Equity markets moved higher in March, and international stocks led the way with strong returns. Foreign developed and emerging market equities returned more than 2.0% during the month, boosted by positive political developments in the Netherlands and France. Although the United Kingdom officially triggered the Brexit process during the month, this was widely anticipated, and the renegotiation of trade terms will be a long, drawn out process over the next couple of years. As a result, equity markets had little reaction to the official filing of Britain’s departure from membership in the European Union. U.S. stocks were mixed, with the S&P 500 Index slightly higher and mid cap stocks slightly lower in March. Emerging market bonds performed very well during the month, with a blended index of USD-denominated and local currency debt returning more than 1.3%.
The Federal Reserve raised the target for the Federal Funds rate during the March meeting to a range of 0.75% to 1.00%. The Fed noted improvements in the job market, moderate gains in inflation readings, and steady growth in the U.S. economy. It projected two more rate hikes this year but indicated that this forecast is dependent upon economic and market forces.
Emerging market equities are one of the strongest performing asset classes this year, with returns of 11.45%. The S&P 500 Index also had a strong first quarter and gained 6.07%.
Despite concerns over political elections in the Netherlands, France, and Italy, international developed markets have performed very well since the start the year. The MSCI All Country World Ex US Index returned 7.86% in the first quarter. Fixed income investments have generated positive but more modest returns. Core bond indices like the Barclays U.S. Aggregate and the Barclays Municipal Index have risen 0.82% and 1.58%, respectively. Emerging market bonds have performed very well to start the year, with a blended U.S. dollar and local currency index returning 5.19%.
It may come as a surprise to investors that international stocks have started the year on such a strong note. Developed market international equities returned more than 7% and emerging market equities returned more than 11% in the first quarter. Heading into 2017, political risks, both in the U.S. and abroad, garnered significant attention, as did how those risks might cast a cloud over international equity returns. Despite these potential risks, diversified portfolios have been well served by their international equity exposure.
To recap, we knew heading into 2017 that there would be numerous political events that could lead to trouble for international markets this year. The Netherlands had a general election in March, which posed a risk if the pro-nationalist (and anti-EU) candidate Geert Wilders picked up seats. France’s presidential election is set for later in April, and the far right wing candidate Marine Le Pen has received much press attention with her anti-establishment rhetoric. Lingering in the background was the outcome of the British referendum on EU membership, the exit from which was set to be officially triggered in March. Later in 2017, Germany and Italy are also holding general elections. Despite all of these potential “risks” to the EU system, international equities, led in part by European stocks, have performed very well.
Why has this been the case if there is seemingly so much risk to the system? For starters, many pundits were caught off guard by the outcomes of the British referendum and the U.S. presidential election last year. Fool me once, shame on you; fool me twice, shame on me; and fool me three times … well, very few wished to be on the wrong foot for yet another political surprise. As a result, they erred on the side of projecting caution with the EU.
So far, however, some of the aforementioned elections have tilted towards centrist, pro-EU parties rather than the populist uprising that many predicted. Pro-EU surprised in the Dutch elections, a pro-EU candidate is currently leading in Germany’s early nomination process, and Marine Le Pen’s poll numbers have declined steadily since her late 2016 surge. Although the Italian election poses the risk that an anti-EU party seizes power, the country has also seen 44 different governments in the last 50 years. Suffice it to say, political upheaval is nothing new there. In summary, the combination of extremely negative sentiment toward international markets to start the year and positive political outcomes has led to a relief rally in international equities.
But relief hasn’t been the only factor driving international stocks higher. Economic growth has improved as well. After experiencing a double-dip recession in 2011-2012, the Eurozone has lagged the U.S. in terms of equity market returns and economic growth over the last five years. However, real GDP growth was similar between the two continents in the last calendar year, and private investment in the Eurozone significantly outpaced that in the U.S.
The Eurozone service sector confidence hit its highest level in the last 9 years during the first quarter. Eurozone home prices are also increasing at the fastest rate during the current expansion. Simply put, the Eurozone has been boosted by accelerating economic data along with better than expected political outcomes. Though some may be concerned that the “Trump Rally” may be derailed if his economic agenda runs out of steam, this line of thinking ignores the fact that global economic data abroad has been fairly strong and underpinned international equity returns more than U.S. stimulus hopes. It is misleading at best merely to depict economic strength and equity market gains in Europe as a “Trump Rally.”
