The first quarter of 2017 was dominated by political headlines, firming economic data, and stronger corporate earnings. After an initial wave of bullish sentiment leading up to and following the inauguration of President Trump, a wave of bearish pessimism swept over Wall Street in March as Congress failed to repeal and replace the Affordable Care Act (ACA). Investors muse that if Congress—and a seemingly fractured Republican majority—is unable to fix health care now, then perhaps the key economic pillars of “Trumponomics,” such as tax reform, deregulation and repatriation, won’t pass either. The stock market has traded more sideways during the month of March, but the underlying economic picture has been a positive one so far this year.
Core inflation continues to quietly grind higher. The Department of Commerce reported the core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—rose to 1.8% in February 2017 on an annualized year-over-year (y/y) basis. It also revised January’s reading up a tick to 1.8%. Those are the highest levels we’ve seen since October 2012, a more than 4-year high. Core PCE inflation, which had troughed at 1.3% in July 2015, has been moving higher over the past two years, although it remains below the Fed’s oft-stated 2% inflation target. Over the past three months, core PCE inflation on a month-over-month basis has inched up 0.2% in February, 0.3% in January and 0.1% in December, which translates into an annualized increase of 2.5% on the basis of this 3-month core rate. So the more recent 3-month data shows an accelerating trend of core inflation over the trailing 12-month results.
Other measures of inflation tell the same story. The core wholesale inflation producer price index (PPI), which strips out volatile food, energy and trade prices, reached a 2½-year high in March, and core year-over-year consumer price index (CPI), a retail inflation measure that also strips out volatile food and energy prices, although it slipped a tick in February, matched its highest reading in nearly five years (April 2012).
Wage growth is recovering. Wage inflation troughed at a 1.5% increase year over year in October 2012, and rose 2.8% annually in February 2017. Other than a spike to a 2.9% growth rate in December 2016, this is the healthiest wage growth has been since June 2009, which is when the Great Recession was coming to an end. We expect this positive trend to continue, with wage inflation rising up to perhaps 4% year over year over the next two years.
Energy prices have bottomed. Crude oil prices, as measured by West Texas intermediate (WTI), had plunged 75% from $108 per barrel in June 2014 to a 12-year low of $26 in February 2016. Since then, crude has more than doubled to $55 per barrel in this year’s first quarter. That’s because Saudi Arabia finally got serious about coordinated production cuts to firm prices with an historic OPEC and non-OPEC accord to cut 1.8 million barrels a day from production starting this past January 1. A trading range of perhaps $40-60 per barrel now seems appropriate over the balance of 2017. But that sharp recovery in crude—and a narrower trading range over the past several months— has helped to stabilize nominal inflation trends.
Housing prices have accelerated. Home prices in the 20 largest U.S. cities rose 5.7% in January 2017, their fastest pace since July 2014, according to the lagging Case-Shiller index, which measures housing prices on a rolling 3-month average basis. Both new and existing home sales have been strong, thanks to low mortgage rates, a solid labor market, rising wages and increased household formations, while prices have risen steadily due to a lack of inventory. The strength of the housing market has contributed to the increase in both nominal and core inflation, a trend that we anticipate will continue.
Upside risks to economic growth and inflation? The Fed recently hiked interest rates by a quarter point at it mid-March 2017 meeting, its second such hike in three months’ time and third hike since exiting its zero-bound policy in December 2015. Our view is the Fed is on tap to hike two more times this year. But in light of the increase in inflation and the continued strength in the labor market, some policymakers are hinting that perhaps a more rapid retreat from monetary-policy accommodation is appropriate, with maybe three or more hikes this year. In addition, the Fed may also begin to unwind its $4.5 trillion balance sheet before the end of calendar 2017, which we expect will be Janet Yellen’s last as Fed chair.
We continue to believe stronger economic and corporate earnings growth and rising levels of inflation due to potential structural fiscal-policy reforms by the Trump administration will prompt the Fed to continue to hike interest rates. This should drive both bond yields and stock prices higher over time.
Equity Market Summary
THE FIRST QUARTER OF 2017 WAS DOMINATED BY POLITICAL HEADLINES AND STRENGTHENING ECONOMIC DATA GLOBALLY. This trend gave positive momentum to the S&P 500 Index as it finished nearly 6.1% higher for the quarter although it was essentially flat for the month of March. Emerging markets increased by 11.45% for the quarter due to improved optimism on global growth. Oil prices declined approximately 6% for the quarter which weighed on the energy sector (down about 6.7% QTD) as well as overall commodity returns. The price declines come on the heels of concerns of higher inventory levels. With the oil price surge slowing, a rapid increase in inflation seems unlikely. Consumer confidence readings in the U.S. increased to a 16-year high which reflects continued improvement in future economic conditions. REITs also performed well as housing data continues to improve. With the markets poised to digest the new set of quarterly corporate earnings beginning in April, a rotation has been going on in many asset classes and sectors the first quarter of 2017. The “Trump trade” winners we saw at the end of 2016 of the U.S. dollar, U.S. small caps, financials and energy have given up some gains while technology has surged YTD of over 12%. The Trump-inspired rally for the year did lose some steam in March due to policy missteps (e.g., inability to pass healthcare reform) which caused investors some concern that it will inhibit the Administration’s ability to stimulate economic growth and improve corporate earnings. While the year following a presidential election typically shows a bounce in equity markets, there will be at least several quarters before proposed changes by the administration, including tax reform, lead to improvements in corporate profitability.
