Stocks continued to perform well in April, with international developed and emerging market equities leading the way yet again. Investors cheered favorable political outcomes in Europe and improving foreign economic growth. U.S. stocks also performed well, in part because of optimism over the potential for tax reform.
The U.S. Bureau of Economic Analysis reported that the economy grew at a 0.7% annualized rate in the first quarter. Although broad economic growth was sluggish, this is not unusual for the start of the year when many seasonal forces are at play. The job market continues to perform well. Unemployment is at 4.5%, and business surveys show an expansion in hiring across multiple sectors. The Federal Reserve’s target for the Federal Funds rate remains within a range of 0.75% to 1.00%, while the consensus forecast among economists is that the Fed will potentially hike rates two more times this year.
Emerging market equities continue to perform very well in 2017, with returns of 13.88% YTD through April. The MSCI All Country World Ex US Index, a gauge of foreign equities, returned 2.14% in April and is up 10.17%, YTD.
U.S. stocks performed positively during the month, with the S&P 500 Index returning 1.03% in April and extending its YTD return to 7.16%. Small caps rebounded in April, but still lag large caps, with the Russell 2000 Index returning 3.59% through the first four months of the year.
Fixed income securities performed positively during the month, led by emerging market bonds. The JP Morgan Emerging Market local currency index has returned 7.75% YTD, while the emerging market U.S. dollar-denominated index has returned 5.41%. U.S. core bonds were modestly positive, with the Barclays U.S. Aggregate Bond index returning 0.73% during the month as yields fell.
Stocks continued to generate positive returns in April, bringing their YTD returns to levels that would be commendable for the full year, let alone the first four months. Last month, we noted that the strong performance in international equities might come as a surprise to investors who expected rising political risks to lead to volatile stock prices and poor returns. General elections in the Netherlands and, most importantly for the EU political system, France brought the risk that populist candidates could wreak havoc on the integrity of the EU and cast doubt on the future of the monetary union based on the Euro as currency. After surprise results in the U.S. presidential election and the British referendum last year, pundits erred on the side of caution with respect to handicapping the election risk in EU. The far right-wing French candidate Marine Le Pen has received significant press attention with her anti-establishment rhetoric and was viewed as a Trump 2.0 version that could disrupt the system.
Yet in spite of concerns that Le Pen was riding a wave of populist momentum, her results in the first round of the French election were no better than polling results indicated, and she actually underperformed the centrist candidate Emmanuel Macron. Equity investors cheered the results for a number of reasons. First, the outcome for Macron indicated that the polls indeed can be trusted. What became a popular theme after Brexit and the Trump victory was that we had to “ignore the polls,” and the implication was that people should expect an outcome that would result in the greatest degree of uncertainty for global markets. With the first round results aligning with the polls, markets were able to regain some confidence in political polling. Second, the results seemed to corroborate the view that the EU is not headed on a course of anti-establishment destruction that would put the monetary and currency union at risk.
To be sure, Marine Le Pen performed better than her results in the 2012 election, garnering 22% of the vote this time versus 18% then. However, with Macron expected to pull in a significant amount of votes from other centrist candidates in the second and final round, taking place on May 7, Le Pen faces an uphill battle that neither Trump nor Brexit experienced. While Donald Trump’s pre-election odds seemed stacked against him at various points, which are similar to Le Pen’s odds at present, his polling within key swing states was actually within the margin of error. Le Pen, who is trailing Macron by more than 20 percentage points on a national basis (there is no electoral college in France), is not even close to being within the polling margin of error.
Although diving this deeply into the French presidential election may seem trivial to investors focused on the long-term investment plan we have put in place, the illustration provides a good example of how we approach geo-political risk in general when thinking about broad portfolio allocations. Heading into the year, with European political risk generating a significant amount of press from the Wall Street Journal and other financial market publications, a number of investment managers were quoted as tactically managing their portfolios around the potential for heightened political risk. Yet despite these risks, foreign developed stocks have generated YTD returns over 10% and have given little to no room for even the most prescient of investors to manage around the election risk. European equities were positive heading into the first round of the French election and immediately shot higher after the results were finalized. For international equities, the combination of improving economic signals, attractive relative valuations, and favorable central bank policy has been the main investment thesis for our allocation to the asset class. Better-than-expected political outcomes are turning out to be the short-term catalyst to lead to performance above U.S. stocks, and we are encouraged to see that patience is finally paying off with these investments.
In the U.S., the economy grew at a 0.7% annualized rate in the first quarter, according to the initial estimate from the Bureau of Economic Analysis. The pace of growth was below consensus expectations of 1.1% growth and moderated mostly as a result of inventory adjustments and weaker than expected consumer and government spending. Although growth in the first quarter was slow, it is important to note that Q1 GDP growth has been persistently sluggish compared to growth in the remainder of the year.
