First Quarter Recap
Through the first quarter of the year, stock markets have been volatile, and many equity indices have generated slight negative returns. The S&P 500 rose 5% in January only to experience a 4% decline in February and a 2% decline in March. Though much attention was paid to the 10% “correction” that occurred in stocks – measuring the decline from the peak on January 26 to the lows on February 8 – bond markets have also experienced negative performance. The Barclays U.S. Aggregate Index, a broad measure of bond market performance, fell -1.46% in the first quarter. Municipal bonds have performed worse, falling -1.61% in the first quarter. Much of the pressure within the bond market has been a result of the stronger prospects for economic growth and inflation, which has raised concerns that the Federal Reserve might hike rates at a faster than expected pace.
Though bond returns have been poor to start the year, and it has affected portfolio returns in the sense that they have offered no positive benefits during the volatility experienced over the last month, it’s important to remember that a bad return in bonds is not the same as a bad return in stocks. The last year of negative returns in broad bond markets was 2013, where the Barclays Agg fell -2%. Though bonds do not present incredible values at present, rising rates have begun to work their way into higher coupons for investors, which will be realized over the coming years.
Turning back to stocks, there has been a wide range in performance between growth and value. For instance, the Russell 1000 Growth index has returned 1.42% while the Russell 1000 Value index has fallen -2.83%. Technology shares performed incredibly well during the first two months of the year, only to be felled by inquiries into Facebook’s data sharing hit the entire sector at the end of March. Though performance between growth and value has narrowed more recently, you can see the three-year returns are still wide, with the Russell 1000 Growth returning 42% over the last three years while the Russell 1000 Value has returned just 24%. In our outlook, we will touch a bit more on the discrepancy between growth and value and whether we will see a change in leadership here.
2nd Quarter Outlook
The Return of Volatility
The other shoe had to drop. With stock markets experiencing such strong returns over the course of 2016 and 2017, it was only a matter of time before some turbulence came back to the market. In our February edition of Viewpoints, we noted that “some caution is warranted, particularly as volatility has remained incredibly low and we have now entered the longest stretch since 1929 without a 5% correction in the S&P 500. We should manage expectations as it relates to being complacent with equity prices potentially experiencing some volatility in the next few months.” Little did we know that a 10% correction in the market would occur over the next few weeks.
Naturally, investors want to know whether volatility will continue through the rest of the year. To answer that question, it is important to look at what has changed and what has stayed the same with respect to the fundamentals and outlook for stocks. Regarding the economy, there has been some pullback in growth expectations for the first quarter, but, generally speaking, economic growth is still in good shape. The number of people filing for jobless claims hit its lowest level since 1973. The unemployment rate is at its lowest level since 2000. Housing prices have increased at a 5% annual growth rate for the last two years. Consumer confidence is hovering at a 15-year high.
The last six corrections (defined as stock prices falling 10% from a recent peak) saw the market bottom within a month or two and slowly regain ground over the next six months. Whether the market follows this playbook hinges on a few things going forward.
One element of particular interest is the discussion of trade tariffs. The start of a trade war late in the economic cycle is not a welcome event by any stretch and could cause the nascent recovery in global economies to grind to a halt. Fortunately, it seems as though President Trump’s initiatives here are more bark than bite. For starters, after announcing immediate tariffs on steel, the administration quickly noted that there would be exemptions for NAFTA members, the EU, Australia, and Argentina. Also, Brazil and South Korea could be shielded as well. If NAFTA, the EU, and some major emerging markets are excluded, who does that leave for a trade war? China and Turkmenistan, presumably.
China is a major trading partner, and thus why the market worried about the potential for a trade war between two of the largest economies in the world. However, there was immediate relief when the Wall Street Journal noted that “China and the U.S. have quietly started negotiating to improve U.S. access to Chinese markets, after a week filled with harsh words from both sides.” In short, mutual economic destruction through a trade war is not in the interest of either country. In the end, there will be an adjustment of tariffs, one that likely helps Trump make the case that he negotiated a “magnificent deal”, regardless of how consequential it is. In practice it will likely not set off a firestorm of crippling trade sanctions.
Regarding the political element, we may see it play a bigger part in market drama this year. Last year, the market shrugged off every bit of news from Washington D.C. This year, the tune has changed with much greater focus on the trade war question, the lack of continuity within leadership, and the potential for President Trump to “wing it” with less mainstream voices in his cabinet. The potential for a change in political power during the mid-term elections will bring gridlock to Washington D.C., which is not necessarily a bad thing, but it also presents some question for the tailwinds of deregulation and further fiscal stimulus.
