Sunny Side Up – For Now (2Q17) – Altair’s Latest Market Review
John D. Rockefeller reportedly had a clever answer ready whenever asked what the stock market would do: “It will fluctuate.” But the oil magnate would have been surprised about the market’s oddly calm first seven months of 2017.
Regardless of political affiliation, we all anticipated a flurry of market-moving developments in the first year of Donald Trump’s unconventional presidency – an uncertain mix of the market-friendly and market-unfriendly, as we wrote following last November’s election. Just as massive fiscal stimulus was in the works, so too was the potential for a global trade war. We did not envision blissful market serenity, absent of any meaningful fluctuation, pullback or drama.
The markets were expecting an action film; instead they got Goldilocks, minus the bears. Investors in stocks have found the combination of a not-too-warm economy and a not-too-aggressive Federal Reserve to be “just right.” Strong corporate earnings, improving global growth and the fizzling of ultranationalist threats in Europe have so far trumped the noise coming out of Washington.
To be sure, the political tumult has created many questions about the second-half outlook and raised doubts about the White House’s ambitious pro-growth agenda. But that has not translated to Wall Street, where the stock market has been as unflappable as Alfred E. Neuman (“What, me worry?”). Volatility as measured by the VIX Index hit a 24-year low, U.S. stocks had their best first-half performance since 2013, led by tech and growth stocks, and returns abroad were even better than their domestic peers. Emerging market stocks, aided by a weakening U.S. dollar, have flourished as the year’s top asset class.
Have the markets been complacent or do investors just have well-placed confidence in the economy and the Federal Reserve? A little of both, in our view.
We share some of the skepticism of the bond market, which has priced in a much less sunny outlook than stocks. Economic growth and inflation do not seem poised to sizzle, judging from recent data and the ongoing congressional gridlock.
A primary concern is that the Fed is still pondering another interest-rate hike this fall despite inflation heading in the wrong direction, well below its 2 percent target. Raising rates again so soon and reducing the balance sheet amid lukewarm economic growth could be asking for market disruption.
Yet there is a good chance for fiscal accomplishments in the second half that could rev up the market momentum that has cooled since early March.
With those counterbalancing influences in mind, we plan no immediate allocation changes and recommend that clients stay at their long-term targets. Savor the calm market climate that has dominated 2017 so far; just do not expect it to last for the rest of the year.
More on these thoughts and others as we continue our quarterly discussion of the markets:
1. The fiscal victory that has eluded the Trump administration remains within reasonable reach, and markets have not fully priced it in.
Investors have waited more than six months for the new White House and Congress to deliver a promised stimulus for the economy and American businesses. They need to see follow-through soon or this year’s healthy stock gains could be at risk. But we think the growing pessimism about prospects for pro-growth policies is premature.
Doubt began creeping into the markets and growth projections months ago, big winter gains notwithstanding. After surging 12 percent from the November election to March 1st, the Standard & Poor’s 500 has advanced just 3 percent since. The International Monetary Fund recently lowered its forecast for U.S. economic growth both this year and next to 2.1 percent, saying the Trump plans for tax cuts and infrastructure spending are “still evolving” and cannot be assumed.
This all suggests that there is still room for stocks to move higher if political progress can finally be made this fall.
Strategas Research Partners CEO Jason Trennert sees upside potential – depending on that big “if.” “The Trump trade is underpriced,” Trennert told Barron’s last month. “Expectations are so low that any sense of growing confidence in the White House would be a big positive surprise.”
If Republicans can move beyond health care after getting bogged down for months on that issue, the key fiscal issues could finally move to the forefront.
“Next, Tax Reform and Infrastructure. WIN!” – @realDonaldTrump on Twitter, July 22nd
While the holdup on a health care overhaul could ultimately limit the amount available to fund tax reform, wins remain feasible on both corporate tax cuts and overseas tax repatriation. The White House also is working on its stalled plan to spur $1 trillion in infrastructure investment with both federal funding and private financing, including potentially a repatriation holiday on overseas earnings that would boost companies’ bottom lines by bringing back trillions in profits held abroad.
