The first quarter reflected the continued optimism that began last November with stocks showing solid gains and bonds stabilizing. There has been a surprising lack of volatility in stocks, as can be seen with the VIX index (which measures the volatility of the S&P500) trending at all time low levels. This indicates the positive view on stocks, and therefore the economy, that investors now seem to embrace. The Federal Reserve raised rates in March and signaled more rate hikes to come in 2017. This is yet another confirmation that the economy is healthy and the Fed sees growth ahead. Outside the U.S., developed economies are improving as well. With strong consumer sentiment, robust jobs reports, investor optimism and the Fed’s validation it is easy to see why stocks have performed. The questions we continue to debate internally are how much growth is reflected in current valuations and what could thwart expectations.
With the Federal Reserve’s rate hike in March, they indicated that the economy is strong enough to continue a path to normalized monetary policy. After years of accommodative policy, this change in direction did not spook the markets as the decision was highly-telegraphed. However, this normalization will still likely result in a historically low “neutral” Fed funds rate; some suggesting as low as 3% at the end of the cycle. The structural changes in the economy (high debt levels, baby boomers retiring in droves, etc.) are why rates need to stay low. The additional two to three hikes forecasted for 2017 will be data-dependent according to the Fed. Inflation, employment and consumer sentiment must hold the current course for the Fed to follow through. Keep in mind that even with two rate hikes behind us and more coming, we are still in an accommodative monetary posture. The Fed is still buying bonds in the open market and the Fed Funds rate remains far below long term averages.
Adding uncertainty, we currently see a large disparity between first quarter GDP forecasts from the NY Fed and the Atlanta Fed. The NY Fed “Nowcast” of first quarter 2017 GDP stands at 2.9%, while the Atlanta Fed “GDPNow” is much lower at 1.2%. This is mainly driven by differing views on the strength of consumer spending. So while we are encouraged by the Fed’s view of economic strength, there is obviously a wide difference of opinions amongst forecasters.
Durable goods orders were strong in February, as were core capital goods shipments. Within the industrial production report, manufacturing, mining and ex-auto manufacturing were all strong. While housing data has been mixed, the housing market index (HMI) did surge in March. International economic reports have surprised to the positive, which bodes well for multinational corporations and the export side of the U.S. economy. The Consumer Confidence Board recently reported that the reading for March showed the highest level since December of 2000.
While the data has been generally positive and endorses the Fed’s action there are potential policy changes that could change the data in either direction. First, tax policy: potential re-patriation, more competitive corporate tax rates, border adjustment taxes and simplification of the tax code all will need to be monitored. If policy is implemented, the effect would encourage economic growth while inaction would have the opposite effect. The U.S. is simply not competitive globally on the tax front and both sides of the aisle agree changes need to be made. Second, stimulus in the form of an infrastructure spending plan will carry similar consequences. Finally, a sustainable healthcare policy will need to be developed as 20% of the U.S. GDP is related to this industry. We will eagerly watch as updates unfold on these three fronts. In the coming weeks we will also begin to review first quarter earnings reports which should provide some clarity on the positive data mentioned above is translating into earnings.
The first quarter of 2017 saw the S&P 500 post a positive 6.1% return. After a strong February, the S&P 500 peaked on March 1st and has been trading sideways ever since. The equity markets are currently very optimistic but as mentioned above, further legislative delays or any miscues in upcoming earnings season could lead to a market pullback.
For the first quarter, nine of the eleven economic sectors in the S&P 500 posted positive results. The Technology sector was the best performing sector during Q1 (up 12.6%). Anticipation of the new iPhone due out later this Fall has sent Apple (AAPL) shares to new highs, and has carried many tech companies along with it. Apple’s market cap has now eclipsed the $750B mark. Consumer Discretionary (up 8.5%) and Healthcare (up 8.4%) were the next best performing sectors in Q1. Inaction on the Affordable Care Act and less rhetoric around drug pricing helped buoy the Healthcare sector. Increased consumer confidence has investors betting on an increase in discretionary spending.
