08 Jul More of the Same
Stocks, especially large cap U.S. and emerging market securities, continued to dominate global markets.
Bond returns were muted, but positive, due to lower inflation and decreased Treasury supply.
All eyes are on Washington as it faces an impending debt ceiling debate, uncertainty around the Fed’s balance sheet, and growing unease around the Trump administration’s ambitious economic agenda.
Global risk assets had the wind at their backs for the first half of 2017, especially stocks from emerging markets and from the large cap and growth-oriented segments of the U.S. market. In fact, the NASDAQ 100’s 16.8% return during the first half of 2017 was the tech-heavy index’s best start to a year since 2009. Low interest rates and strong year-over-year earnings growth were the key drivers.
During the quarter, the confounding divergence between survey-based (soft) measures of economic growth, which had surged after the U.S. presidential election, and quantifiable (hard) data, which had remained stubbornly pessimistic, finally subsided, and the two types of measures met somewhere in the middle: soft data declined while hard data improved modestly.
To illustrate this convergence, consider the Atlanta Fed’s GDPNow, which predicts second-quarter growth of 2.7% – a drop from the over 4% growth rate it was predicting just three months ago. Consumer spending also fell slightly: real personal consumption expenditures grew by just 2.7% year-over-year. This comes on the heels of a 16-year high in the Conference Board’s Consumer Confidence Index in March, which declined to a much lower reading of 118.9 by the end of June.
Q2, 2017: Key Market Total Returns
Despite modest economic growth, corporate earnings grew solidly. They were helped by favorable comparisons to this time last year, when a five-quarters’ long earnings recession was coming to a close. According to Standard & Poor’s, S&P 500 operating earnings were up 20% year-over-year in the first quarter. Second-quarter earnings growth is expected to be a similarly impressive 21% year-over-year, but expectations for the full year are now down slightly to $128 per share. The CBOE’s Volatility Index even briefly spiked above 15 on two occasions, but quickly reversed and remained mostly in the low double-digits throughout the quarter.
Inflation trended lower during the quarter after hitting a high of 2.8% in February. The decline was no surprise, though, as the base-effects of low energy prices from last year rolled out of the year-over-year calculation and oil prices turned lower again. Reduced Treasury supply as a result of the debt ceiling limit being reached also helped keep rates contained, driving positive returns in fixed income markets.
Labor markets remained healthy as initial jobless claims moved even lower. The four-week moving average dropped below 240,000. Initial claims have now remained below 300,000 for the longest time since the 1970s. Non-farm payroll additions moderated over the past three months, averaging just 121,000, while the unemployment rate plummeted to 4.3%. The labor force participation rate stabilized at what appears to be a structurally lower level of under 63%.
Gridlock in Washington continues, raising doubts about what can be accomplished by the end of the year. According to a recent poll by Bloomberg, 27% of economists now expect slower growth in 2017 as a result of the new administration’s economic agenda, up from 14% in March. Zero percent of respondents expect higher growth this year, down from 31% in March.
Washington remains in the spotlight on two other key topics: the debt ceiling debate and the Fed’s plan to unwind its balance sheet. In terms of the debt ceiling, the U.S. Treasury expects it will run out of cash by October, which may at least create a mile marker for Washington to get its act together. And, after announcing another interest rate increase in June, the Federal Reserve stated it would start reducing its $4 trillion balance sheet and that it could raise interest rates further this year even as inflation has rolled over.
Growth stocks significantly outperformed their value counterparts, giving them a commanding lead this year. Larger companies materially outperformed their smaller peers in part because of the massive inflows to passive investing products. Per Bloomberg and ICI data, nearly $500 billion flowed from active to passive investment vehicles in the first half of the year. Initial reactions to the Department of Labor fiduciary rule suggest this trend could get worse before it gets better. What’s more, Ameriprise recently decided to cut 1,500 funds from its offerings, based on short-term performance, assets, and costs. Should other brokerage firms follow suit, passive strategies could enjoy even greater inflows, further benefitting large- and mega-cap stocks, which represent the greatest share of popular benchmarks and so receive the majority of passive investment dollars.