None of course are guaranteed passage, and they could well carry over into 2018. But those issues are much less contentious than health care, and infrastructure spending has bipartisan support.
Market fallout from Congress’ failure to get a tax deal done could be substantial. We think it is still more likely than not, however, that several of the pro-growth policies, including lower taxes, are passed given that Republicans control the White House, Senate and House.
Another White House pro-growth initiative, financial and energy deregulation, is being carried out without dependence on Congress. President Trump’s Cabinet already is “methodically implementing a far-reaching deregulatory agenda,” as The Wall Street Journal characterizes it. The short-term impact on the economy could be good; the long-term impact is uncertain.
In the meantime, it is important to remember that the economy’s performance historically has had a much greater impact than politics on financial markets – a point that helps explain the markets’ zen amid Washington disorder.
While annual U.S. GDP growth remains mired in the 2 percent range, the economy stands to benefit from a rebound in companies’ profitability following a 1½-year earnings recession. Profits are forecast to accelerate further in the second half, putting 2017 comfortably on pace to be the first full year of earnings growth since 2014. A weakening dollar figures to be a key driver since 40 percent of S&P 500 companies’ revenue comes from overseas.
Beyond earnings, there are soft spots in the economy that merit watching closely. Retail, auto and pending home sales all have lagged, and indexes measuring small business optimism and consumer confidence have fluctuated. U.S. stock valuations are high and the bull market – 100 months old in July – cannot last forever.
All factors considered, however, we are comfortable maintaining target allocations across risk categories. Global growth is expanding, Europe’s recovery is picking up and corporate profit strength can carry the U.S. economy into 2018. Importantly, too, the Leading Economic Index does not suggest a big recession risk in the near to intermediate term, nor do corporate bond and high-yield spreads, which are relatively tight by historical norms.
While the days of low volatility are probably numbered, we do not see enough clouds on the horizon to merit underweighting our target allocations. We would not make defensive moves unless the risk of a recession is uncomfortably high.
2. The Fed is losing ground in its effort to nudge inflation higher and should forgo more rate hikes until it rises.
More than four years have passed since we invoked Sherlock Holmes in this space in discussing what we called the Mystery of the Missing Inflation, playing off a Holmes reference in an IMF report. The enigma was how we had escaped high inflation despite low interest rates and years of aggressive money-printing by central banks.
Time to put Sherlock back on the case.
Today, normal inflation is not only still AWOL globally but has faded off the radar in the United States. After rising briefly above the Fed’s 2 percent target in February for the first time since early 2012, the core PCE price index has sunk to 1.4 percent as of our publication date. By the Fed’s own projection, it is not expected to reach 2 percent again until sometime in 2018.
That creates a conundrum for the U.S. central bank, which is tasked with promoting maximum employment and stable prices. Unemployment is at a 16-year low of 4.3 percent, the equivalent of full employment, which argues for raising rates. But inflation is far below target and falling, a strong reason to hold off pushing interest rates back toward normal levels after nearly a decade of keeping them ultra-low.
Fed Chair Janet Yellen told Congress in July that the economy is in good enough shape to cope with higher rates. However, the Fed will be playing a risky game of chicken with the bond market if it plows ahead with plans to both hike the benchmark federal funds rate for a third time in 2017 and reduce its $4.5 trillion balance sheet this fall.
Signs of bond investors’ wariness abound. The 10-year U.S. Treasury yield languishes around 2.2 percent. The flattening yield curve – meaning short- and long-term interest rates are moving closer to parity – is further evidence of concern about the future pace of growth. Market expectations for future inflation, too, are dropping.
The 10-year inflation breakeven rate, or the yield difference between 10-year Treasury Inflation Protected Securities (TIPS) and regular 10-year Treasury notes, recently fell below 1.7 percent. Declining inflation expectations can strongly influence where inflation ends up, making companies reluctant to pay higher wages and consumers more hesitant to spend.
