The first quarter of 2017 played out fairly eventfully, surprising few. Inauguration Day, a major milestone in itself, opened the door to a volatile new iteration of politics as Donald Trump settles into his new job as Commander in Chief. The national political dialogue, still poisoned from a rancid election season, shows no signs of mending fences and coming together. Much less controversially, the economy and its corporate constituents prospered moderately, while economic survey data raise the possibility of further improvement. Although heightened political uncertainty poses multiple risks for investors, so far fundamental progress has filtered through to appeal to the wisdom of the crowd.
Looking back at the market’s performance, evidence of political turmoil is far from obvious. Stocks delivered their strongest quarterly performance since 2015, as the S&P 500 returned 6.1 percent, with minimal volatility (the blue line in Figure 1 represents the index, excluding dividends). However, the impact of Washington dynamics is more apparent below the surface. For example, in spite of a strong start, bank stocks (yellow line) fell back to finish roughly flat for the quarter after the Republican healthcare bill failed to get off the ground in mid-March, which clouded the outlook for tax cuts and deregulation of other sectors, particularly Financial Services.
Figure 1: First-Quarter Equity Market Performance
The political regime change, however, might share some of the credit for the market’s performance so far this year. A sharp rise in consumer and business confidence since the election appears attributable to the likelihood that regulation and taxes will reverse their upward trends. While the policy particulars remain uncertain, stocks can very well benefit from the surrounding optimism itself, as an indication of willingness to spend. In fact, the two sectors to which this idea logically applies best, Technology and Consumer Discretionary, showed the strongest performance and led the market higher.
There is a second explanation for the market’s strength though. The economy had already begun to pick up by the middle of last year, as GDP growth accelerated from 1.1 percent in the first half to 2.8 percent in the second, oil prices rebounded, and profit forecasts stabilized. The Federal Open Market Committee (FOMC) of the Federal Reserve recognized this strength and reacted by raising interest rates one quarter-point in December and another in March, sooner than the market had anticipated, representing an authoritative vote of confidence. So a combination of sentiment and actual performance, rather than any specific policy itself, has made stocks attractive.
The current monetary policy stance has important implications for the yield curve going forward. The FOMC expects to continue tightening short-term policy rates for the foreseeable future to tighten the flow of credit. These higher rates make interest on deposits relatively attractive, at the expense of demand for longer-term debt. Furthermore, the FOMC plans to cease the reinvestment of its assets, which grew enormously from quantitative easing, beginning possibly later this year. Removing this steady source of demand for longer-term bonds could cause those rates to rise as well. Therefore, economic strength poses a risk to bondholders, especially those who own long-term bonds.
International equity performance also reflects a rising tide of growth, particularly emerging markets, which benefited from the rebound in commodity prices and the stabilization of the rising dollar as well. The MSCI All Country World Index, excluding the US, returned 8.3 percent for the quarter, outpacing the US by more than two percentage points, while the MSCI Emerging Markets Index returned 12.5 percent. International stocks still appear relatively good value, at 14 times projected earnings, compared with almost 18 times for the US. But political risks are both local and geopolitical, with the EU facing challenges in Europe, the Middle East unstable as ever, and Asia facing an unstable North Korea and reset trade relations.
Looking forward, these trends can continue in the short term, but domestically, the government will eventually have to deliver tax cuts and deregulation for reality to catch up to expectations. While confidence is encouraging, finances limit spending power. To the extent optimism begins to take effect and boost the real US economy, other cyclical sectors, such as Industrials and Energy, should follow suit. Internationally, a combination of prudence and stability will deliver results. We have positioned portfolios accordingly.
Martin C. McWilliams III, CFA®
AVP, Associate Portfolio Manager
David M. Kirkpatrick, CFP®
SVP, Portfolio Manager
Charles A. Williams, CFP®,CTFA®
SVP, Portfolio Manager
Brian A. Barker, CFP®, AIF®
SVP, Director of Asset Management