Markets: The first quarter of 2017 was dominated by political headlines and firming economic data. Stocks have generally rallied on better global growth and expectations for tax cuts and economic stimulus in the U.S. market. Global stocks largely outperformed fixed income over the course of the quarter, despite a rally in bonds and pullback in stocks during the last few weeks of March.
We expect modest returns from major asset classes over our 3- to 5-year time frame. However, we also worry that expectations may be running ahead of reality. This warrants some caution in the near-term and highlights the need for intelligent portfolio management and investor discipline. In the medium-term, we remain constructive and the fundamentals are strong. Investors should look at any short-term weakness as an opportunity, and not necessarily a time to take risk off the table, in our opinion.
Economics: The U.S. economy appears very healthy. Revised fourth quarter GDP numbers show that the U.S. economy grew at a moderate pace of 2.1% at the end of 2016. The February jobs report came in above expectations, with the U.S. economy adding 235,000 jobs and the unemployment rate falling slightly to 4.7%. Inflationary pressures continue to build in the U.S., with headline CPI rising by 0.1% in February to 2.8%. After an unimposing start to 2017, we would expect growth to accelerate in the second quarter. A late-winter surge in the leading economic indicators also points to the staying power of this expansion.
Fed: In a widely anticipated move, the Federal Open Markets Committee (FOMC) raised rates at the March meeting, which is the third rate hike this cycle. The federal funds rate is now in a target range between 0.75% and 1.00%. The FOMC’s quarterly projections for growth, inflation, employment and interest rates were largely unchanged, reflecting smooth sailing in the economic outlook and financial markets since the December meeting. Barring an unforeseen shock, we expect further interest rate increases in 2017. It is important to note that monetary policy remains very accommodative, i.e. rates are still low relative to history.
The bull market should persevere: The beginning of 2017 has seen markets pause after a very strong run into the end of last year. While we may see a short-term correction at some point, we do not believe this bull market is over. We don’t believe we’ve reached a top in equity prices, but more volatility is likely. The good news is that investor sentiment appears to have improved over the last year. This leads us to believe that investors are unlikely to overreact to negative news as they did periodically throughout 2016.
Stock Market and Politics: The new administration seems focused on implementing a pro-growth agenda, and markets have reacted with optimism. However, markets may be overestimating the ability of President Trump to boost the economy. We ourselves also do not expect President Trump to provide much of an economic boost over the next 6 to 12 months. While the 2017 earnings picture is fairly encouraging, there is clearly room for disappointment. This does not mean it is game over for tax reform and infrastructure projects, but simply that it may take several years.
Earnings, valuations, and dividends: Stock market returns tend to be driven by three main factors: earnings growth, change in valuations, and dividends. Recent returns have primarily been driven by changes in valuations, so we believe earnings growth is needed to push markets higher. Recent earnings reports have been encouraging, and JP Morgan expects high single digit profit growth with the potential for upside in 2017. We believe earnings growth and dividends can provide fundamental support for U.S. equity markets to gradually move higher over the course of the next few years.
Global Valuations: Foreign equity markets appear cheap relative to U.S. stocks. European and Japan equities are around fair value, in our opinion, and emerging markets are still reasonably cheap.
Should investors react to the Fed? We believe that this year's rate hikes are already built into bond yields. While investors may worry that a rising rate environment is bad for bonds, they should keep in mind that the Federal Reserve doesn't control the entire yield curve. Changes in the federal funds rate most directly affect the short end of the curve, or shorter maturity bonds. When the Fed raises rates, it pushes up yields on short-term bonds. But yields on 10-year bonds, for example, can be affected by a whole host of other factors, including risk sentiment, expectations for inflation and economic growth, and investors' demand for longer-maturity securities. Put simply, the long end of the yield curve doesn't always move in sync with the short end, so the Fed's rate increase may not cause prices to fall on longer-term bonds. What's more, longer bonds can provide yield as well as protection in the event of a flight to quality that causes stocks and other, riskier assets to underperform.
Attractive bond sectors: Despite the expectations for higher rates, we believe bonds still play a valuable role in many investors’ portfolios. In addition to providing a source of income, bonds may help reduce volatility and diversify equity risk. Investors should assess whether they are properly positioned for a potential environment of rising rates. Since different bond sectors are driven by different factors, building a diversified portfolio of multiple strategies can help enhance returns, while reducing interest-rate sensitivity. Asset classes that historically have tended to do well during periods of rising rates, include high yield bonds, floating rate bank loans, Treasury inflation-protected securities, and individual bond ladders. Some investors may be hesitant about adding exposure to these sectors since they present some credit risk, but a trusted advisor can help manage the risk.
Thank you for your confidence and trust.
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, Citi research and Nuveen.