“I think, like any set of forecasts, those forecasts will change over time, and they’ll change depending on the way the outlook of the economy changes. So, that’s really all I can say. It could change up. It could change down. I wouldn’t want to, for now, these are the best forecasts that people could make. And, you know, it could be that if the economy’s a little bit stronger or a little bit weaker, then the path could be a little less gradual or a little more gradual.”
Congress finally passed a budget in February. After months of short-term fixes and brief government shutdowns, the passage enabled the U.S. Treasury to issue an enormous amount of debt. After issuing just $53 billion in January, the markets endured $436 billion of new supply in February and March.
But it was not all bad news. Fourth-quarter operating earnings for the S&P 500 were up a whopping 21% when compared to a year earlier—the highest growth rate since the fourth quarter of 2013. Technology (+39%) and energy (+615% or $2.93 per share, up from $0.41) experienced the largest growth rates. Except for telecommunications and real estate, each sector posted positive growth. Expectations for 2018 increased materially as the quarter progressed. Standard and Poor’s analysts now expect $156 per share for the S&P 500 Index, up from $145 earlier in the year. While analysts are prone to err on the side of optimism, that jump would represent a 25% increase from 2017. The S&P 500 now trades at 21.2 times trailing twelve-month operating earnings, relatively unchanged from the previous quarter’s reading. Operating margins hit a new record of 10.3%, besting the old record from the previous quarter by 11 basis points. Interestingly, margins in only three sectors (consumer staples, financials, technology) improved.
The Fed’s preferred inflation measure, the Core Personal Consumption Expenditures (PCE) price index, rose slightly from 1.5% to 1.6%. The labor market remained strong. Non-farm payrolls increased a robust 242,000 per month while the unemployment rate stayed at 4.1%. Fourth-quarter real GDP growth was finalized at 2.9%.
Large and small cap stock returns were almost identical; however, the return differential between growth and value was stark. Among smaller companies, the Russell 2000 Growth Index was higher by 2.3% while the Russell 2000 Value Index was lower by -2.6%. In the large cap space, the Russell 1000 Growth Index gained 1.4% while the Russell 1000 Value Index lost -2.8%.
Consumer discretionary, up 3%, was the best performing sector in the S&P 500 Index. Strong returns of Amazon (20% of the sector and up over 20%) and Netflix (4% of the sector and up over 50%) masked weakness of most other companies in the sector. Even with the price per barrel of WTI crude oil rising by more than 8% to almost $65, energy stocks were among the weakest sectors, losing -6%. WTI rose despite U.S. production continuing to climb to record levels— a rate of 10.4 million barrels per day. WTI is up over 25% in the past year while stocks in the energy sector have declined by -0.3%. Within REITs, every sub-sector posted negative returns with healthcare and retail down over -10% and -8%, respectively. The MSCI US REIT Index now yields 4.8% after returning -8%.
Tax-exempt fixed income securities, as measured by the S&P National Municipal Bond Index, lost -1.2%. High-yield bonds declined by -0.9%, according to the Bloomberg BarCap High Yield Corporate Index. The 10-year U.S. Treasury note yield rose 34 basis points to 2.74%. Over the course of the quarter, the spread between the 10-year and 2-year Treasury yields dropped 4 basis points to 0.47%, a new low for this cycle.
Less trafficked areas of the world seemed to benefit from being out of the headlines. The MSCI Emerging Markets Index was higher by 1.4% while the MSCI Frontier Index gained 5.1%. Brazil led the way, returning 12%, while Russia was higher by 9% and is now up over 21% over the past year. After being up over 50% last year, China was higher by 2% in the quarter. China responded to U.S. tariffs by announcing a set of their own that included pork, scrap aluminum, and fruits and vegetables. In Iocal currency terms, the MSCI Emerging Markets Index was up 0.8%, indicating U.S. dollar weakness against the basket of currencies held in the index. The MSCI EAFE Index lost -1.4% in dollar terms and was lower by -4.2% in local currency terms. The President of the European Commission, Jean-Claude Juncker, noted the rising angst with U.S. trade policy:
“We would like a reasonable relationship to the United States, but we cannot simply put our head in the sand.”
Capturing the tone of the discourse, Juncker went on to threaten tariffs on Harley-Davidson, bourbon and Levi’s. It might not have been a coincidence that Harley Davidson is based in Paul Ryan’s home state (Wisconsin), bourbon is made in Mitch McConnell’s home state (Kentucky), and Levi’s is based in San Francisco (the hometown of Nancy Pelosi).
Part of the reason for equity weakness in March was concern surrounding stock market darlings Facebook and Tesla. It came to light that Cambridge Analytica, a politically-oriented data consultant, gained access to the personal information of at least 50 million Facebook users. Tesla had numerous issues to deal with (missing production goals, recalling 123,000 cars), but the most important were a Moody’s debt downgrade and a note suggesting the company will likely need to raise a substantial amount of capital in the near term to offset the significant cash burn. Unless new market leadership emerges, Facebook and Tesla may need to have these issues resolved to reinvigorate the bull market.
In early January, the Atlanta Fed GDPNow “Nowcast” estimated fourth-quarter GDP to be in excess of 4%. As the quarter wore on, that number was lowered as it became difficult to keep up with the lofty expectations set by earlier released data. Over the past three weeks, several regional Fed surveys and the Institute for Supply Management’s Manufacturing PMI have quietly missed expectations. Investors will likely be focused on whether this trend continues, especially if the Fed continues to tighten monetary policy. How the Fed manages to unwind its balance sheet will also be of intense focus. April will see an additional $10 billion ($30 billion total) in securities roll-off their balance sheet per month.
Investors will need to navigate these volatile cross-currents amid a deluge of positive and negative news.
The SpringTide Investment Team
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