The third quarter was (again) characterized by the lowest stock market volatility in decades, coupled with an increasingly volatile bond market. Corporate earnings in the second quarter increased approximately 10% year-over-year, which reinforced the narrative that the economy continues its slow but improving growth trajectory. As expected, The Federal Reserve has laid out a plan to continue tightening monetary policy with both rate increases and balance sheet “normalization.” The net result is a stock market setting all-time highs, a bond market searching for direction, and a continued guessing game regarding many “unknowns” including tax policy and international conflicts.
GDP rose at a 3% annual rate in the second quarter of 2017. With a growth rate of 1.2% in the first quarter, it means the economy set a 2.1% pace for the first half of 2017. Forecasts of Q3 GDP growth, as represented by the Atlanta Fed’s GDPNow model, began near 4% and have since been revised down to 2.7%. The effects of the two economically disruptive hurricanes are likely a contributing factor for lower estimates although activity should bounce back in the fourth quarter.
Retail sales in August fell short of estimates, with downward revisions to the June and July results. Auto sales have been trending lower as well, with year-over-year declines reported for every month in 2017. It is likely that this slowdown reflects some tightening in credit for auto loans and that cars are lasting longer and being driven more miles before replacement. However, it is estimated that between 300,000 and 500,000 vehicles were damaged in the Houston market alone from Hurricane Harvey according to Automobile Magazine . In the coming quarters there will be some “noise” in the numbers as the expectation is that there will be a bump in sales as those vehicles are replaced. In fact, numbers that came out just this week showed a very strong rebound in auto sales . We think this will also be the case for homebuilders and home suppliers as well.
On a positive note, again due to orders for hurricane relief and rebuilding efforts, the Institute for Supply Management (ISM) said its index of national factory activity surged to a reading of 60.8 last month, the highest reading since May 2004. A reading above 50 in the ISM index indicates an expansion in manufacturing. While this is positive economically, manufacturing makes up only about 12 percent of the U.S. economy. Also in August, spending on residential construction projects increased 0.4 percent, rising for a fourth straight month.
Despite the weaker consumer data for August, business sentiment remains elevated. The global economy continues to improve and the dollar has weakened in the first eight months of the year, which should support U.S. exports and manufacturing. Short of any major policy changes or international conflicts, this leads us to a continuation of the slow growth economy we have been writing about for 8 years now. We do believe that an effective simplification of the tax code could be the driver for the next leg of growth in this cycle. While an outline has been distributed by policy writers, we will not opine on the potential economic and market impacts until we see a finalized tax bill.
Despite the impact of two hurricanes and a lack of progress on Healthcare reform, equity markets continue to rally. For the third quarter of 2017, the S&P 500 posted a positive 4.5% return. Year-to-date, the S&P 500 has appreciated 14.2%. The S&P 500 has now risen for eight consecutive quarters.
For the third quarter, ten of the eleven economic sectors in the S&P 500 posted positive results. The Technology sector was the best performing sector during Q3 (up 8.7%). Tech remains the best performing sector year-to-date (up 27.4%). The Energy & Telecommunications sectors both had bounce back quarters in Q3 (both up 6.8%) and were the next best performing sectors. Energy benefitted from oil demand growth, which is expected to be up 1.5% this year, along with ongoing OPEC oil supply curtailments. Telecom stocks rallied on the expectations of T-Mobile and Sprint merging, which could lead to less price competition in the industry. Energy and Telecom however are the worst performing sectors year-to-date (down 6.6% and down 4.7% respectively).
The one negative sector during the quarter was Consumer Staples (down 1.4%). Staples companies have been slowly transitioning their products to align with changing consumer preferences, and have also been impacted by persistent food deflation. The sector however, is positive year-to-date (up 6.6%).
As shown below, the “Trump Trade,” out of favor for most of 2017, experienced a déjà vu moment in September. Sectors that would benefit most from a lower U.S. corporate tax rate, economic growth, and general reflation rallied on hopes of the new tax framework being implemented.
Equity markets in 2017 have seen a dearth of volatility. So far this year, we have seen less than 5% of trading days with a move in the S&P 500 of greater than +/- 1%. This is the lowest level since 1982 when intra-day data began to be recorded. In addition, for the first time in more than ten years, there have been zero +/- 2% days yet this year. That being said, October is historically the most volatile month so stay tuned.
