A Global Awakening (3Q17)
Hurricanes, floods, wildfires, North Korean missiles, Washington turbulence, interest rate hikes – no act of nature or mankind has been capable of slowing the markets’ steady rise so far in 2017.
History and common sense tell us that “the bull market in everything,” as The Economist semi-hyperbolically dubbed it this month, cannot last. A significant portion of recent returns in the market is driven by optimism for growth both here, because of the Trump administration’s economic agenda, and abroad that has yet to happen.
Certain developments give us great pause – high stock valuations and a tightening Fed among them. Yet the improving global economy and solid corporate earnings provide a compelling counterweight and help explain why our caution flag is yellow, not red. While watching for any change in this delicate balance, we are maintaining our recommended allocation levels at long-term target levels (neither overweight nor underweight) for clients’ higher-, medium- and lower-risk assets.
Filmmaker Ken Burns, whose 10-part television documentary on the Vietnam War provided riveting viewing this fall, said the following recently about historical ambiguity: “Sometimes a thing and the opposite of a thing are true at the same time.” Burns’ quote strikes us as apt to also characterize a stock market that is expensive by most measures on the surface yet remains promising given the continuing strong potential of the underlying company and economic data.
The threat of a pullback certainly is elevated after a long period of low volatility such as this one. The Standard & Poor’s 500 Index has not declined by as much as 3 percent since last November, before the election – the second-longest streak ever. Through nearly 10 months, 2017 is on track to be a record-breaking year in terms of calm. But a pullback and the end of the bull market are not necessarily the same.
As Federal Reserve chair Janet Yellen said in 2015, it is a myth that expansions die of old age. They typically end when the economy slips back into recession, as recent research by the San Francisco Fed into expansions of the past 70 years documented.
The encouraging news for investors is that economic indicators are mostly positive and a recession, while always possible, does not appear likely in the near term.
While the markets’ hopes that the Trump administration and Congress will deliver significant pro-growth legislation in the near future may be unrealistic, we think the increasingly upbeat investment climate overseas coupled with still-stable U.S. earnings growth bode positively for markets. Still, we remain guarded about the markets’ mostly uninterrupted run higher this year.
Our quarterly discussion continues as we delve further into five current topics that shape our thinking about the markets:
1. The global economic outlook is better than it has been in years, which partially offsets concerns about high valuations.
What lies ahead I have no way of knowing, but under my feet, baby, grass is growing. –Tom Petty (1950-2017)
The United States, even with its plodding growth, has helped keep the world economy stable since the global recession of 2009 as many developed countries struggled to break free of slumps. Now, at last, a broad global expansion is under way that can spread the burden.
As economic global warming goes, this recovery remains many degrees short of sizzling. Evidence consists nearly as much of upbeat forecasts as it does of recent increases in GDP. Nevertheless, the composite picture is that of a world economy enjoying its best growth spurt since the beginning of the decade and improving underlying conditions suggest it is sustainable.
Among the progress markers that we find encouraging:
- Most of the world’s economies are experiencing higher growth. Among the 10 largest, the International Monetary Fund says only the United Kingdom is expected to see growth slow in both 2017 and 2018, due to fallout from Brexit. India and China boast the most growth.
- 2017 is on track to be the strongest year for global growth since 2014, with the outlook still gaining momentum. The IMF in October raised its growth forecast to 3.6 percent for this year and 3.7 percent for next year, up from 3.2 percent in 2016.
- European economies are finally beginning to flourish, thanks to rising business and household spending and an improved political climate that has boosted the confidence of companies and investors. Real GDP growth in the eurozone rose above a 2 percent annual pace in the second quarter for the first time since 2011.
- Corporate earnings growth for 2017 is forecast to top 10 percent in all major regions for the first time since 2005, excluding the bounce after the 2008-09 global financial crisis. As economic outlooks have brightened, analysts’ estimates for the emerging markets and Japan have risen sharply since earlier in the year while forecasts for the U.S. and Europe have held steady.
To be sure, the recovery remains incomplete. Inflation, already below the 2 percent target of most advanced countries, has softened further; wage growth remains weak around the globe; and far-right populism in Europe remains alive with the foothold that extremist parties gained in German and Austrian parliaments this fall. But, in the IMF’s words, the global acceleration is “notable because it is broad-based.”