Why has inflation stayed so low for so long? No economic detective has yet come up with the definitive answer. Various theories suggest that it may result from an aging population that saves more, excess debt that encourages saving over spending or automated technology that keeps a lid on human wages.
This much is no mystery to us: The Fed should wait for higher inflation before tightening further.
Fed officials have shown a willingness in the past to change their plans when it becomes clear that forecasts were too rosy. We count on their open-mindedness again. If they proceed with another rate increase before inflation accelerates back toward the 2 percent mark, we will be prepared to revise recommended portfolio allocations to account for increased risk of market volatility.
3. Emerging markets have demonstrated their growing resilience in a year many expected them to retreat. We continue to maintain a full weighting.
A glance at any chart ranking asset classes by yearly performance will typically turn up “EM” at the very top or bottom. In the last 15 years, we count seven years when emerging market stocks ranked first or second in returns and five when they finished last or next-to-last.
So far this year, they are the top performer again with an 18.8 percent return (as gauged by the iShares MSCI Emerging Markets ETF) at the year’s midway point that already rivals their best full-year return since 2009.
International developed stocks, too, had a strong first half. The defeat of potentially destabilizing populist candidates in France and elsewhere lessened political risk in Europe and spurred a 14.8 percent return for the iShares MSCI EAFE ETF. The U.S. dollar’s 7 percent drop also was a catalyst, accounting for nearly half the gain in dollar-denominated investments. But most impressive for investors abroad was the sharp rise of emerging markets stocks through six straight months of gains.
Forecasters painted a pessimistic outlook coming into the year. President-elect Trump’s tough talk on trade issues with Mexico and China, the dollar’s run to a 14-year high and the Fed’s monetary tightening all threatened to shrink the flow of investor dollars to developing markets. Ultimately, however, strengthening global trade, the dollar’s descent and the absence of punitive trade actions proved more than enough to offset two interest-rate hikes and a decline in oil prices.
Risks will always abound in this asset class. The past decade has seen emerging markets more often at the bottom than the top, with an annualized return of just 1.2 percent. China’s heavy debt remains a concern even though it has not moved markets since the scare of late 2015 and early 2016.
However, we see reasons to remain encouraged about emerging markets. Global growth is picking up momentum, large emerging economies are maturing and the impact of an improving European economy bodes well, since the eurozone is a top trading partner for many of these markets. We want to stay fully invested.
4. Growth stocks’ dominance of value this year bucks last year’s trend; we still believe in allocations to both styles.
Many investors anticipated a continuation in 2017 of last year’s trend when value trounced growth at all market-cap levels by 10 to 20 percentage points. That conservative tilt reflected a year of heightened political uncertainty, culminating in a rush to buy previously out-of-favor financial and industrial companies after Donald Trump’s election.
Instead, this year’s different-colored rally has been powered by growth – specifically technology. The so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Alphabet/Google) have all swelled by at least 26 percent and as much as 52 percent as of this writing.
The surge appears driven by tech firms’ expanding earnings and investors’ voracious risk appetite in an economy growing steadily but slowly enough to keep the Fed at bay. Regardless of the reasons, growth is on pace to outdo last year’s value rout. U.S. growth stocks built the biggest first-half advantage over their peers since 2000 and expanded it to 11 percentage points at both the large- and small-cap levels as of July.
The reversal underscores why we favor including both investing styles in portfolios, since we have seen a back-and-forth rotation throughout the years, with little predictability as to when the turn will come.
Growth outperformed value by an annualized average of 0.7 percent for the 12-year period ended in April, a new study by economists Eugene Fama and Kenneth French found. But over the prior eight decades, dating to 1926, value outperformed growth by an annualized average of 4.8 percent. There was only one other 12-year period in which value trailed growth – from 1988 to March 2000, when the dotcom bubble burst.
It is possible, as some analysts say, that value will do better as the future growth outlook improves. As the saying goes, trends keep going until they don’t.