According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is now 17.7x, which is above the 5-year average (of 15.6x). The P/E ratio is one way to gauge the attractiveness of stocks, and we continue to be mindful of valuations, while acknowledging the prolonged strength of the global economy.
The bond market continued its search for direction during the third quarter. The yield on the 10-year U.S. Treasury ended the second quarter at 2.31%, fell to a 2017 low of 2.04% in early September, only to rise again and close the quarter basically where it started at 2.33%. The two contributing factors in this back and forth are the geopolitical risk presented by North Korea and the Fed’s plans (i.e. balance sheet normalization and interest rate hikes).
North Korea sparks a “flight to safety” in capital markets with every rocket launch and it is inherently difficult to factor this variable into investment decisions. Reactions seem to be diminishing over time and the market’s complacency indicates investors do not believe an attack is imminent.
The Fed, however, is a real risk for bond investors as they do have the ability to steepen the yield curve (remember when yields go up, bond prices go down). While target inflation of 2% has not been sustainably achieved, rate hikes and balance sheet normalization are still on track. At quarter-end there was a 70% chance of the Fed Funds rate being increased in December, potentially taking it up to 1.25-1.50%.
With a rate hike probable, the wild card is how quickly the Fed will allow their balance sheet to run off. Since the financial crisis unfolded in 2008, the Fed has accumulated approximately $4.5 Trillion in bonds (primarily Treasuries and Mortgage Backed Securities) in an effort to keep interest rates low. Considering the economy has recovered and employment is strong, the process of reducing the balance sheet begins this month. Below is a picture of what the Fed has communicated to investors about their timeframe to ultimately reduce the balance sheet to $2.0 to 2.5 Trillion. Starting at $10 Billion per month, this process speeds up to $50 Billion per month after the first year, assuming markets remain stable. Our expectation is that this process will steepen the yield curve as the market may require higher rates to absorb the refunding of these holdings. This would be a welcome relief for investors looking for reinvestment opportunities.
The tax-free municipal market performed roughly in-line with the taxable sector, with yields hitting a 2017 low in mid-September only to rise again by the end of the quarter. New bond issuance remains low relative to refunding issues and secondary offerings are still showing strong demand.
In this environment we are taking longer to build fixed income portfolios as we see what effects this historic unwinding of the Fed’s balance sheet has on the yield market. Fortunately, with four rate increases under our belt, the money market and short-term offerings are much more attractive and a good parking spot while we implement our strategy.
The stock market continues a low volatility bull run, while the bond market bounces around in a trading range looking for guidance on monetary policy and the resulting inflation expectations. Our view of risk in this environment largely centers around the Government. Namely, the ability of Congress to pass new health care legislation and tax reform coupled with the Federal Reserve’s plan of raising the overnight rate and reducing their balance sheet. If these risks abate and corporate earnings continue to grow at a 10% pace next year, the above average stock market returns will be justified. In that light, we are continuing to find value in individual companies. Bond allocations will continue to earn coupons and we are reminded of our greatest protection - a maturity date at which point we will (hopefully) have the opportunity to earn higher yields. While we are conservative in our approach, we will continue to invest as opportunities present themselves and adapt as the landscape changes.
We have attached two documents for you to review. The first is a Material Notice & Update regarding a separate mailing(s) you will receive from our office as well as Fidelity and in addition a “billing language update”. We have also included for you a second document titled “Investor Protection Checklist” that was provided to us by Fidelity for your benefit. While we feel we are taking clear and actionable steps in our own firm’s security measures, cyber fraud continues to escalate, is becoming more sophisticated, and is ever changing. These threats take various forms, including email scams (e.g., phishing), where criminals obtain investors’ identity and use that information to commit various forms of wire and other fraud. The attached Investor Protection Checklist describes tactics that we believe you should be aware of to protect yourself from fraud.
Please carefully review this checklist with all members of your household. We also ask that you do the following:
• If you change a current address, notify us so that we can update our records.
• If you suspect that your email account has been compromised, call us immediately.
• If you suspect that your Fidelity account has been compromised, call us immediately. If it’s after business hours, call us and call 1-800-FIDELITY and ask for the Customer Protection Team to inform them of suspicious account activity.
If you have any questions please call us.