Investment Commentary - Second Quarter 2017

Written by Don Wilson, CFA, CFP® on July 7, 2017

• Global economic growth picked up
• Broadly positive environment for global stocks
• Bond prices rose even as the Fed raised rates
• The Fed plans to begin reducing its balance sheet

At the midway point of 2017 investors can be encouraged by market gains thus far. All but four of thirty major global stock indexes have risen this year, boosted by a pickup in global growth and earnings.  Despite the Federal Reserve raising the short-term Fed Funds rate twice this year, longer-term interest rates have declined and bond prices have risen.  Volatility, often considered a measure of investors’ level of concern, has reached its lowest level in a decade (see chart below), indicating a very low level of concern amongst investors.  However, in the ninth year of a bull market, with stretched valuations, and central banks beginning to tighten monetary policy, investors should remain vigilant and avoid complacency.

Source: Federal Reserve Economic Data, Semiannual CBOE Volatility Index (VIX)

U.S. Stocks
U.S. stocks climbed higher in the second quarter with major indexes reaching all-time highs.  Large caps as measured by the S&P 500 returned 3.1% for the quarter and are up 9.3% year to date.  Small caps were the laggards during the quarter as hopes for a tax cut that would help small companies waned, but the Russell 2000 still managed a 2.5% gain.  Year to date small cap stocks are up 5.0%.  In a reversal from last year, growth stocks are strongly outperforming value stocks.  Year to date, the Russell 1000 Growth index is up 14.0% while the Russell 1000 Value index is up only 4.7%.

Several factors led growth stocks to outperform value stocks thus far this year.  Many cyclical value stocks rebounded strongly after the election on hopes of stimulative economic policies from the Trump administration.  Political turmoil in Washington has dampened those hopes and the returns for some of those stocks this year.  As the outlook for growth in the U.S. has moderated, investors have sought faster growing companies benefitting from a changing U.S. economy.  As a result, the stocks of a few large companies, Facebook, Amazon, Apple, Netflix and Google (FAANG) have gained nearly 25% on average so far in 2017.  Valuations on these stocks are extremely high and they are vulnerable to the disappointment of high expectations.  Value stocks have also been impacted by declining oil prices which have caused energy stocks to be the worst performing sector this year (after being the best performing sector last year).  That has hurt value stocks as the energy sector makes up a much larger part of the value index than the growth index.  While growth stocks have prevailed thus far in 2017, trends can change quickly and investors should remain selective.

International Stocks
After underperforming U.S. large cap stocks in six of the last seven years, international stocks have outperformed year to date.  Developed international stocks as measured by the MSCI EAFE Index rose 6.1% in the second quarter and are up 13.8% year to date.  In local currency terms the MSCI EAFE is up only 7.6%, thus nearly half the return has come from foreign currencies strengthening against the dollar.  Emerging market stocks have done even better, up 6.3% this quarter and 18.4% year to date.  European stocks and the euro benefitted from decreased political uncertainty as anti-European Union candidates in the Netherlands and France were defeated in recent elections.  Additionally, after years of sluggish growth, the global economy and international corporate earnings have strengthened. 

While we are encouraged by these recent developments and how international stocks have benefitted client portfolios, we balance that with continued longer term concerns we have about the structural flaws and banking system of the Eurozone, China’s massive debt increase in recent years, and Japan’s poor demographic situation and extremely high debt levels.  Additionally, global equity managers we respect do not believe high quality international stocks are significantly cheaper than comparable U.S. stocks.  In weighing the risks and rewards, we are satisfied with our current allocation to international stocks and will continue to evaluate opportunities going forward.

Bonds and the Federal Reserve
Bonds rose during the second quarter with the Barclays Aggregate bond Index up 1.5% and up 2.3% year to date.  The Lipper Intermediate Municipal index was up 1.6%.  High Yield bonds continued to be a strong performer up 2.1% in the quarter as yields moved lower and spreads compressed.  TIPS were down 0.4% as the outlook for inflation decreased. 

The 10 year U.S. Treasury yield began the year at 2.45% and by the end of the second quarter had fallen to 2.31%.  This decline in yield occurred despite the Federal Reserve raising the Fed Funds rate twice so far this year.  Longer maturity yields declined as the outlook for growth and inflation subsided.  However, this decline in interest rates may be temporary if U.S. and global economic growth continue.    

During the quarter the Federal Reserve announced they will begin to reduce the size of their balance sheet later this year. For the past couple of years, the Fed has been reinvesting the proceeds from maturing bonds they purchased during Quantitative Easing to keep their balance sheet stable. At nearly $4.5 trillion this still represents a massive expansion since 2008 when it stood at less than $1 trillion (See chart below).

Source: Federal Reserve, FactSet, J.P. Morgan Asset Management.

While the Fed’s balance sheet has been stable, since early 2015 the European Central Bank(ECB), the Bank of Japan(BOJ), and the Bank of England(BOE) have expanded their balance sheets by $4 trillion buying bonds, stocks, and currencies.  These purchases have helped to push up stock and bond prices and push down volatility.  In addition to the Fed beginning to reduce their balance sheet, the ECB appears likely to begin tapering its asset purchases in the near future.  Central banks are starting to shift from the ultra-accommodative monetary policies they have pursued since the beginning of the global financial crisis.  We are likely to see the impact of the reversal of these policies on stocks and bonds in the coming months and years.

The U.S. economy has continued to muddle along with GDP growth of 2.1% over the last year, the overall average since the beginning of the expansion in 2009.  Inflation moved back below the Fed’s target with its most recent reading of 1.9%.  The unemployment rate remains very low at 4.4%, however wage growth remains subdued.  Some of the enthusiasm the market saw after last year’s presidential election appears to have begun to fade as many of the new administration’s policies have been met with push back. 

Alternative strategies were positive the last three months and year to date through May the HFRI Fund of Funds Composite Index is up 3.3%.  Amongst strategies we follow, more stock oriented strategies generated solid gains.  U.S. and global real estate performed well also with the MSCI World Real Estate Index up 3.7%.  Hedged strategies with a value bias and managed futures declined during the quarter.  Overall, our alternatives remain conservatively positioned, provide important diversification and are part of our efforts to protect capital for our clients when the current low volatility environment inevitably turns.

As we pass the midway point of 2017, it has been a good year thus far for investors.  Despite lofty valuations, political gridlock in Washington, and terrorist acts overseas, the markets have remained resilient.  This is a good reminder that for long-term investors most of the news should be considered nothing more than noise.  Recently some clients have asked about getting materially more aggressive or conservative, often it seems based on their political leanings.  Our advice is the same during this political environment as it was in previous ones.  Don’t be swayed by the current political winds and maintain a disciplined investment strategy based on your long-term objectives.  By staying disciplined, buying good businesses and realizing the benefits of diversification we seek to help our clients protect and grow their capital in order to reach their financial goals.

The statements and opinions expressed herein are subject to change without notice based on market and other conditions.  The information provided is for informational purposes only and should not be construed as investment or legal opinion.  Please consult a tax or financial advisor with questions about your specific situation.