Economic improvement overseas comes at a welcome time amid questions at home about historically lofty valuations. With U.S. growth still stuck in the 2 percent range (the IMF projects 2.2 percent in 2017 and 2.3 percent in 2018) and most data positive but unspectacular, we are among those who would prefer stronger justification for this year’s virtually uninterrupted rise in stock prices.
Global acceleration has a direct payoff for U.S. companies. S&P 500 corporations got 43 percent of their earnings from abroad in 2016 and are expected to get more this year. The worldwide pickup has led to an acceleration in sales, helped by the dollar’s decline against other currencies, bolstering bottom lines. U.S. firms, riding momentum from the past year after ending a 1½-year earnings recession, should benefit further as the world economy strengthens.
Further evidence of this synchronized global improvement can be seen in international returns, which continue to outpace the U.S. this year for the first time since 2012. Most stock markets around the world are performing even more strongly than the S&P 500.
About those high U.S. valuations: The Standard & Poor’s 500 Index’s trailing 12-month price-earnings ratio, currently around 22, remains far below peak level from the dot-com crash of 2000 and does not by itself spell the imminent end of this bull market. However, while roughly in line with the average PE this century, it is well above the long-term average of about 17 since 1970.
Overall, the sustained global expansion rooted in solid company earnings and stable growth gives us more confidence in the outlook for stocks and helps assuage concerns about the aging bull.
2. Changes in the Fed’s makeup and strategy, including the balance sheet unwind, are a risk to markets.
Caution has been the Federal Reserve’s byword during the nearly four years of Janet Yellen’s tenure. However, a decision point is nearing on whether to alter this approach and we are closely watching the outcome and its potential consequences.
Going slowly on tightening has helped keep the bull market in stocks alive and well and the bond market positive through four interest-rate hikes. The S&P 500 has returned more than 13 percent annually since the Fed made the last asset purchase associated with its quantitative easing program on October 29th, 2014; the Vanguard Total Bond Market ETF has averaged 2.5 percent per year during the same period.
Now two moving parts need to align to keep markets from becoming overly rattled by Fed changes.
First, the Fed must keep to the self-prescribed schedule it began implementing in October to reduce its $4.5 trillion balance sheet through a series of baby steps, at least initially.
By not reinvesting some of the proceeds of maturing bonds, the central bank has started to reverse years of easy-money policies that helped ensure a heavy flow of cash into financial markets. Given the giant boost that asset purchases gave to stocks and bonds, it is only logical that shrinking the balance sheet could be detrimental for both. But a cautious pace can help minimize the risk.
Markets have not flinched since the Fed announced its plan, which initially calls for reductions of $10 billion a month before peaking at $50 billion a month next October. Their collective shrug is largely because those amounts, while not insubstantial, pale in comparison to the $85 billion a month of asset purchases at the peak of quantitative easing.
At this pace, as Bank Credit Analyst notes, the unwind should not affect liquidity or the amount of money in circulation. A faster pace of normalization or a change in economic conditions could easily alter that, however.
Second, and perhaps more important, the Fed is just beginning a makeover that goes far beyond the next chairman, whom President Trump is expected to nominate his choice for within days. Three of seven seats on its board of governors sit vacant, even after private-equity executive Randal Quarles was added on October 13th. Another will turn over if Yellen departs.
Since the governing board comprises a majority of the 12 voting members of the Federal Open Market Committee, the body that actually sets interest rates and oversees inflation and employment policies, the Fed’s decision-making core will be reshaped over a period of just a few months. That creates a lot more of what markets abhor: uncertainty.
It is important to remember that the Fed sometimes inadvertently causes recessions through policy decisions that may only identified as mistakes in hindsight. It is this risk that keeps us hyper-focused on Fed statements and actions, which we consider more useful for asset allocation decisions than high P/E ratios.
We are prepared to recommend a more conservative positioning for clients’ portfolios if we see a change we do not like. A more aggressive Fed would heighten the risk for stocks in particular in the short term. So far, however, the circumspect pace of both the rate increases and the balance-sheet reduction represent appropriately prudent monetary tightening.
3. A tax overhaul is likely to be a boon for financial markets, but political hurdles could push its approval back or block it entirely.
Chances of tax reform being enacted in the coming months have risen in recent days, offering the prospect of gains ahead for investors as well as taxpayers. It remains too soon to forecast the specific consequences. But we want to at least discuss briefly the big picture for an issue we expect to strongly influence how markets perform over the next year.
