2017 is off to a strong start with stocks, bonds and alternatives all up during the 1st quarter. The stock market rally that began last November with the presidential election has continued with little resistance. Increased optimism is being tested, however, as Congress appears unwilling to move quickly on the market-friendly reforms President Trump is pursuing. For an impatient market that has discounted lots of potential growth, a slower and possibly watered-down implementation of tax reform could cause stocks to take a breather and possibly give back some recent gains. Further gains will most likely be predicated on the success of the President to advance his economic agenda – deregulation of the financial and energy sectors, greater infrastructure spending, and corporate tax simplification that encourages capital spending rather than financial engineering.
Fundamentally, the economy continues to improve with job growth, increasing manufacturing activity, stronger corporate earnings and higher capital investment. This improvement has brought higher inflation, which has now reached the Fed’s target of 2%, and is climbing at a steep trajectory while providing the Fed cover for increasing short term rates at a faster pace than markets may like. Moreover, the Fed is openly discussing its plan to wind down the additional $3.5 trillion bond portfolio that was purchased to stimulate the economy after the financial crisis. Merely letting these bonds mature would amount to monetary tightening which is also a concern to the market.
Global economies are also on the rise with corporate profits in Emerging Markets and Japan improving the most following a difficult few years of earnings stagnation. Improving international fundamentals, both in developed and emerging markets, combined with low stock market valuations, particularly in emerging markets (12.1 forward P/E), argue for continued portfolio exposure. Stock valuations in the US continue to be at the high end of the historical range (currently 18.1 forward P/E vs. 70-year average of 15.7 P/E on the S&P 500) which argue for caution.
The variable that may create added volatility in both stocks and bonds is unexpected inflation. However, this alone is typically not the only cause of a bear market. Classic characteristics of a market top also include heavy stock inflows, an M&A boom, an abundance of IPOs, downward earnings revisions, and expanding credit risk spreads – none of which are present today.
1st Quarter 2017 Performance
- Stocks globally were up (↑7.0%), led by Emerging International (↑12.2%) and International Small Cap (↑9.2%)
- After a strong Q4 2016, US stocks underperformed global stocks in Q1 2017. US Small Cap had the smallest gain (↑2.5%) while US Large Cap gained (↑6.3%)
- The share spike in interest rates that followed the election and hurt bond prices stabilized in Q1. High quality municipal bonds increased (↑1.4%) during the quarter
- Credit strategies performed well from oversold levels led by Emerging Markets Debt posting the best returns (↑5.0%)
- Hedged equity strategies performed in line with expectations (↑2.8%) and represented 40% of market returns with 28% of market risk
- Multi alternative strategies with bond-like risk performed similarly to bonds despite their different underlying drivers (↑1.2%)
- Managed Futures strategies continue to struggle in the current low volatility environment (↑1.0%)
- After exceptionally strong gains in 2016, MLPs lost steam (↓0.9%) with energy prices decreasing late in the quarter
Chief Investment Officer