During the current expansion, as illustrated by the far right column in the table above, GDP growth in the first quarter has averaged 1.04% compared to a 2.40% to 2.51% range for the other three quarters of the year. Seasonal effects, which include a pullback in consumer spending after the holidays, lower business activity, and inventory reductions, among other things, tend to weigh on the first quarter more so than other quarters. We highlight this pattern to show that weak GDP growth early in the year is not overly troubling.
Some economists were also encouraged by the internal details in the report. Goldman Sachs noted that “despite the softer Q1 consumption outcome, the robust pace of business investment growth and the likely temporary nature of the drag from inventories and utilities suggest a firmer pace of growth in the quarters ahead.” In short, Goldman found reasons to be optimistic as wages were growing at their strongest rate of the current expansion and business increased capital expenditures at an accelerated pace, which bodes well for future economic growth.
In terms of the new administration’s influence on the economy, it is still too early to tell what the ultimate effect of its pro-business push will be. Q1 GDP growth was lackluster, but there is a multitude of factors that went into that figure on which the President had little to no bearing. One agenda item that has come up recently and provided a small lift to stocks at the end of the month was the proposal for a broad tax reform. Though the details were sparse, the main takeaways are as follows:
To be candid, the “plan” was published on a single page with few technical details on how it would be implemented. For instance, there was no mention of the income ranges around which the three new personal income tax rates would be built. There was also no mention of 401(k) contributions within the formal release, although the administration did say that these would be exempt from taxation. Areas like municipal bond income were also not mentioned in the proposal. With very few details in the proposal, it is not possible presently to project exactly how each person will be affected by the new tax plan.
The administration has positioned this as a starting point for negotiations. Some have already called it “dead on arrival” in Congress due to the fact that some Democrats will balk at lowering tax rates on the highest income bracket and some Republicans will push back at the deficit increase that is at stake. The big question going forward is not necessarily whether the plan gets passed, since that would involve wholesale buy-in across the entire Republican party that would be difficult to accomplish, but which particular elements get taken up by Congress. There seems to be broad agreement on lowering business taxes, which would be beneficial to LLCs and S-corps. There is also GOP support (as seen in the Paul Ryan tax plan released earlier this year) for eliminating the estate tax and the alternative minimum tax.
To be clear, we do not believe that investment decisions should be solely based on whether or not the tax plan gets pushed through. There is simply too much uncertainty both on the timing as well as the details of the plan to make an educated call on how markets may or may not benefit from new tax policy. If features such as the repatriation holiday for overseas cash holdings or overall corporate tax rates get lowered, this would likely be positive for the market. But until there is clarity that this type of tax reform will actually pass, we will simply keep an eye on any progress that is made with the plan, while analyzing the long-term economic prospects of the U.S. and global economy as the primary gauge for our investment rationale.
With respect to the global economy, growth is positive and steady, trending in the right direction. We are encouraged by the improvement in economic growth in Europe as well as emerging markets, which have benefited from the rebound in commodity prices as well as improved economic demand in China. Equity valuations are varied across the globe. U.S. stocks are trading at a premium to their historical average, and emerging and foreign developed stocks are trading at discounts. Although U.S. valuations are slightly above average, we believe that they are justified given the low interest rate environment combined with strong balance sheets and improving earnings. We caution investors to not get too complacent as we head into summer, because disappointment over lack of progress on tax reform legislation or a more aggressive shift in Fed policy could introduce volatility to stock markets. However, we are pleased to see the benefits of diversification in our portfolios YTD as many areas have contributed positively to returns. We believe that a combination of global stocks, bonds, and alternative investments will provide an appropriate balance of risk mitigation and return generation capability.
The information and statistics contained in this report have been obtained from sources we believe to be reliable but cannot be guaranteed. Any projections, market outlooks or estimates in this letter are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of these investments. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. These projections, market outlooks or estimates are subject to change without notice. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. All indexes are unmanaged and you cannot invest directly in an index. Index returns do not include fees or expenses. Actual client portfolio returns may vary due to the timing of portfolio inception and/or client-imposed restrictions or guidelines. Actual client portfolio returns would be reduced by any applicable investment advisory fees and other expenses incurred in the management of an advisory account. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Sage Financial Group. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Sage Financial Group is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Sage Financial Group’s current written disclosure statement discussing our advisory services and fees is available for review upon request.
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 Goldman Sachs research report: “GDP Rises 0.7% in Q1 but Details Suggest Stronger Growth Ahead.” Date: 4/28/2017