Yet another element that markets will hinge on going forward is corporate earnings. Heading into the second quarter, fresh on the heels of volatility, investors will look to forward earnings guidance from major corporations. Earnings growth for the S&P 500 is expected to come in at 17% in the first quarter. Much of that is due in part to tax cuts kicking in, a factor that is already expected and arguably priced into current valuations. If the outlook for growth remains strong, the market may put volatility in the rearview and resume its upward trajectory.
Lastly, the final consideration that could keep volatility here for a while is a change in leadership amongst equity asset classes. What do we mean by this? For the last three years, we have heard about the FANG stocks – Facebook, Amazon, Netflix, and Google. Over the last five years, the FANG stocks have risen 495% while the S&P 500 has risen 83%. Emerging market equities, which have been out of favor until recently, have risen just 22% over the last five years. However, over the last month, the FANG stocks have fallen 7.6% while the S&P 500 index has fallen 4% and EM stocks have fallen 1.5%. Technology focused funds saw inflows of $5 billion in 2017 and over $10 billion in 2016. Within the Russell 1000 Growth index, technology now makes up around 40% of the index weighting. We could be in the early stages of rotation from technology and growth oriented strategies towards value and defensive strategies.
It’s impossible to tell how long this sector/style rotation may continue but one thing we do know for sure is that cyclicality is ever present in markets. No one company or sector or asset class has a strangle hold on the title of “Best performer” in perpetuity. To see rotation from tech darlings, which have become a pervasive allocation in everything from simple market cap weighted indexes, to growth strategies, to smart beta factors such as momentum or quality would not be surprising in the least. This is not to say they are bad businesses. Far from it. Google has become a a commonplace verb for good reason, Netflix has displaced traditional TV in many ways, and anyone with an Amazon Prime account knows how easy it is to order household items at the push of a button. Yet instances like the Facebook privacy controversy in the wake of the election show just how quickly the narrative can turn and send an investment, or asset class, from darling to dog. Though we hesitate to recommend abandoning growth strategies entirely we believe greater incorporation of value styles makes sense for the present market environment.
Global Equity Market Notes
In addition to incorporating more of a value tilt within U.S. stocks, we continue to look abroad for investment outperformance compared to U.S. markets. Our thesis for rotating to incorporating more foreign equity exposure is multi faceted:
- Valuations remain favorable and are at a discount vs. the United States
- Economic expansions are in the early to middle innings vs. later stages in the U.S.
- Corporate earnings growth has room for improvement via margin expansion
- Foreign central banks continue to be supportive of markets vs. the Federal Reserve turning less supportive
We have spoken to the valuation gaps that exist within U.S. vs. foreign equities in prior commentary, as well as some of the key economic data points that illustrate greater room for expansion abroad. On the last bullet point, the classic axiom says that investors should not “fight the Fed.” In the U.S., the Federal Reserve is effectively telling equity and credit markets they are on their own at this point. Fed chairman Jerome Powell has noted high valuations in equity markets and though this is not an indication that he wants to deflate the market, it also signals that the Fed is unlikely to ride to the rescue if U.S. markets continue to experience volatility. The Fed has also been reducing the size of their balance sheet at the same time as they are raising interest rates, two levers which will eventually lead to tighter financial conditions in the U.S.
In the chart above you can see the light blue line, representing financial conditions in the U.S., tightening, compared to easing in areas outside of the U.S. This is mostly due in part to the Federal Reserve raising interest rates and shrinking their balance sheet, which ultimately pulls liquidity from the system. By comparison, other central banks, such as the Bank of Japan, the European Central Bank, and the Swiss National Bank, are still purchasing assets, and pushing liquidity into their respective markets. To put it in a numerical perspective, according to KKR, the Federal Reserve is set to reduce its balance sheet by $395 billion in 2018. Conversely, the European Central Bank is set to expand its balance sheet by $270 billion in 2018.
Why does this matter? For starters, there is less money in U.S. markets to buy assets like corporate bonds and stocks. Second, tighter financial conditions make it harder for both consumers and corporations to borrow money. Though U.S. consumers have not taken on excess credit in the current economic cycle, corporations have built up large debt piles that will need to be refinanced in coming years. Cycles typically come to an end when spending – corporate or consumer – gets constrained and it is usually constrained by a tightening of financial conditions. Again, this is not to raise the alarm bell that a U.S. recession is imminent, but that the warning signs of tighter financial conditions are starting to accumulate.