As for conditions in the U.S., the defeat of the Republicans’ healthcare proposal led to some volatility in the stock market because some questioned the likelihood that a tax reform package would (easily) be passed. Given how strong equity returns have been to start the year – stocks in the S&P 500 Index are up over 6%, which is a solid return for a full year, let alone the first three months of 2017 – it is not a surprise to see the market retrace some of its gains. Whether volatility picks up further will depend on a few factors. First, the market rally over the last year has not hinged entirely on hopes of some grand Trump stimulus. Rather, the primary driving factor has been a recovery in earnings and economic growth from weak levels at the end of 2015 and the start of 2016. If economic growth holds steady or continues at its recent pace, equity markets should be bolstered from a deep correction.
This is not to say that there won’t be a downturn in stocks this year. Indeed, it would be unusual if a downturn did not occur, for JP Morgan estimates that stocks undergo a 14% correction, on average, in any given calendar year. We mention this to encourage investors to remain diligent if equity markets do experience some volatility, because (1) it is a normal event and (2) there is a strong economic backdrop supporting corporate earnings. Although corporate earnings may have a hard time reaching the projection of 20% plus growth by the end of this year (they do not have the easy year-over-year hurdle that they had in the last year), there is still a strong job market and increased business confidence to push earnings higher.
An additional source of potential volatility could be future Federal Reserve action. The Federal Reserve raised rates to a new range of 0.75% to 1.00% at its March meeting, a move that many expected. What was less certain, however, was the tone the Fed would take in its statement regarding future rate hikes. If there had been a shift towards a more hawkish tone, and a signal of an accelerated timeline for future rate hikes, the market would have potentially reacted negatively. However, the Fed struck a moderate tone and continued to underscore its reliance on hard and fast economic data, as opposed to an anticipation of further acceleration in the data, before adjusting its rate hike forecast higher. The distinction is important, because some have speculated that any economic momentum that may be generated by the current administration’s fiscal agenda could be thwarted if the Fed preemptively reacts to curb animal spirits. Instead, the Fed does not wish to pre-empt any potential fiscal stimulus but will wait to see the inflationary effects of it, if it does occur at all. This was one concern for emerging markets to start the year; a more aggressive Fed policy would likely result in a stronger dollar, which could in turn pressure emerging market currencies.
That has not played out so far. With fiscal stimulus appearing to be less of a sure thing and the Fed holding a moderate position, the dollar has weakened by more than 2.0% this year against a basket of currencies. Further, export-reliant countries, such as Mexico and Korea, that stood to face the brunt of a Trump imposed border tax have seen their currencies rise by more than 8%, each, as a result of a softer tone from the administration with respect to trade tariffs. The fact that President Trump has surrounded himself with bankers who have seen the fruits of global trade, such as Steve Mnuchin, Gary Cohn, and Wilbur Ross, has given greater confidence to the idea that a trade war is not imminent.
The potential for a softer trade policy, combined with less attractive returns from U.S. fixed income securities due to rising rates, has put emerging market bonds in the spotlight this year. The chart below compares emerging market (EM) and developed market (DM) bond yields. As has been widely discussed in the financial press, DM bonds offer yields of below 2.0%.
However, EM bonds offer yields over 6.0%, and the spread between the two (the blue area on the chart) illustrates that the spread is attractive relative to historical levels. This is one area of the portfolio with which Sage has urged investors to be patient, because it can be a volatile asset class that underperforms U.S.-based assets at times. However, emerging market bonds outperformed U.S. bonds last year and have continued to do so this year. Based on improving economic fundamentals and the attractive premium in yields, which is highlighted in the chart, we continue to believe emerging market bonds warrant a place in a diversified investor’s portfolio.
In conclusion, the first quarter of 2017 was a strong one for stocks. International and emerging market equities outperformed U.S. stocks, and all were broadly positive. Bonds have also generated positive returns, with outperformance coming from areas like emerging market bonds and high yield bonds relative to the core U.S. bond indices. The pickup in international equity returns may come as a surprise to observers who were convinced that political risk would weigh heavily on international markets. However, early election results and polling in key areas like France have favored a more centrist, pro-EU platform instead of the populist uprising that many predicted after mistakenly dismissing Brexit and the Trump victory. Europe has also been buoyed by improving economic growth, which has begun to eclipse growth in the U.S. for the first time in years. Improving economic growth has also helped spur emerging market equities on to double-digit returns, in spite of fears that President Trump would pursue a trade war. We are encouraged by the contributions these areas have made to diversified portfolios and will continue to monitor economic and political developments as they relate to the investments we hold in your portfolio.
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