Market Outlook: March 2018

ECONOMIC SUMMARY

In February, the S&P suffered its worst month in two years, falling 3.9% and breaking a record-setting stretch in which stocks had risen for 15 consecutive months on a total-return basis. This happened despite the favorable combination of a strong labor market, solid economic and corporate profit growth, cycle highs for consumer confidence, manufacturing and leading indicators, and relatively benign levels of inflation. What is the source of this disconnect between markets and economic fundamentals?

We think the market is fearful that the new Fed Chairman Jerome Powell will abandon outgoing head Janet Yellen’s dovish pace of three quarter-point rate hikes last year, and instead substitute four or five hikes this year (maybe sneaking in a half-pointer along the way), with a similar plan for 2019. We did not get this from his testimony and think the market is overreacting.

Two signposts to watch. The delayed jobs report comes out on March 9, and investors will give particular focus to wage growth. Average hourly earnings rose for the fourth consecutive month in January by a stronger-than-expected year-over-year (y/y) gain of 2.9%, the strongest increase since June 2009. With the tightening labor market and President Trump’s December tax cut, we believe wage growth should tick up over the next year or so. Later this month, Powell will chair his first 2-day policy-setting meeting (we expect a quarter-point hike), and the market will be hanging on his every word and turn of phrase.

Nothing new under the sun. Over the course of the Fed’s 100-year history, the market has a tendency to greet the incoming Fed chair with a sharp 10-15% correction due to a lack of initial confidence. That decline tends to reverse itself by the end of that first year.  Fundamentals still matter!  Several recent key data points suggest the equity market is overreacting to initial Powell-related nervousness:

• Initial weekly unemployment claims (a leading economic and employment indicator) for the survey week that ended Feb. 24 fell to only 210,000 jobs, a new 49-year cycle low.
• S&P corporate profits for the fourth quarter are running up 15% y/y, with three quarters of the companies beating consensus estimates by 5%.
• ISM manufacturing index in February soared to 60.8 (a new 14-year high) from 59.1 in January.
• Conference Board’s consumer confidence index spiked to 130.8 in February (a new 18-year cycle high) from 124.3 in January.
• Leading Economic Indicators (LEI) in January leapt 1% to a new 58-year cycle high of 108.1, up from 107.0 in December.
• Domestic final sales (GDP minus volatile net trade and inventory) grew at 4.3% in the fourth quarter of 2017 on a quarter-over-quarter basis. That’s the fastest growth in domestic demand since the third quarter of 2014 versus 1.9% in the third quarter—much better than the nominal 2.5% GDP print. 

Despite solid economic growth, inflation does not appear to be a problem:

• Core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, has risen only 1.5% in each of the past three months through January, well below the Fed’s stated 2% core inflation target. 
• Core retail consumer price index (CPI) inflation (which strips out food and energy prices) was unchanged at a 1.8% y/y gain for the third time in the past four months in January. 

What’s wrong with these numbers? Absolutely nothing. So if the technicians continue to have temporarily seized control of the equity markets over the coming weeks, we suggest deploying dry powder and buying on weakness.

EQUITY MARKET SUMMARY

• February 2018 saw the S&P 500 index end 3.7% lower. The start of the equity market downturn in February were two economic surprises: the larger than expected growth in hourly wage earnings and that this might lead to a faster pace of Fed rate hikes. For the first time in more than two years, all the major equity asset classes showed a loss for the month. The Dow Jones Industrial Average (DJIA) fell 4.05% for the month while the NASDAQ Composite fell by 1.29%. The selling was synchronized globally as developed foreign markets as measured by the MSCI EAFE index decreased as well by 2.86% for the month while emerging markets stocks as measured by the MSCI Emerging Markets index decreased by 2.8% for the month.
• Expectations of higher growth from corporate tax reform have helped to increase the expected earnings per share in 2018 by 19%. The third quarter 2017 corporate earnings season so far have shown over three quarters of companies beating their earnings estimates and over two-thirds beat on revenue estimates. Six sectors are showing positive earnings growth for the quarter, led by the energy sector. Large cap stocks continued its outperformance versus small cap stocks for the month. This is the strongest earnings season in over eight years.
• Stock market volatility returned strongly with the CBOE Volatility Index (VIX) increasing to levels not seen since August 2015. Risk asset prices were down sharply, although they started to regain their strength as the month went on. Investors have become very sensitive to the possible uptick in inflation, with the annual wage growth increasing to 2.9%, a possible increase in the pace of Fed tightening, and the 10-year Treasury yield increasing towards 3%. There were 12 daily moves in the S&P 500 of at least 1%, already 5-% more than 2017’s total of eight.

  LARGE CAPS OUTPERFORM SMALLER CAPS YTD:

  Dow Jones	-0.30%
  S&P 500	1.01%
  Russell 2000	0.01%
  NASDAQ	5.13%

  GROWTH OUTPERFORMING VALUE YTD :

  Large Cap	3.48% vs. -1.67%
  Mid Cap	2.28% vs. -2.78%
  Small Cap	2.45% vs. 2.61%

   

• Best performers: Year to date through the end of October, the Technology sector has the best returns at 6.9% followed by Consumer Discretionary at 4.6%. While both sectors have benefited from reasonable valuations, the growth expectations of Technology and Healthcare have increased from an improvement in consumer sentiment over the last several months.
• Worst performers: Energy (-7.2%) and Utilities (-7%) have had the worst negative YTD returns with oil prices declining due to inventory supply/demand imbalances and Utilities with its high dividend payout ratios is suffering by being an income proxy with rising rates.

 FIXED INCOME SUMMARY

The 10-year Treasury yield increased 47 basis points (0.47%) to 2.86%, since the beginning of the year. This sizable increase came after a stronger than expected U.S. jobs report showed higher wage growth, which, along with resource constraints, commodity prices, and calendar effects from easy comps, are likely to boost inflation towards the Fed’s 2% target. 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).

U.S. fixed income investment performance is negative in all sectors through the end of February. The Barclays Aggregate index is down -2.09% YTD and the Barclays High Yield returned -0.26%. Municipal bonds are -1.47%, and U.S. Corporates have declined more than any other sector, -2.56%, driven by higher rates and wider spreads.

Year-to-Date Index Returns (as of 2/28):