Investment Commentary - First Quarter 2017

Written by Don Wilson, CFA, CFP® on April 4, 2017

• Good quarter for stocks around the world
• Consumer & business confidence soared
• Rising populism in Europe could impact upcoming elections
• The Fed raised rates but bonds still up modestly

The stock market began the year on a strong note, picking up where it left off last year.  As the quarter drew to a close, investor sentiment cooled momentarily when the Trump administration failed to pass its first big policy item, the repeal and replacement of the Affordable Care Act.  This raised questions about the new administration’s ability to implement its policies aimed at strengthening economic growth through fiscal stimulus, tax reform, and deregulation. 

Optimism regarding the U.S. economy has soared since the election.  In March the Consumer Confidence Index surged to its highest level in sixteen years. Another measure, The University of Michigan’s Consumer Confidence Index, hit a decade high in January.  Business surveys have been hitting multi-year highs as well.  While sentiment has risen sharply, so far actual economic activity is little changed.  A new report by Morgan Stanley Research compares the sentiment survey data and the actual activity data of Bloomberg’s Economic Surprise Index (see chart below).  The “hard” data made up of actual activity such as retail sales and business spending has been coming in as expected.  The “soft” data measuring consumer and business sentiment has been much higher than expected and the gap between the two is at a record level.  We expect that gap to close with moderately improved economic growth and current expectations coming back down to more reasonable levels. 

Sources: Bloomberg, Morgan Stanley Research, Wall Street Journal

The stock market has reflected the surge in consumer and business confidence.  The S&P 500 rose steadily through most of the first quarter returning 6.1%, a strong start to the year.  In fact, during a period that ended in March, the S&P 500 went 105 trading days without closing down more than one percent, its longest stretch since 1995.  In a reversal of trends from last year, large-cap stocks are outperforming small-cap stocks.  The Russell 1000 Index is up 6.0% and the Russell 2000 Index is up only 2.5%.  Just as pronounced is the reversal between growth and value stocks.  The Russell 1000 Growth gained 8.9% versus 3.3% for the Russell 1000 Value. 

Another reversal of trends was international stocks outpacing domestic stocks as the MSCI EAFE Index rose 7.3% for the quarter.  Emerging markets had even stronger performance up 11.5%.  Part of the performance of international and emerging market stocks for U.S. investors resulted from the U.S. dollar weakening during the quarter.

Conflicting forces are likely to pull international stocks in opposite directions in 2017.  On the positive side, the global economy is showing signs of recovery which should benefit both the Eurozone and Japan.  Also, international stocks have lagged far behind U.S. stocks in recent years, and have room to catch up.  Conversely, rising populism poses a significant threat to the European Union.   A recent study found populism is at its highest levels since the 1930s (see chart below). 

Source: Luxemburg Foundation, February 2016

The rise in populism in Europe was evidenced last year by the Brexit vote.  Additionally, although the far-right candidate in Holland lost, the fact that this party is now the second largest in the Netherlands’ parliament is evidence of populism’s recent gains.  A common thread amongst populist candidates in Europe is a call to remove their country from the Eurozone.  Upcoming elections in France, Germany, and perhaps Italy, are expected to be won by mainstream candidates but last year showed that sometimes the unexpected happens.  Longer term we believe the euro currency system is structurally flawed and will hinder economic growth in Europe until it is resolved.  This contributes to our decision to remain underweight to international equities. 

Despite the Federal Reserve raising rates in March, the Barclays U.S. Aggregate Bond Index rose 0.8% for the quarter.  The yield curve flattened as short term interest rates rose while intermediate and long term rates were relatively unchanged after rising during the second half of 2016.  The Fed is expected to raise rates a couple of more times this year.  However, as this quarter shows, the Federal Reserve’s rate movements primarily impact short-term interest rates.  Intermediate and long term interest rates are more impacted by economic growth and inflation expectations.  Looking forward, rates are likely to continue to rise from still low current levels, and we expect muted bond returns.  Our bond portfolios are positioned with shorter average maturities than the broad bond market to help protect the bond portfolio in a rising rate environment. 

Within alternative investments, more equity-centric strategies benefitted from a strong quarter in global stock markets.  It was a good quarter for global real estate as well, while returns for strategies less tied to stocks were mixed.  In commodities, gold rose while oil prices slid.  Given the environment of high stock valuations and low bond yields, the investment opportunity set is currently more limited which is a primary driver behind the conservative positioning of our alternative investments.  The opportunity set will change over time, and when it improves our flexible alternative strategy will take advantage of this. 

In conclusion, it was a good quarter for investors with positive performance across stocks, bonds, and alternatives.  The global economy appears to be on firmer footing and poised for moderately stronger growth.  Tax and regulatory reform could benefit stocks, but high expectations seem to be already priced in.  In this environment, we are seeking to balance growth while managing risk in our clients’ portfolios. 

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.