Two developments have given the reform drive new momentum and possibly advanced the timeline: the Senate’s budget resolution enabling a tax bill to pass with a simple majority and the increasing political need for President Trump and congressional Republicans to score a major legislative victory ahead of 2018 elections.
Importantly, as Strategas Research Partners notes, the 51-vote majority needed for passage in the Senate allows Congress to move a significant tax cut even if the larger reform fails. This increases the probability of some form of tax legislation passing in the first quarter of 2018 even if Republican leaders’ goal of passage by Christmas proves unrealistic.
With specific proposals still emerging as we publish, we are focused most closely on the corporate tax reduction as the change with the biggest chance to boost markets. RBC Capital Markets’ economists estimate that a reduction in the marginal corporate tax rate to 20 percent could be worth 200 points to the S&P 500 by adding $10.50 to companies’ per-share earnings. It is likely, however, that investors have already partly incorporated this expectation into stock prices.
Another potential game-changer for markets is the proposed repatriation tax holiday that could bring back hundreds of billions of dollars in capital that U.S. companies have stashed overseas. Whether that will goose economic and wage growth remains a matter of debate – it depends on the extent to which companies use the repatriated money to create jobs, invest in their businesses, buy back shares or pay off debt. But it clearly could draw more money into U.S. stocks.
Investing based on political prognostication is a game we prefer not to play, however, especially with such a wide range of outcomes possible – from full-fledged tax reform to tax cuts only to no bill at all. As Treasury Secretary Steven Mnuchin has warned, U.S. stocks will shed a “significant amount” of recent gains if Congress deadlocks on tax reform.
We think some form of tax legislation is likely, but with all the potential political and other obstacles we are not counting on anything being enacted in the next six months.
4. While other pro-growth initiatives remain stalled, the Trump administration is proceeding as planned with deregulation.
Noisy inaction on plans for health-care reform, a tax overhaul and infrastructure spending has dominated the media spotlight and political conversation in Washington this year. Without having to grapple with Congress on regulatory issues, however, the new administration is making headway on one top priority behind the scenes.
We view this as noteworthy because, while regulation and deregulation have unintended consequences for markets and beyond, in the short term most deregulation is generally considered to be favorable for most investors. It is a key factor behind the continuing high levels of optimism reflected in surveys of businesses and entrepreneurs.
One visible measure of the anti-regulation drive is the sharp drop in the number of regulations and public notices published in the Federal Register. The government publication is on a pace to add about 61,000 pages in 2017, down 37 percent from nearly 97,000 last year. If it holds, that would mark the largest decline in U.S. regulatory activity since the Register was established in 1936, according to Bianco Research.
Other evidence stems from the “two-for-one” executive order that President Trump issued during his first week in office, mandating that government agencies offset each new regulation with two deregulatory actions. Agencies had proposed or finalized 25 deregulatory measures by the beginning of October.
The administration contends that reversals and delays of existing rules have eliminated an estimated $300 million in annual costs. That is difficult to verify, as is any direct link to GDP growth. But examples of business-friendly deregulation are plentiful, including the rollback or blocking of restrictions on financial institutions, oil and gas fracking, power plant emissions and federal drug approvals.
It is unclear how far the deregulatory push will progress beyond the blocking of new regulations and looser enforcement of existing ones, and to what extent it might lift economic growth. The repeal of older regulations reportedly is proving more difficult.
For the time being at least, however, the progress on deregulation has helped buoy the confidence of the business community and Wall Street and likely serves as another tailwind for investors.
5. North Korea remains an unquantifiable threat to markets. History from past crises suggests initial market setbacks can be painful but generally are overcome relatively quickly.
Markets do not price in the risk of “black swans” because by definition those events are unprecedented and unpredictable. But should they, or we, factor in the possibility of conflict erupting from very visible threats such as this year’s buildup of tensions over North Korea’s ramped-up militarization? That is a valid question with no facile answer.
Thus far, we are comfortable with the markets’ minimalist reaction to the threat. It is nearly impossible to handicap geopolitical events, and this situation has yet to escalate beyond aggressive rhetoric between Pyongyang and Washington. But this is an evolving situation and we are always watchful for any need to alter positioning based on global developments.
A war on the Korean Peninsula, if it came to that, would unquestionably have horrific consequences and inflict serious damage to the global economy. Markets, for better or worse, are currently pegging the probability of that outcome as negligible.
