Slight deceleration in economic growth. Economic growth in the U.S. was revised downward slightly to a rate of 2.6% in the fourth quarter of 2017. The slight deceleration in real Gross Domestic Product (GDP) growth came from a wider trade deficit (more imports than exports) and a slowdown in inventories. Strong consumer spending growth of 3.8% annualized partially offset the reduction. We expect economic growth to increase in the first half of 2018 due to tax cuts with a possible slowdown in the second half of the year.
Continued job growth. The U.S. economy added 200,000 jobs last month, slightly higher than expected and accompanied by a downward revision to the previous month’s number. The unemployment rate stayed the same at 4.4% and the participation rate stayed at 62.7%. Wage growth increased slightly to 2.3% year-over-year as wage pressures increased. We are reaching full employment in our economy, which could limit U.S. economic growth in 2019 and beyond.
Inflation shows continued firming. While the headline consumer price index (CPI) decreased slightly to 2.1% year over year, the year over year core measure (less food and energy) rose to 1.8% from rising home prices and medical costs. Increases in gasoline and rent were the major reasons for the increase. Wage growth is showing signs of increasing which is causing investors some concern that rates will go up faster than expected. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, which covers a wide range of household spending items, decreased slightly to 1.7%.
Corporate profits show continued strength. With over two-thirds of companies reporting, corporate profit estimates show a 20% year over year growth rate. Sectors showing particular profit strength include materials, energy, health care and technology. Fourth quarter 2017 revenues are estimated to have risen over 8% year over year, the strongest growth rate since the 4th quarter of 2011. Almost 70% of companies are beating revenue estimates, coming from the weakening U.S. dollar, rebound in energy prices and stronger economic growth both domestically and internationally. Many companies are announcing one-time tax charges from the Tax Cuts and Jobs Act. Many companies have increased their profit guidance for 2018.
The Federal Reserve and interest rates. The Federal Open Market Committee (FOMC) did not change the federal funds rate at their meeting last week. This meeting was Chair Yellen’s final meeting with Jerome Powell taking over. The Fed funds rate projections denote three rate hikes this year, in keeping with expectations. They also will continue with the gradual reductions of its balance sheet holdings of Treasuries and mortgage-backed securities. This should put slightly more upward pressure on rates along with several new voting members of the committee and a new chair. The expectation is for 3-4 rate hikes this year.
EQUITY MARKET SUMMARY
- The market continued to accelerate in January reaching new highs daily. The S&P added 5.72% during the month, the Dow Jones Industrial Average (DJIA) advanced 5.88%, and the NASDAQ Composite 7.40%. Small cap stocks (Russell 2000) lagged larger cap stocks, but were still up 2.61%. The S&P 500 experienced some mild volatility around US gov’t shutdown noise but that was largely a distraction as the key macro tailwinds remain in place (solid growth, tame inflation, acquiescent central banks, robust corporate fundamentals, tax anticipation, capital return, M&A, etc.). Developed foreign markets as measured by the MSCI EAFE index increased by 5.03% for the month, while emerging markets stocks were strongest up 8.32%.
- Stock market volatility ticked up toward the end of the month with the CBOE Volatility Index (VIX) ending the month up 22.6% after being flat for most of the month.
- Expectations for corporate tax reform tempered by fears of more rapidly rising interest rates should help drive the U.S. equity markets going forward. Earnings growth will be critical to further market gains given that current valuations are at roughly long term equilibrium levels, after taking into account the impact of the recently passed tax reform.
LARGE CAPS OUTPERFORM SMALLER CAPS YTD:
Dow Jones 5.9% S&P 500 5.7% Russell 2000 2.6%
GROWTH OUTPERFORMING VALUE YTD :
Large Cap 7.2% vs. 4.1% Mid Cap 5.7% vs. 2.3% Small Cap 3.9% vs. 1.2%
- Best performers: The best performing sectors in January were Consumer Discretionary +9.32%, driven by Retailers. The National Retail Federation reported a 5.5% spending increase in the 2017 holiday season, which was the biggest year over year increase in more than a decade. Information Technology +7.63%, followed by Healthcare (+6.65%), and Financials (+6.48%), continued their outperformance in 2017, driven by solid earnings and an expected tailwind from higher rates.
- Worst performers: Utilities (-3.07%), Real Estate (-1.89%), and Telecom (+0.55%) were the worst performing sectors in January. Typically, your interest rate sensitive sectors, it makes sense that they would be weak given the sell-off in the 10 year Treasury.
- All International markets perform well; Emerging markets shine. The MSCI Emerging Markets Index was the best performing asset class of the month (+8.32%) for the month, and the MSCI EAFE (Developed Int’l) Index returned +5.03%. Higher growth and gains from currency movements such as the weakening dollar were drivers.
FIXED INCOME SUMMARY
The 10-year Treasury yield increased 32 basis points (0.32%) to 2.71%. This sizable increase came after a stronger than expected U.S. jobs report that showed higher wage growth. The wage growth spooked markets into revising their expectations upward about inflation. This yield increase also reflects concern that the Fed may take a more “hawkish” tone towards improving economic growth (the possibility the Fed may have more than three rate hikes this year to stem increasing expectations of inflation).
Historically, rising rates from very low levels does not cause stocks to decline. Rising Treasury yields from these levels usually does not lead to falling stock prices. Usually the equity markets decline only when rates rise from higher levels than they are now, because when that happens, it tends to be a sign of inflation, whereas rising rates from low levels (as they are now) is a sign of increasing economic growth. The bond market sold off last week most probably due to an overdue correction from a long period of remarkably little volatility.
U.S. fixed income investment performance is negative year-to-date except for high yield. The Barclays Aggregate index dipped by 1.15% YTD and the Barclays High Yield returned 0.6%. Municipal bonds declined the most of any sector by 1.18% and U.S. Corporates have declined by 0.96% so far. The sell-off in muni bonds has been driven by the sell-off in Treasuries and a steepening of the curve, which had really flattened toward the end of 2017. The impact of tax reform on individual investors was largely a non-issue and demand should theoretically see a bit of a lift in higher tax states due to SALT limitations.
Year-to-Date Index Returns (as of 1/31):
|Barclays Global Agg||-0.45%|
|Barclays U.S. High Yield||0.60%|
|Barclays Muni Agg||-1.18%|