The tortoise-vs.-hare competition between growth and value is an endless chase with abrupt lead changes and no certain winner. This year, the hare has reawakened after last year’s snooze and sprinted ahead. In a long race, however, we want to continue to bet on both investing styles with our recommended allocations.
Improving global growth and strong corporate earnings continue to offset market risks such as weak inflation, elevated stock valuations, and geopolitical risks in North Korea, China and elsewhere.
Despite the current political gridlock, the Trump administration is still able to score some pro-growth agenda victories through financial and energy sector deregulation, as well as tax cuts similar to those in 2003. These initiatives could continue the momentum in markets.
Market volatility has remained at a historically low level far longer than expected but could rise when Congress returns from its summer break in the fall to take up multiple divisive issues.
We believe the Federal Reserve could be getting ahead of itself if it raises rates again before inflation climbs back to target levels.
The French election improved political stability in Europe. We retain full weighting to both developed and emerging markets but are watching closely their future elections (especially Italy) and the actions of the European Central Bank.
Clients should remain allocated according to their long-term asset allocation targets. However, we recommend raising cash now to meet liquidity needs given the strong first-half performance.
High hopes for growth and improving earnings put investors back in “risk-on” mode in the first half, lifting U.S. stocks to their strongest six-month start since 2013. Momentum that ignited with lofty expectations for President Donald Trump’s pro-growth agenda carried over into the second quarter even as those initiatives remained bogged down in Congress, sustained by healthier corporate profits and a more stable global outlook.
Job market growth and a stable if unspectacular economy contributed to consumer and investor optimism. The iShares S&P 500 ETF, an investable benchmark for large-cap stocks, delivered a 9.2 percent total return through June 30th after a 3.1 percent gain in the second quarter. Technology shares were in the forefront as the FAANG stocks (Facebook, Amazon, Apple, Netflix and Alphabet/Google) reached multiple record highs. The tech-dominated Nasdaq Composite Index soared before pulling back in June, still returning more than 14 percent for the half.
The iShares Russell 2000 ETF, an investable gauge for stocks of the next 2,000 companies after the biggest 1,000 in market cap, lagged its large-cap peer for a second consecutive quarter after its strong post-election rally. The small-caps benchmark was up 4.8 percent at midyear following a 2.5 percent rise in the April-through-June period.
Rebounding from last year, growth reclaimed its bull-market dominance over value as an investing style in the year’s first six months as investors took on more risk. The iShares Russell 1000 Growth ETF outperformed its value counterpart in the quarter, 4.6 percent to 1.3 percent, for a whopping 9.4 percentage-point advantage (13.8-4.4) in the first half. The differential was similar, 9.6 percentage points, among smaller companies as measured by the iShares Russell 2000 Growth and Value ETFs.
The biggest first-half gainer among the 11 S&P 500 sectors was health care, up 16 percent, followed by technology (+14 percent) and consumer discretionary (+11 percent). Energy (-13 percent) and telecoms (-5 percent) were the first-half losers.
Accelerating growth in Europe and developing nations helped fuel a continuing 2017 surge in international stocks that eased only slightly in the second quarter. With emerging market stocks leading the way, it was the best first-half performance for global stocks since 2009.
The iShares MSCI All-Country World ex-US ETF, an investable benchmark for international stocks measured in dollars, advanced 6.1 percent and was up 14.9 percent year-to-date at quarter-end. That gave overseas stocks a collective 5.7 percentage-point edge over their U.S. counterparts in what could be their first calendar-year outperformance in years. Top-performing markets by country as measured by iShares country ETFs were Spain (up 25 percent), India (+24 percent) and Mexico (+23 percent), while Russia’s oil-dependent market fell.