There are no data to crunch to reliably gauge the risk or consequences of a military conflict. But U.S. stocks’ past reaction to conflicts may provide some context for investors. In a wide majority of military conflicts dating to World War II – including 11 of the 13 examples in the adjacent chart – the S&P 500 recovered its initial losses within six months.
We do not take this risk lightly. But based on the experience of recent decades, markets tend to experience only very short-term impacts from geopolitical crises. Historically, economic growth and corporate profits have had far greater influence.
In closing, we can only hope that the outcome in North Korea echoes another of Tom Petty’s lyrics: “Most things I worry about never happen anyway.”
Momentum in the world economy provides ample reason to maintain current risk levels. We advise remaining allocated to your long-term asset allocation targets.
At the same time, increases in consumer and business optimism and other “soft” data have yet to translate to commensurate economic progress beyond what market prices already anticipate. We are monitoring this divergence closely.
Thus, the market remains vulnerable to a pullback after a year of almost unprecedented calm. But major drawdowns historically are associated with recessions, and leading economic indicators suggest the odds of a near-term recession are low.
We are skeptical that Congress will approve a tax overhaul any time soon. The final results could boost economic growth and risk assets, but passage is still uncertain.
The makeover of the Federal Reserve’s leadership leaves its course uncertain in 2018 for both the pace of interest-rate hikes and the speed of the balance-sheet unwind. A more aggressive approach to tightening would likely support a more defensive portfolio positioning.
Bonds should continue to play an important diversification role in this slow-growth environment. We have yet to see signs of the accelerated growth or inflation that would cause yields to rise significantly.
U.S. large-cap stocks joined in an across-the-board increase for all asset classes in the third quarter, trailing international stocks again but surpassing their historical full-year average with three months to go.
The iShares S&P 500 ETF, which represents more than three-quarters of U.S. stock-market capitalization, climbed 4.4 percent for a 14.0 percent total return through September. The index has now risen in eight consecutive quarters.
Spurring the latest upsurge were stronger-than-expected corporate earnings, continued improvement in the labor market, growing hopes for tax reform legislation in Washington and another quiet quarter volatility-wise. Markets remained mostly unrattled by high stock valuations and the threat of military confrontation between North Korea and the United States.
Small caps surged in September after languishing for much of the year, energized by the long-awaited emergence of President Trump’s tax reform plan that is expected to benefit domestic companies disproportionately. The iShares Russell 2000 ETF, which was lower in July and August, rebounded to add 5.9 percent for the quarter and had a year-to-date return of 10.9 percent.
Growth continued to be the investing style of choice. The iShares Russell 1000 Growth ETF outperformed the corresponding value ETF by 5.8 percent to 3.0 percent in the quarter to extend its 2017 lead over its counterpart to nearly 13 percentage points. Growth also prevailed in mid-cap and small-cap stocks.
Technology continued to be the top-performing S&P 500 sector, up 23.8 percent year-to-date after an 8.4 percent advance in the quarter. Three of the five FAANG stocks – Facebook, Apple and Netflix – were up over 30 percent for the year while Amazon and Google parent Alphabet had returned 21 percent and 18 percent, respectively. Energy surged 10.1 percent in September on the back of crude oil’s price rise to finish with a 6.9 percent quarterly increase. Along with telecom, which shed 4.8 percent, it remained one of only two sectors to have lost ground in 2017, however.
Stocks in the developed world and especially emerging markets marched ever higher in the third quarter, boosted by economic optimism, a relatively benign investing environment and improving outlooks for Europe, Asia and developing countries. Another decline in the dollar of nearly 3 percent also provided a lift to dollar-based investments.
Coming off their best first-half performance in eight years, foreign stocks kept rising at close to the same pace. The iShares MSCI All-Country World ex-US ETF, a gauge of international stocks denominated in dollars, added 6.1 percent for a 21.8 percent return through nine months.
Non-U.S. developed-world stocks as proxied by the iShares MSCI EAFE ETF returned 5.0 percent for the three months, extending their year-to-date return to 20.6 percent. Gains would have been significantly less without the benefit of the weaker dollar; measured in local currencies, the returns were 3.4 percent and 11.6 percent respectively.