In the S&P 500 Index, Energy (-6.6%) was the only sector to experience negative returns for the quarter, primarily due to crude oil’s continued decline. The benchmark WTI crude contract fell 10.5% over the quarter, dropping from the mid-$50s per barrel down to the mid-$40s. This comes at a time when U.S. crude oil production is just 6% off its all-time highs, according to data from the U.S. Energy Information Administration. Year to date, the energy sector is lower by 12.7%. Utilities and Consumer Staples trailed other sectors, returning 1.5% and 2.2%, respectively. Thanks to a late quarter rally, Financials managed a respectable 4.4% gain, even as the yield curve flattened. Health Care and Technology, both growth sectors, were up 7.1% and 3.1%, respectively—although Technology suffered a late quarter dive that sapped 3.5% from what would have been another blockbuster quarter for the sector.
Despite the unpredictable landscape, bonds also produced solid absolute returns, helped by the decline in inflation. U.S. Treasury note issuance was just $73 billion in the quarter, down 14% from last year. Consequently, the Bloomberg BarCap Aggregate Bond Index increased by 1.4%. The 10-year U.S. Treasury note yield declined roughly 13 basis points over the quarter, falling to 2.3%, while the yield curve (as measured by the yield spread between the two-year and 10-year Treasury) flattened 21 basis points, to end at 0.93%.
Foreign assets led global stock markets again this quarter. The 4.8% quarterly drop in the U.S. dollar, its worst since 2010, certainly helped. Emerging markets rallied 6.3%, up by almost 19% through the first half of the year. From a country standpoint, China was the winner, earning a low double-digit return for the quarter and up over 20% for the year. Developed markets, proxied by the MSCI EAFE Index, increased 6.1%. For the year, the benchmark is higher by 13.8%. Europe was higher by a consistent 7.4%, bringing the year-to-date return to an impressive 15.4%. Euro-area inflation declined on a year-over-year basis to 1.3%, but has made significant “progress” since the near-zero levels in 2016. First-quarter GDP for the Eurozone was 1.9%. Japanese stocks approached a two-year high towards the end of June after the market was up 5.2% in the quarter, leaving it up 9.9% so far in 2017. Consumer prices in Japan came in at 0.4% year-over-year and have been stable for several months now.
While the trade-weighted dollar index had a poor quarter, most of the damage was focused on the euro cross rate, where the dollar depreciated 7%. Most of this move happened late in the quarter, on the heels of European Central Bank President Mario Draghi’s speech at the ECB Forum on Central Banking. Investors paid particular attention to this portion of his remarks:
“monetary policy is working to build up reflationary pressures, but this process is being slowed by a combination of external price shocks, more slack in the labour market and a changing relationship between slack and inflation. The past period of low inflation is also perpetuating these dynamics. These effects, however, are on the whole temporary and should not cause inflation to deviate from its trend over the medium term, so long as monetary policy continues to maintain the solid anchoring of inflation expectations.”
Although the market took these comments to be hawkish, “sources” noted they were taken out of context. This is probably true. The ECB is unlikely to take substantial action prior to observing how the initial unwind of securities from the Federal Reserve’s balance sheet (and one of largest monetary policy experiments in history) impacts global markets.
With more of the same being the theme of at least the last three months, we wonder how long the unusual calm that has lulled markets will last. We will continue to watch diligently and look for dislocations or opportunities that may present themselves.
Investors will be watching how corporations respond to lower tax rates in the coming year and how repatriated cash is deployed. The Trump administration has also set expectations it will announce some details on infrastructure spending in late January. Investors will also be acutely tuned in to any details around the magnitude and timing of an infrastructure spending bill. Although the significant Treasury bond issuance set for February and March may not make as many headlines, we believe it also has the potential to similarly move markets.As we look toward the final quarter of 2017, we are especially interested in evolving economic policies, including an increase in U.S. Treasury supply alongside a potential rate hike and the start of quantitative tightening. We are also intrigued by Amazon’s decision to open a second headquarters and by the possible effects for the chosen city and region. In closing, we want to express our concern for the people of Las Vegas, Puerto Rico, Houston, Florida, and everywhere else rocked by trauma in the past several weeks.
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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