Positive momentum from the end of 2016 carried into January. Both U.S. and foreign stocks generated strong returns to start 2017. The MSCI Emerging Markets Equity Index was one of the best performers to start the year, returning 5.47%. International large cap stocks also performed well, with the MSCI All Country World Ex US Index returning 3.54%.
Despite political transition and the uncertainty that accompanies it, the U.S. economy has continued to show signs of improving growth. Consumer confidence recently hit its highest level in twelve years, the Philadelphia Federal Reserve’s index of business conditions expanded at its fastest pace in two years, and companies such as IBM, General Motors, and Amazon announced hiring plans to further build out their U.S. work force.
Both U.S. and international equities were up during the month while bonds were modestly positive.
The S&P 500 Index rose 1.90% in January while the Russell 2000 Index, a benchmark of small capitalization stocks, gained 0.39%.
Core bonds, as measured by the Barclays U.S. Aggregate Bond Index and the Barclays Municipal Index were up 0.20% and 0.66%, respectively. The Bank of America US High Yield Master Index rose 1.34% during the month as junk bonds gained in price due to improving corporate earnings.
“As goes January, so goes the year” is an oft-repeated stock market adage. Investors often cling to this when January starts off positively, in hope that the rest of the year will be smooth sailing. But when stocks dive in January, they can perhaps wonder whether they should allocate more towards safer assets such as bonds or cash. As we start this new year on a positive note, we believe it is worth comparing and contrasting 2017 to 2016. January of 2016 was one of the worst starts to a calendar year in the market’s history. Yet if you had moved out of your equity positions after the rocky beginning, then you would have missed out on a very strong rally through the rest of year, with both U.S. and emerging market equities posting double-digit returns.
Conversely, we would caution investors who are enjoying the current stock market rally not to become complacent. Despite the improvements seen in U.S. and global economic trends, volatility can always lurk just around the corner, and it is important to be mentally prepared for it. It is our base case assumption that stocks will continue to provide positive returns for investors over the long-term. The most important part of that statement are the words “long-term.” One month, up or down, does not an investing career make. While stocks may continue to perform well throughout 2017, there will also likely be pockets of volatility, as there are almost every year, along the way.
On the political transition, President Trump has yet to gain significant traction on the two biggest pieces of his economic agenda, infrastructure spending and tax reform. There has been discussion of lowering both corporate and individual tax rates but little in the way of a concrete proposal, let alone the fact that consensus over a potential proposal is far from a given. If tax reform and fiscal spending get pushed to the back burner or appear less likely than some anticipate, volatility could return to the equity market.
That being said, although a formal bill has yet to materialize, a number of businesses have announced hiring and capex plans for their U.S. operations. Regardless of whether these announcements are truly a result of the new administration (President Trump would like to claim as much), the point remains that businesses have begun to fill some of the capital investment slack that has been present in the economy. Amazon, for instance, recently announced that it intended to add up to 100,000 workers to fulfillment centers. Wal-Mart increased its baseline pay a few years ago and now plans to build nearly 60 stores this year, which should result in thousands of new retail and construction jobs. Bayer and General Motors have both announced billion dollar investment plans in order to build plants and R&D facilities.
We have noted in previous versions of Insights that the beginning of the year is often a weak seasonal period for the U.S. economy. For example, in the first quarter, the economy has only grown by an average rate of 1.03% during the current expansion. However, economists from the Atlanta Federal Reserve Bank estimate the current quarter to be on pace for growth of 2.3%.
One area that we will be closely watching this year is the Federal Reserve and their interest rate policy. In December, the Fed raised rates to an official range of 0.50 to 0.75%. This was just the second interest rate increase during the current economic expansion. The Fed noted specifically in its December statement that “market-based measures of inflation have moved up considerably but still are low.” The following chart shows the year-over year change in core consumer price index (Core CPI), which has been modest during the current expansion but has recently ticked up due to a number of factors.