The iShares MSCI Emerging Markets ETF, measured in dollars, continued its banner year with an 8.3 percent return that left it up 28.6 percent for 2017. The BRIC countries accounted for some of the top performers for the quarter and/or year-to-date as measured by iShares country ETFs: Brazil surged 22 percent for the three months and was up 24.7 percent in 2017, Russia jumped 16.8 percent (up 5.5 percent for the year), India was up 25.4 percent through nine months after a 2.9 percent quarterly return and China’s 2017 return was at 24.8 percent following a 9.8 percent quarter.
Big winners abroad so far in 2017 also have included markets in Italy (up 31.2 percent as measured in dollars), Spain (28.3 percent), Hong Kong (27.3 percent), Germany (24.2 percent) and Japan, whose 14.0 percent return through September matched that of the U.S. market.
U.S. real estate investment trusts recorded a third straight positive quarter in 2017 despite pulling back after the Fed signaled it was on track for a December rate hike.
REITs rose more than 5 percent between early July and early September, benefiting from the benign economic outlook and a decline in the 10-year Treasury yield. They came under pressure late in the quarter from the Toys R Us bankruptcy and the Fed’s indication at its September meeting that it may soon raise rates. Real estate values tend to be sensitive to interest rates.
The Vanguard REIT Index Fund finished the quarter with a 0.9 percent uptick for a 3.5 percent return through nine months.
International REITs continued to flourish as the outlook for global growth accelerated. The Vanguard Global ex-U.S. Real Estate Fund logged a 5.8 percent increase to push its year-to-date return to 20.0 percent. International REITs are less sensitive to U.S. interest rates while still paying healthy dividend yields.
Commodities posted their first winning quarter of 2017, a bounce-back that kept alive the possibility of a second consecutive positive year. Energy and metals both saw strong gains against the backdrop of an improving global economy. Oil prices rose sharply on strong demand for crude and signs the U.S. shale boom is slowing, which would ease the global supply glut.
The iPath Bloomberg Commodity Index Total Return ETN, an investable benchmark that tracks 22 commodities, rose 2.6 percent in the quarter while remaining down 4.0 percent for the year. Steep drops in some agricultural and livestock prices – wheat down 14 percent due to drought concerns in the Northern Plains, hogs down 11 percent due to oversupply – lessened the boost from oil (+11 percent) and industrial metals (+10 percent).
Hedge funds as a group reached the three-quarters mark of 2017 on pace for one of their best-performing years since the 2008-09 financial crisis. Stock-focused hedge funds have fared best, winning big from bets on high-flying tech stocks.
The HFRX Equity Hedge Index, rose 3.2 percent and was up 7.1 percent for the year. That represents significant improvement in an asset class that has disappointed investors during much of the eight-year bull market. An improved environment for stock-picking, outperformance of popular stocks like Amazon and successful bets against retailers all are credited with helping in the resurgence after a flat year for the industry in 2016. The unexpected decline in the U.S. dollar has hurt some strategies.
The HFRX Global Index, a measure which also includes international funds, increased 1.8 percent for a return of 4.4 percent through nine months.
Bonds added modest gains, continuing a year of stability and upward movement despite the Federal Reserve’s ongoing rate hike cycle. Prices rose in July and August as the yield on the 10-year Treasury note fell at a time of escalating tensions over North Korea and hurricanes pounding Texas and Florida. September marked a reversal of that trend as renewed optimism on tax reform, an easing of geopolitical tension and a more hawkish-sounding Fed pushed yields higher. The yield on the 10-year U.S. Treasury note bottomed at 2.04 percent on September 7th before climbing back to 2.33 percent – still below the year’s starting point of 2.45 percent.
The Vanguard Total Bond Market ETF, a gauge of higher-quality taxable bonds, gained 0.8 percent and was up 3.1 percent through three quarters of 2017.
The strengthening global economic outlook boosted overseas bonds even more. Altair’s global fixed income investable benchmark – a 60/40 blend of the SPDR Barclay’s International Treasury Bond ETF and Vanguard Total Bond ETF – returned 1.4 percent in the quarter to boost its 2017 return to 6.2 percent through September 30th.
Muni bonds followed a similar path to that of their taxable counterparts, continuing to deliver solid returns with little volatility. Concerns that interest rates would rise sharply under the new administration’s pro-growth agenda have abated. Another factor driving prices higher is the issuance of much less debt by cities and states this year. Altair’s proxy for the muni market, a blend of the Market Vectors’ short and intermediate ETFs, returned 0.8 percent in the third quarter for a year-to-date return of 3.6 percent.
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.