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2017 Q2 Recap & Investment Outlook
2nd Quarter Synopsis
The second quarter saw a continuation of economic growth around the world and stocks were largely positive for the quarter. Most of the returns came early on in the quarter with the S&P 500 (large cap stocks) finishing +3.09%, the Russell 2000 (small cap stocks) finishing +2.46% and the MSCI EAFA (international stocks) leading the way at +6.12% .
While domestic stocks rose on the hopes of Trump’s pro-growth policies gaining traction and improving economic conditions, international stocks were able to outpace their domestic counterparts on the quarter and year. They benefitted from both improved economic activity and a fall in the dollar which has declined approximately 5% since setting a recent high in December of 2016. Not all sectors were positive and the energy sector in particular was especially hard hit (-7.61%) during the quarter as a supply glut remained and concerns about Russia raising output and OPEC’s compliance to their previous cuts.
Earlier in the year, equities were buoyed by the prospect of Trump’s pro-growth policies. While that theme faded slightly during the second quarter, the main driver of improving stock prices was widespread global growth in both GDP and earnings and decreasing global political risks.Please see the following chart from Charles Schwab below that details the IMF growth assumptions for the top twenty economies:
The big news on the quarter was the Fed raising rates another .25% and signaling a beginning to sales of the bonds they hold on their balance sheet. Both moves are considered tightening and although the actions were designed to raise rates and cool inflation pressures, the bond markets saw the moves in a different light. The ten year treasury rate had previously soared from 1.9% after the Trump election peaking at 2.6% in anticipation of tax reform and fiscal stimulus. However, the bond market rallied and rates fell to 2.12% as institutional investors believed that the June Fed actions raised the likelihood of a recession.
Just as rates seemed to be trending lower, they spiked in the last few days of the quarter as global central banks took hawkish stances. The volatility of interest rates thus far in 2017 is illustrated on the following chart:
Even still, we see the Fed’s moves as more of an attempt to return some of their policy tools to their toolbox in case the need to spur a stalling economy arises rather than an attempt to tap the brakes on an economy about to experience inflation.
The S&P 500 and the Russell 2000 are trading at rich valuations. For instance, the S&P 500 is trading at 18.5x forward earnings compared to a historical valuation of 16.5x forward earnings. Underlying economic indicators are good but not great, growth expectations are modest and there is no overarching secular theme at this time. Accordingly, our research suggests that stocks are expensive due to a pricing in of Trump’s proposed policies which is demonstrated by the 50 companies in the S&P 500 that paid the highest tax rates outperforming the broad index since Trump was elected. We see the following possibilities for domestic stocks over the next 12-24 months:
Upside Possibilities: Pro-growth Trump policies of Fiscal Stimulus or Tax Reform are enacted. Stocks rise.
Status Quo Possibilities: Market trades in the current range as earnings growth slowly brings multiples closer to historical norms. Stocks stay flat to slightly down.
Downside Possibilities: No action on Trump’s proposals. Fed action leads to recession. Geo-political risk increases. Natural disaster or other catastrophe affects the economy.
International equities came into the year at more attractive valuations than US companies but with more economic and political risk than domestic stocks. Many of the populism/protectionism fears began to lift over the first half of 2017 as evidenced by the recent French election and UK snap vote. Add in improved economic activity and a weaker dollar and now we’re seeing strong performance from international equities for the first time in years. Now, leading economic indicators remain strong, sentiment is above average and unemployment is improving. All of these factors keep us recommending an out-sized allocation to international stocks. Even still, some political risks remain;
We continue to see core bonds as a bad investment due to the risk reward profile. Core bonds such as Treasuries, Agencies and High Quality Corporates do not have enough yield to insulate them from interest rate rises. Additionally, we still see high yield credit as offering limited value as spreads over Treasuries remain low and lending covenants have weakened. Given these risks, we have positioned our target portfolios mainly in short term bonds until we see the 10 Year Treasury Rate climb closer to 2.75-3%. The recent portfolio addition of the AB Income Fund was designed to add yield (approximately 5%) with a strategy that can weather both rate and credit cycles.
We’re not expecting fireworks in the bond markets, but we could see any of the following scenarios play out and have positioned our fixed income allocations in anticipation of these market moving possibilities:
- Trumps policies are enacted leading to higher inflation expectations and higher bond yields.
- Unemployment continues downward leading to wage growth and inflation. Bond yields move higher.
- Fed continues to tighten which increases recession fears moving bond yields lower.
We are also watching the labor markets as they are going to be the harbingers of successful Fed policy. The Fed focuses on two factors: unemployment and inflation. They use their policy tools in an attempt to steer unemployment near its natural low while keeping inflation around 2%. The necessary actions are fairly obvious when unemployment is high (lower rates and ease monetary policy to encourage growth and hiring) or when inflation is high (raise rates and tighten monetary policy to raise unemployment to remove inflationary pressures from wage growth). Things get tricky when the economy has grown to the point where we are nearing the natural rate of unemployment. If unemployment continues to drop, inflation generally follows because employers now need to offer higher compensation for workers (wage growth). As the labor force has more wealth, prices rise and we have inflation from the wage growth.
Why does this matter now? As indicated by raising rates and signaling the reversal of their bond buying program, the Federal Reserve believes that the economy is approaching the natural rate of unemployment and is tapping the brakes. Thus far, the capital and labor markets have absorbed the policy shift with little fanfare. However, the effects of a policy shift oftentimes are not observable for several quarters. If the Fed put too much pressure on the economy we’ll see unemployment rates rise into what could become a recession.
The second quarter saw a strong sell-off in the oil markets. There has been some price recovery in early July, but a supply glut remains. While OPEC appears to be in strong compliance with cuts which historically takes 2-3 quarters to make an impact on inventories, Russia appears to be upping production. Additionally, US Shale production has put a cap on prices as they’ve lowered their costs and boosted output on technological jumps. However, a limited labor supply could raise costs in the near term.
Couple the supply increases with a modest increase in demand and we see the price drops we saw during the second quarter. We understand that this is a volatile asset class and do not see reason to sell out at this point. We will be watching inflation, oil inventories and aggregate demand close over the next quarter to see if we see additional signs of weakness. On the flip side, geo-political turmoil in the Middle East or Russia could push oil prices higher.
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Past performance is not necessarily indicative of future returns. The performance described in this report is based on investment selections for the period in question. There is no guarantee that these same investments will continue to perform as described. All investing carries a risk of loss, including principal, that clients should be prepared to bear. Registration as an investment adviser does not imply any certain level of skill or training. For a more complete discussion of Ferris Capital, please review our Form ADV, available at www.sec.gov.