The two negative sectors during the quarter were Energy (down 6.7%) and Telecommunications (down 4.0%). After rallying in 2016, the Energy sector has pulled back over inventory concerns. Oil inventories in the U.S. and elsewhere are still near peak levels, even with OPEC scaling back production. The Telecom sector has seen renewed competition with most companies reintroducing unlimited data plans.
According to FactSet Research, the 12-month forward P/E (Price/Earnings) Ratio for the S&P 500 is now 17.6x, which is above the 5-year average (of 15.0x) and the 10-year average (of 13.9x) seen in the below chart. The 20-year average of 17.2x is nearly in-line with current readings. The P/E Ratio is one way we can gauge how expensive stocks are. With low interest rates and valuations approximately in-line with long-term averages, current prices are not yet excessive but we are monitoring this closely.
We also thought it would be helpful to put some perspective on how stocks have historically performed in a rising Fed Funds environment. On the next page is a chart that clearly shows stocks perform better when the Fed is raising interest rates. It appears that stocks are reacting just as they have over time:
Over shorter time periods, macroeconomic forces often drive stock price movements. Over the long run, the performance of a business and its valuation drive the stock price. We continue to focus on long-term business fundamentals and investing in quality companies selling below fair value.
The taxable bond market, as measured by the Barclay’s Aggregate Index, bounced between gains and losses during the quarter, and finished positive 0.8%. The volatility that is notably absent in the stock market is manifesting itself in the bond market. This shift is due to the sentiment in markets changing from “how weak is the economy going to be” to “how strong is the economy going to be,” building confidence in stocks and concerns over bonds.
The ten-year U.S. Treasury began the quarter with a 2.44% yield, rallied to a 2.32% in mid-January, sold off to 2.62% in March, only to rally back to a 2.39% at quarter-end. While in absolute terms this may not seem like much, these moves represent a 2-3% change in price (equal to an entire year of income). As noted previously, after the Fed raised rates in March it issued reassuring commentary for fixed income investors. The main tenets were that the “neutral” Fed Funds rate would be lower than historical averages and any future rate increases will be reliant upon economic data. We suspect the bond market will continue to “bounce around” until we receive more clarity on tax policy and infrastructure spending.
In this environment, we are focusing on the five-year portion of the yield curve where we can achieve yields in the 2.0% to 2.75% range using callable Agencies and bullet Taxable Municipals and Corporates. The chart below shows the change in the yield curve over the last 12 months. The blue line is the current yield curve and the red line is the curve from a year ago. We see the value in the highlighted yellow box (~5 years out) where yields appear to have already reacted to forecasted rate increases.
The tax-free municipal market was slightly stronger than taxable bonds, appreciating by 1.1% for the quarter. This market was the most affected by concerns over tax policy changes and those concerns have moderately abated in 2017. The supply overhang we witnessed towards the end of last year has also diminished. Like taxable bonds, we are focusing on five-year bullets where yields are in the 2.0% range, which is much higher than anything we’ve seen over the last couple of years. We also continue to buy above market coupons, longer maturity issues with an intermediate call date to capture additional yield.
We acknowledge the risk that tax policy can have in this sector. However, we do believe that the risk is priced into the market at these levels. We do not assign a high probability to tax rates being reduced for those individuals in the top bracket to the extent that will make tax free bonds unattractive.
Since the inauguration there has been a lot of “noise” and heated rhetoric as the new administration seeks to enact new policies. Early results (or lack thereof) demonstrate how difficult it is to enact political change, even where there is popular support. Stocks have moved over the last 5 months on the expectation that Washington will execute pro-growth policies. There is risk that stocks could retrace that path if it appears that these policies will not be enacted. It is important to remind ourselves that all is not dependent on Washington; the U.S economy is a multi-faceted system. We fully expect that volatility will likely pick up in the coming months but we will continue to carefully select stocks and bonds that we think will perform well – not necessarily in the next 9 months, but in the next 3 – 5 years.