1st Quarter 2017: Market & Economy

MARKET & ECONOMY

Markets higher in Q1 as investors eye Washington

There was no shortage of news during the first quarter but markets were unusually quiet. In fact, it was the least volatile quarter for the S&P 500 since 1967, according to Barron’s. Most major benchmarks were up for the quarter. Large-cap stocks led the way in the US with the S&P 500 rising 6.07%. Small-cap stocks lagged some with the Russell 2000 up 2.47% for the quarter, which is probably reasonable considering the big year small caps had in 2016. Bonds were able to hold onto small gains despite a rate increase by the Federal Reserve.

At the start of the year, one of the most talked about and popular trades among Wall Street analysts was to bet that the dollar would continue to strengthen against other currencies. The opposite happened over the first three months of 2017 with the dollar falling 2% relative to other global currencies. While the traders on the losing end of that wager may still be proved right, the weakening dollar propelled foreign stocks to nice gains in the first quarter. Emerging markets had their best quarter in five years as the MSCI Emerging Markets index rose over 11%.

Fed set on returning to “normal”

The Federal Reserve took another step toward more normal monetary policy by raising the Fed Funds rate another quarter of a percent in March. Since December of 2015, the Fed has now raised rates three times for a cumulative increase of three quarters of one percent. The upper limit target for Fed Funds is now 1%. Supporting the Fed’s decision is the rise in inflation we have seen recently, as seen in the chart below showing headline CPI. As of right now, it looks like we likely will see another two or three rate hikes before the end of the year.

Predictably, short-term interest rates have moved higher since December as a result of the Fed’s rate hikes. As the Fed continues to pull back from stimulative monetary policy, short-term borrowers—particularly people with credit card balances—will be the first to feel the effects.

Long-term rates, on the other hand, haven’t budged. From the beginning of December to the end of March, the Fed Funds rate rose 0.50% but 10-year and 30-year treasury yields have actually fallen slightly, by 0.02% and 0.04% respectively. This is troubling to the Fed. An upwardly sloped yield curve (the longer the maturity, the higher the yield) is often a sign of a healthy economy, while an inverted yield curve (where short yields are higher than long yields) often signals recession risk. One option on the table for the Fed to potentially drive longer-maturity yields higher is to start selling some of the nearly $4.5 trillion worth of bonds from its balance sheet. These are the bonds the Fed accumulated during the three Quantitative Easing programs from 2008‑14. Fed governors should offer more details over the coming months.

“This is an historic moment from which there can be no turning back”

The quote above is from British Prime Minister Theresa May shortly after triggering Article 50 which officially begins the process of the UK’s exit from the European Union. The UK, in effect, is about to become a free agent and the two-year countdown has begun. In that time, the UK must negotiate new trade deals with the EU and other nations around the world. Of all the news that came out this quarter, this will likely have the largest effect on the global economy as the UK is the fifth largest economy in the world by GDP, according to the World Bank. In the end, the final trade deals probably won’t harm the global economy but it is hard to imagine the process going smoothly. No country has ever left the EU and remaining EU members are sure to want to set a precedent to discourage other countries from following the UK’s example. Part of the bumpiness in the process will likely be a result of human behavior resulting from uncertainty. Since the Brexit vote, there have already been signs that UK citizens are preparing for turbulence by borrowing less and making fewer larger purchases. The process, however, has only just begun and we will be closely watching what happens.

In the US, all eyes remain on Washington

The market has continued to drift higher but low volatility could continue while investors wait for signed legislation regarding tax reform, trade policy, Obamacare, regulation, and infrastructure spending. As you can tell, the theme so far in 2017 is “wait and see.” While we know significant changes are likely coming, we can’t know the details, the timing or the impact, especially in the short term. The market has never been very good with uncertainty or patience, so there should be bouts of volatility up and down in the months to come.

Long term, however, we see reasons to be optimistic. The underlying fundamentals of the market are improving. According to FactSet, S&P 500 earnings are expected to rise 9.1% in the first quarter compared to first-quarter earnings last year. If they do rise that much, it would be the single largest quarterly gain in the last five years. As you can see by the blue bars in the earnings chart opposite, companies are expecting even larger earnings gains throughout 2017.

Stocks have been trading at high valuations for some time and it is reassuring to finally see signs that fundamentals are beginning to catch up to prices. First quarter returns were positive but we await news from Washington, the Fed, and the UK that will shape expectations for 2018 and beyond. In the interim, we’re rebalancing accounts and remaining true to our disciplined approach for the portfolio.