An unexpected drop in the U.S. dollar index against other currencies – 4.7 percent in the second quarter and 6.6 percent in the first half – was a key contributor to foreign stocks’ outperformance. Non-U.S. developed-world stocks as proxied by the iShares MSCI EAFE ETF returned 14.8 percent in dollars in the first half after a 6.4 percent quarterly gain. Measured in local currencies, without the benefit of the dollar’s decline, the returns were 7.9 percent for the first half following a 2.9 percent gain from April through June. Europe’s long-sluggish Stoxx 600 Index rose 5 percent in the first half, boosted by a French election outcome that removed considerable uncertainty for investors with the defeat of an anti-euro outsider.
Emerging markets entered the year weighed down by fears of trade conflict and a rising dollar following President Trump’s election. When neither materialized, those stocks rebounded strongly. The iShares MSCI Emerging Markets ETF, measured in dollars, gained 5.6 percent in the second quarter for a first-half return of 18.8 percent.
The strong returns of higher-risk investments including growth stocks left U.S. REITs and other value-oriented investments behind in the first half as bond proxies lagged. REITs nonetheless generated positive returns as short-term interest rates rose.
The Vanguard REIT Index Fund returned 1.6 percent for the quarter and was up 2.6 percent at midyear. REITs, which historically have been interest rate-sensitive, have benefited from the Fed’s slow pace of rate hikes. Solid fundamentals in the sector also have contributed to a lack of volatility.
Improved economic growth abroad has helped produce more impressive returns in international REITs. The Vanguard Global ex-U.S. Real Estate Fund gained 6.2 percent in the quarter and 13.5 percent for the first six months of the year.
After breaking a five-year losing streak in 2016, commodities registered a second straight losing quarter as sagging oil prices brought down the entire energy-dominated complex. OPEC’s strategy to force prices higher by cutting production to reduce the world supply glut has flopped due in part to ramped-up production from U.S. shale and Libya.
The iPath Bloomberg Commodity Index Total Return ETN, an investable benchmark tracking 22 separate commodities, declined 3.6 percent in the second quarter and returned negative 6.4 percent in the first half. Along with iron ore (-21 percent), both natural gas (-18 percent) and crude oil (-14 percent) sustained double-digit declines. Lumber (16 percent) and aluminum (13 percent) were the best-performing commodity futures in the first half; gold rose 8 percent.
Hedged/opportunistic strategies saw positive returns in the first half. Hedge funds benefited from the strong performance of equity markets, but historically low volatility limited some hedging strategies and kept gains modest. Strategies focused on shorting or betting against stocks continued to struggle, especially those managers that were long value and short growth.
The HFRX Equity Hedge Index, composed of investable hedge funds, was up 3.7 percent at midyear after a 1.0 percent return in the second quarter. That left the category trailing stocks but outperforming bonds, as has been the norm throughout the eight-year bull market. The HFRX Global Index, an investable benchmark that includes international funds, posted a 0.9 percent return in the quarter for a six-month return of 2.6 percent.
Bond prices continued to move higher as yields remained subdued and expectations for a heating-up economy did not yet materialize. The yield on the 10-year U.S. Treasury note edged lower for a second straight quarter, hitting the midyear point at 2.30 percent after entering 2017 at 2.45 percent.
The Vanguard Total Bond Market ETF, a benchmark for higher-quality taxable bonds, added 1.6 percent in the quarter for a first-half return of 2.3 percent.
Altair’s global fixed income investable benchmark – a 60/40 blend of the SPDR Barclays International Treasury Bond ETF and Vanguard Total Bond ETF – advanced 2.9 percent in the quarter for a year-to-date gain of 4.7 percent as of June 30.
Municipal bonds produced modest gains, continuing to defy concerns that surfaced last fall after the election of President Donald Trump. Many observers had expected a pullback this year, anticipating higher inflation and increased government debt and lower tax rates under the Trump administration. But the White House agenda has progressed slowly and inflation remains muted, with bond prices rising as yields declined. Altair’s investable gauge of the U.S. muni market, a blend of the Market Vectors’ short and intermediate ETFs, returned 1.2 percent in the quarter for a total increase of 2.7 percent in the first half.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.