In some ways, rising core inflation can actually be a good thing. Core inflation measures the cost of items that we purchase, but it also measures things like wages and house prices. If we are earning more and our assets are worth more, it is positive for the overall economy. Yet low inflation has been one of the main reasons that the Fed has held off on raising interest rates for so long. Simply put, the central bank has not been encountering the same inflation pressures that it faced in the 1970s or ’80s. However, the Fed has increasingly noted the uptick inflation rates, as evidenced by the quote we highlighted from its December statement, and the uptrend may cause the central bank to raise interest rates faster than it has in recent years, which is a low hurdle to clear considering they only hiked rates once a year in 2015 and 2016. We underscore this development because it is good for the economy that we are moving away from a disinflationary environment, but it may also present challenges for areas like the bond market.
Sage has reduced our traditional fixed income holdings in areas like Treasuries, which have significant interest rate sensitivity and low coupons, and increased exposure to areas such as unconstrained fixed income and high yield strategies, which we believe have lower interest rate risk and more attractive coupons. High yield and unconstrained bonds performed particularly well in the second half of last year as traditional fixed income struggled. For instance, the Morningstar Taxable High Yield Category returned 6.47%, but the Barclays U.S. Aggregate Bond Index fell 2.53% in the second half of the year.
The unconstrained manager category returned 2.84%. Sage continues to believe these categories will offer investors returns that surpass traditional U.S. fixed income. As rates continue to rise and higher yields make Treasuries look more attractive, we may also look to increase our core fixed income exposure in order to take advantage of better risk-reward opportunities. We do not believe that we are quite there yet, with the 10-Year Treasury still yielding just 2.48%, well below its long-term average yield of 6.31%, but we mention the consideration as a potential allocation shift that we are contemplating should yields continue to increase.
Another area that Sage has emphasized in portfolios is emerging market equities. Given the Trump administration’s proposals for a border tax and the president’s sharp comments on trade deficits with EM countries such as Mexico and China, this is an area of the market that may seem particularly prone to policy risk. It is worth noting, however, that, similar to the U.S., many emerging market countries have seen improving economic growth over the last six months.
China’s most recent PMI (purchasing managers’ index) reading was its highest in more than two years. Russia also hit its highest PMI reading in more than two years. Increased manufacturing activity in the U.S., Europe, and China (which has avoided a hard landing) has helped emerging market economies to rebound. Looking forward, if the U.S. is able to engage in fiscal stimulus and increase domestic economic activity, then emerging market economies will likely benefit since they are highly levered to global and U.S. growth.
We have also previously highlighted low price-to-earnings valuations across emerging markets. Indeed, the CAPE ratio in EM equities is currently at 10.4 compared to a historical average of 17.3, which represents a discount of 66%, according to Research Affiliates. (CAPE stands for Cyclically Adjusted Price to Earnings Ratio, and it is a measure of long-term stock market valuations.)
Emerging market currencies are also very attractively valued, trading at an index level of 66 relative to their 10-year average of 92, which represents a discount of 39%. While many have feared what effect there may be on emerging market investments if the U.S. dollar strengthens further, many have also ignored the fact that emerging market currency valuations are already at very low levels. The U.S. may make a pivot towards more nationalistic trade policies, but if it does, it is possible that China will seek to fill the gap and make a pivot towards more global trade policies that benefit emerging markets.
In closing, U.S. and global economic growth has improved over the last quarter. A number of corporations are announcing hiring plans, wage rates are accelerating, and manufacturing data is improving. The stock market has responded positively to the increase in business and to the potential for tax reform from the new administration. However, much of the positive trend in economic growth was in place prior to the current administration taking office. Whether or not you are bullish on the market prospects of the new administration, we believe it is important not to conflate political leanings with long-term investment plans. Administrations may be positive or negative for the short-term investment climate, but economic growth and the long-term return potential it creates for equities are often unfazed by political posturing. Nevertheless, we would caution investors to not be complacent with respect to volatility. The market has enjoyed a strong rally and may be due for some choppy trading if there are delays in the implementation of a fiscal package or its magnitude and provisions disappoint. Rising rates may also present a challenge for traditional fixed income allocations, and Sage has taken measures to incorporate asset categories like high yield and unconstrained fixed income strategies into client portfolios in order to lower our interest rate risk. Lastly, concerning emerging market equities, although President Trump has toed a hard line with respect to global trade, we note that emerging market valuations have undergone significant devaluation over the last few years and may be at an inflection point if global growth continues to improve.
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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