LARGE CAPS OUTPERFORM SMALLER CAPS YTD:
GROWTH OUTPERFORMING VALUE YTD :
|Large Cap||8.91% vs. 3.27%|
|Mid Cap||6.59% vs. 3.76%|
|Small Cap||5.35% vs. -0.13%|
Best performers: Year to date through the end of March, the Technology sector has the best returns at 12.6% followed by Consumer Discretionary at 8.4%. While both sectors have benefited from reasonable valuations, the growth expectations of Technology and Consumer Discretionary have increased from an improvement in consumer sentiment over the last several months.
Worst performers: Energy (-6.7%) and Telecom (-4%) have had the worst negative YTD returns with oil prices declining due to inventory supply/demand imbalances. Telecom with its high dividend payout ratios is suffering by being an income proxy with rising rates. Some of the pullback has to do with higher valuations in these 2 sectors with their strong performance in 2016.
Emerging markets solidly outperformed developed markets as higher growth and gains from currency movements such as the weakening dollar contributed to the 11.44% YTD gain of the MSCI EM (Emerging Markets) compared to a YTD gain of 7.25% by the MSCI EAFE (the more developed market international index).
We continue to think a balanced portfolio including alternatives continues to be appropriate for investors. While we do see some continued upside in equities, we believe returns will be muted with slow but positive economic growth which will limit corporate earnings growth. Valuations on equities have generally moved higher in anticipation of higher growth so prudent to not overreact (and overinvest) in sectors that may have gotten ahead of improving fundamentals.
Fixed Income Summary
- The Federal Open Market Committee (FOMC) raised the target federal funds rate by 25 basis points (0.25%) at its March meeting, as largely expected to 1.0%, its third increase since beginning to raise rates in December 2015.
- Rising inflation is the perennial scourge of fixed-income investors, as the resulting erosion of purchasing power forces bond investors to demand higher nominal yields and lower prices to compensate for the additional risk. So, with the all the inflation metrics we monitor slowly rising to multiyear highs, the Fed’s path toward a tighter monetary policy appears correct.
- The 10-year US Treasury yield: Over the past three weeks or so, benchmark 10-year Treasury yields have actually fallen, from 2.63% to 2.35%, which is surprising given rising inflation. We suspect this is just a short-term, counter-trend, flight-to-safety rally in bonds, as equity investors needed a near-term place to hide while the S&P 500 corrected 3.3% amid the recent health-care policy debacle in Washington.
- Fixed income investment performance remains muted year-to-date, with the Barclays U.S. Agg up 0.82%. High yield continues to be the best performing asset class +2.7% year-to-date, but it is beginning to seem pretty expensive, and actually weaker month-over-month (+2.9% through Feb). Munis are having a better year +1.6% YTD, recovering from election fears of tax reform reducing their attractiveness to high net worth investors. U.S. high yield has been the leading domestic asset class in fixed income for the year at 2.93%. Global bonds are outperforming domestic: Global Agg +2.0% YTD.
YEAR-TO-DATE INDEX RETURNS (3/31)
|Barclays Global Aggregate||+2.01%|
|Barclays US Aggregate||+0.82%|
|Barclays US Intermediate Government/Credit||+0.78%|
|Barclays US Corporate High Yield||+2.70%|
|Barclays Municipal Bond||+1.58%|
About the Authors
Kristin Bell joined Southeastern Trust in May 2015 as Vice President and Portfolio Manager. Kristin came to STC with more than seventeen years experience in investment related analysis, trading, and portfolio management, including roles at Unum Group, Wachovia Bank, and Fidelity Investments. Kristin holds a B.A. in Psychology from Wheaton College as well as the Chartered Financial Analyst designation. She has previously served on the board of St. Peter’s Episcopal School and as Treasurer for the Thrasher School PTA Executive Board.
Robert Clark joined STC in November 2012. He has over a decade of experience in wealth management and has held a number of roles within super-regional financial institutions. Robert holds both the Chartered Financial Analyst designation as well as the Certified Financial Planner designation. He obtained his M.B.A. from Wake Forest University, is a graduate of the U.S. Naval Academy and spent five years as a Naval Officer. Robert is a member of the East TN Society of Financial Analysts.