QUARTERLY MARKET UPDATE as of April 2018
After a two-year absence, volatility reappeared in the stock market this quarter. A strong start to the year reversed course near the end of January, with equities giving back gains to finish down for the quarter. All major stock indices were off with the S & P 500 down 1%. Most of the sectors were down with Telecom Services, Consumer Staples, and Energy declining the most, while the Technology and Consumer Discretionary sectors were both up. In the bond market, interest rates increased about 1/3 of a percentage point across the yield curve. Meanwhile, the US Dollar index which measures the dollar against a basket of foreign currencies continued to weaken for the fifth straight quarter.
The Federal Reserve raised short term interest rates another ¼ point in March to a range of 1.5% to 1.75%. This was the sixth-rate increase since the end of the quantitative easing program in 2015. Two to three additional increases are expected this year depending on various economic factors, especially core inflation, unemployment, and growth. The Fed continues to be transparent with its expected actions, a positive for the markets. While the yield curve has been flattening over the last year, with shorter term rates increasing more than longer term rates, the curve is still upward sloping. If the yield curve flattens, with interest rates about the same across the yield curve, we may be concerned of a pending economic slowdown, but we do not see that happening this year.
The unemployment rate has been steadily declining since 2010 and now stands at 4.1%, with expectations this rate will dip below 4% this year. For several years now that steady decline brought forecasts of pending wage inflation that hadn’t materialized until this past quarter. The new tax law increased disposable income in January amid lower taxes and one-time bonuses. This produced the biggest annual increase in hourly earnings since 2009. The February report suggested this may have been a onetime pop up as the monthly change was a paltry 0.1%. However, we expect wages will remain under pressure from healthy economic growth, continued low and declining unemployment, and an increase in consumer spending driven by the tax cuts.
The economic projections of the Federal Reserve Board members for this year has unemployment declining to 3.8%, and GDP increasing 2.7%. Both figures improving from the last projection in December. As Chairman Powell stated, “some of the headwinds our economy faced in previous years have turned to tailwinds.”
Corporate earnings growth is strong. Per FactSet Research, the estimated earnings growth rate for the S & P 500 this year is 11.8%, the highest annual growth rate since 2011. All eleven sectors are projected to report year over year growth, while profit margins are expected to increase by 10.9%, the highest annual rate since FactSet began tracking the figures in 2008. Capital spending is also expected to accelerate. All are positives for stocks, but we temper our enthusiasm as that growth rate will be difficult to maintain.
Partially offsetting these factors are the continued increases in interest rates that serve as a breaking mechanism on the economy. Some would argue interest rates moving back towards historically normal levels will actually boost lending and economic activity. That in turn may accelerate inflation which would not be helpful to the markets. Less purchasing power and higher debt payments would subtract from economic vitality. So far inflation as measured by the core Personal Consumption Expenditures Index remains under the Fed’s target level of 2%.
The supply of Treasury notes will surge this year as the Federal Reserve shrinks its balance sheet and the U.S. budget deficit swells. Concerns exist that the supply of bonds will exceed demand and push interest rates higher. The supply of bonds over the last few years was at times insufficient to meet demand. Now the added supply is substantial. Yet demand from pension plans, hedge funds, insurance companies, banks, and individuals should be adequate enough to keep interest rates from surging. Although a reduction in demand from foreign buyers, especially China, may be an added concern.
A tariff war would be an obvious negative to the stock markets around the world. The initial announcement by the Trump administration of steel and aluminum tariffs hit global markets hard last month. After more details came out about the many countries that would be exempt from the tariffs the markets rebounded. It is a fair conclusion that what is actually being sought is an agreement with China to provide fair and reciprocal trading. As China and the U.S. continue to meet over these requests we are hopeful the eventual outcome will be a net positive. Nonetheless, this is another area of uncertainty that will develop over the upcoming quarters.
The positives for stocks still outweigh the negatives. Valuation metrics are mixed, with some showing the market is pricey while others show reasonable levels. We have consistently used a forward P/E as our main valuation tool. The current value of 17.5 is well within a reasonable level. For fixed income, we expect allocations will increase in balanced portfolios as interest rates rise making that asset class preferable over cash.