Fixed Income Market Notes
Rising growth and inflation expectations put pressure on the bond market in the first quarter, as Treasury yields rose and bond prices fell. The Barclays U.S. Aggregate Bond index fell 1.46% in the first quarter, it’s worst quarterly return since the fourth quarter of 2016. Few areas within fixed income were spared from the effect of rising rates. In particular, floating rate bonds fared well, due lack of interest rate sensitivity. The S&P/LSTA Leveraged Loan Index returned 1.42% in the first quarter, outperforming nearly all categories of fixed income (as well as many equity markets). Over the last year, we have incorporated an increasing allocation to floating rate/loan investments in the portfolio in expectation of rising rates as well as to diversify away from traditional fixed income at a time when interest rates were at rock bottom. We are wary of taking on significant risk within fixed income markets, particularly in lower rated credit, this late in the economic cycle. However, a two-prong approach to fixed income of utilizing short maturity, high quality bonds and floating rate bonds combines the ability to minimize interest rate risk while taking advantage of higher yields.
In March, at his second meeting as Federal Reserve chairman, Jerome Powell raised interest rates to a range of 1.50% to 1.75% and indicated that the Fed plans on raising rates two to three more times this year. The Fed noted in their statement after the March meeting that they expect economic conditions to continue growing at a moderate rate and inflation to normalize around 2.0%. Looking out at the Fed’s long-run projections, they anticipate interest rates will end the year between 2.0% and 2.25% and will end 2019 between 2.75% and 3.0%. Those forecasts are dependent upon a few items, primarily the pace of economic growth and the path of inflation. If inflation picks up from here, which is a real possibility given a healthy job market, corporations investing in capex, and tax reform pushing more money to work in the economic system, the Fed could be forced to push rates up faster than the market expects.
One area in fixed income we have been incorporating into client portfolios is that of Treasury Inflation Protected Securities (TIPS). The Barclays 0-5 Year TIPS Index returned 0.21% in the first quarter. While the absolute figure is not stunning, returns have been positive while other areas of fixed income have been negative. Earlier in this commentary we noted the potential for inflation to increase from current levels due to a strong job market, increased corporate spending, and a favorable global economic environment. At present levels, Two and Five Year TIPS are pricing in just 2.0% inflation over the coming years, a very modest level compared to historical averages.
By comparison, the average inflation rate in the U.S. over the last fifty years has been 4.1%. In the final two years of the last two economic expansions (2000/2001 and 2006/2007), inflation averaged 3.1%. From our perspective, if there is an overshoot of inflation in the coming years, TIPS will be well positioned to benefit investors as they are only pricing in modest inflation expectations over the near term.
The first quarter of 2018 closed with heightened volatility across both equities and bond markets. For a diversified investor, this meant there was little room for cover as both bond and stock returns were negative. The S&P 500 fell 0.76% during the first three months of the year while the Barclays US Aggregate Bond Index fell 1.46%. Market volatility may continue in the near-term, as political turmoil and rotation within the equity market causes continued uncertainty across a variety of asset classes.
Second quarter earnings reports will provide a guidepost for how the market trades for the foreseeable future. While tax reform will positively affect corporate earnings this year, the balance will lie in how much of that is already priced into current stock levels. Perhaps recent volatility will be seen as an overreaction if executive teams give an “all clear” for growth prospects and signal that they are continuing to reinvest in their business, will buy back shares, or hike dividends.
Another important factor to consider is the continued shift in central bank policy. Though central banks are not solely responsible for the strong returns from equity markets since the end of the financial crisis, they played a large part in providing supportive monetary policy and injecting liquidity into the system. As the U.S. Federal Reserve pulls back their support of asset markets, foreign central banks in Europe and Japan are continuing to push money into the financial system. This support, in addition to favorable economic growth and discounts in equity valuations, leads us to believe that international equity markets provide compelling long-term return opportunities.
In closing, we will leave with this thought: the last five years have not favored diversifying across various investment classes. Buying U.S. large cap stocks and closing your eyes worked extremely well. However, the winds are shifting and, in our opinion, they will favor those who are tactical to incorporate a variety of exposures across fixed income, equity, and alternative investment classes. We thank you for the trust you have placed in us and we welcome any questions your investment portfolio.
 Initial claims data via the Bureau of Labor Statistics; unemployment rate via the Department of Labor; house price data via S&P Case-Shiller; consumer confidence data via University of Michigan.
Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. WhartonHill Investment Advisory and IFP are separate entities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All data is via Morningstar as of 3/31/18 unless otherwise noted.