Domestic stocks shot out of the gate in 2017, led by the S&P 500 gaining 6.1% for the quarter. This was a welcome development given that the first quarter of 2016 was one of the worst in recent history. The rally that began in November has been largely based on expectations that the current administration will be able to implement pro-growth policies such as tax reform, infrastructure spending and regulatory reform. While there have been some recent concerns about the potential timing and effectiveness of proposed legislation, the "the slump" which took place in March was relatively mild. Volatility as measured by the CBOE Index during the first quarter was the second lowest average quarter on record. Further, average daily percentage change for stocks during the first quarter was the lowest since 1965.
March 2017 marked the 8th anniversary of the current bull market, the second longest since 1928. As we look ahead, we are encouraged that U.S. business and consumer confidence surveys have been showing significant improvement. Additionally, consensus estimates are projecting 10% growth in S&P 500 earnings for 2017 while Blue Chip Economic Indicator survey respondents project 2.3% real GDP growth for 2017 (compared to the 1.6% seen in 2016). In the chart below we can see that since 1990, small business sales growth expectations have closely overlapped GDP growth.
Internationally, we have seen an uptick in confidence and a turnaround in equity performance. Improving global economic momentum has boosted expectations for better trade prospects in the emerging markets (i.e. Brazil, Russia, India, China). Emerging market equities returned 11.4% for the quarter. In the developed markets, outside the U.S., concerns about political risks have been outweighed by encouraging economic data globally. Non-U.S. developed market equities returned 7.4% for the quarter.
Valuation-wise, international equities are much cheaper than domestic equities - a direct result of many years of underperformance. Reversion to the mean is powerful and international equity is an important diversifier within a portfolio. We remain positive on stocks (both international and domestic) amid improving fundamentals and economic momentum, especially as rising rates curb global bond returns.
Fixed Income Update
The Bloomberg - Barclays US Aggregate posted a gain of 0.82% in Q1 and the Intermediate Aggregate index gained 0.68%. Gains for the quarter came predominately from lower quality and longer maturity bonds. BBB bonds posted a gain of 1.71% vs. 0.60% for AAA bonds. The excess return of the lower grade bonds resulted from a decline in default risk from perceptions of a strengthening economy. Short bonds maturing in 1-3 years posted a 0.41% gain whereas the 10+ year maturity range posted a 1.43% gain, as the yield curve flattened somewhat.
After years of expecting rates to rise as shown in the graphic above, the Fed raised interest rates in back-to-back sessions for the first time since before the financial crisis. The delay was a result of the economic recovery being slower than expected. The uptick in the pace of rate increases is a positive, signaling continued strength in the economy. One last point from the chart, is that although there is a decrease in the rate of change expectation as compared to 2014 and 2015, we may finally be on a rate increase trajectory.
Another issue of importance is how the Fed handles its balance sheet. During and after the financial crises, the Fed not only bought significant amounts of short-term bonds, bringing short rates down, they also bought large volumes of longer treasuries and mortgage-back securities, thus reducing long rates. If maturing bonds are not replaced with new bonds, the decreasing amount of assets on the Fed's balance sheet will also tend to increase rates. This process is called runoff and could take five years or more, unless the Fed actively sells bonds before maturity. These discussions by the Fed are a sign of its view of an improved economy and should be regarded favorably.
Please contact us with any questions.
Mark Evans, CFA
Julie Brotje Higgins, Ph.D., CFA
Richard Sasala, Ph.D., CFA
Matthew D. Sheets, MBA