Monthly Markets Memo - February 2017
by Dan Zalipski & Scott Rosenquist, CFA
The recent rally has resumed after briefly pausing in January. Over the past month we have seen the equity indices all move higher. The latest move up is broad, includes developed markets, both domestic and abroad, as well as emerging markets.
While international markets are still working to get back to pre-crisis levels, the S&P 500 continues to make new highs. Investors also recently celebrated the Dow crossing 20,000 for the first time, a largely ceremonial mile marker. On the fixed income side, we have seen yields begin to grind higher as investors expect higher interest rates in the future, with the Fed potentially increasing rates two or three times this year. As yields move higher, bond prices decrease. It is no surprise to see indices such as the Barclays Aggregate Bond Index and the Barclays Investment Grade Corporate Bond Index negatively react to the move in yields over the past month.
The headlines this year have been dominated by fast-moving, somewhat chaotic political developments. Hidden beneath that noise is some news that is not getting the exposure it deserves: the U.S. economy is doing relatively well. Job growth remains at a level that is supportive to the low unemployment rate. Jobless claims remain near multi-decade lows. Manufacturing activity in the U.S. is expanding at an increasing rate. Retail sales and consumer spending are also trending higher. The Dallas, Kansas City, and Philadelphia surveys all indicate that businesses are increasing capital expenditures, investing to improve productivity and growth. We acknowledge that GDP growth has been running below its historical average, but are optimistic that growth may increase with the favorable economic conditions outlined above. That outlook is further supported by the potential for increased government spending via fiscal stimulus along with corporate tax cuts.
Another bright spot for the U.S. economy is corporate earnings. Earnings were in a technical recession with negative growth for six quarters starting in early 2015 due to a collapse in oil prices and a strong dollar. As those headwinds fade, earnings have rebounded with the fourth quarter of 2016, marking the second consecutive quarter of earnings growth since early 2015. The timing on this is fortunate, as earnings growth will be critical in generating returns going forward. In simple terms, investors value stocks by looking at earnings, and make a determination of how much they’re willing to pay for those expected earnings, known as a multiple. With multiples above historical averages suggesting stocks are on the more expensive side, investors begin to demand earnings growth to justify higher prices. Looking forward, corporate earnings may get an additional boost should President Trump’s corporate tax reforms become a reality.
Investors are reviewing recent comments from U.S. Federal Reserve Chair Janet Yellen on the outlook of the economy and the future path of interest rates. While the number of hikes is up for debate, the market has historically anticipated rate hikes accurately. The Fed will be data dependent, meaning upcoming economic data (employment and inflation) could potentially change their view. We are generally positioned for higher rates by limiting exposure to interest rate sensitive areas of the market, and have increased exposure to those areas that can benefit from higher rates, namely the financial sector and floating rate securities.
Tax reform is a developing story that will have an impact on the financial markets. Depending on how it is delivered, there could be implications for certain sectors of the economy and the U.S. dollar. This is something that we will continue to monitor as it will probably take some time to get through Congress. Given the complexity of forecasting interest rates and currencies along with policy uncertainty, it is important to focus on fundamentals and maintain a diversified portfolio.
“No one's ever achieved financial fitness with a January resolution that's abandoned by February.”
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