Plum Street Advisors
Q1 2017 Market Commentary – April 11, 2017
Reading the headlines, one might have expected a volatile first quarter in the markets. After all, since President Trump was inaugurated in January he has had to confront intelligence investigations into Russian election meddling, had difficulty getting his cabinet confirmed, seen his executive orders on immigration halted, and failed to pass the American Health Care Act in March. Still, we saw the S&P 500 notch gains in each of the first three months of 2017. It seems the market doesn’t care very much about intelligence investigations, cabinet positions, executive orders, or healthcare bills (except to the extent any of these might make things it does care about – like tax cuts and deregulation – harder in the future). The market is focused on fundamentals. For example, corporate earnings are expected to be up 9.1% year-over-year in the first quarter, according to Factset. Estimates for the rest of 2017 are also continuing to hold up well, in contrast to both 2015 and 2016, when we saw earnings growth expectations evaporate to almost nothing before the year even really got started.
So what’s driving better earnings estimates? We’re seeing widespread gains as the economy continues to slowly improve. Energy is clearly the most changed from last year. Energy companies went from a combined loss in the first quarter of 2016 back to profitability this year. The energy sector gains are being driven by a recovery in energy prices – in March 31, 2016 crude oil stood at $42.79 per gallon while at the end of this quarter it was back up to $50.60. Financials, Tech, and Materials companies are also expected to post double digit earnings growth on a year-over-year basis this quarter. Furthermore, it’s not just earnings from margin improvement – revenue growth is also expected to revive this year. For the first quarter, energy companies are estimated to see 35% revenue growth, followed by technology (+8.5% revenue growth), utilities (+8.1%) and financials (+7.1%).
Looking at the overall economy, “soft” indicators are signaling more bullishness than “hard” indicators. Soft indicators, like consumer confidence surveys and regional manufacturing surveys, are hitting recent highs and pointing to strong continued growth. “Hard” indicators, like consumer expenditures, construction spending, and trade data, are pointing toward weaker growth. If we assume that the soft indicators are more forward looking, it would be reasonable to expect unimpressive first quarter GDP growth of around 1% or less, but strengthening GDP growth in the remainder of the year. Current positive sentiment should continue to be supported by the growth in house prices and in stock market values as well as by lower personal debt levels and easier borrowing.
As we look ahead to the remainder of the year, we will keep a close eye on emerging inflation data. Wage growth has been quietly accelerating on the one hand, while on the other hand we’re also seeing personal consumption expenses going up – from less than 1% (year-over-year) to over 2% in the latest reading in February.
The late-year rally of 2016 extended into the first quarter of 2017, although leadership changed from value stocks to growth stocks. Overall, the Russell 1000 large cap index returned 6.03% for the quarter. Small cap value stocks, which had led the rally last year, fell back a bit and returned -0.13%, as markets became concerned about the impact of rising rates on small companies.
Internationally, the MSCI EAFE index of developed country equities had a solid net return of 7.25%, led by Asian countries (ex Japan), as well as strong returns from Spain and The Netherlands. Emerging markets posted a very good quarter, with an 11.44% net return for the MSCI emerging markets index.
Overall, bonds did reasonably well in the first quarter, with the Bloomberg Barclays US Aggregate bond index returning 0.8% for the quarter. Corporate securities continued their rally, with the riskiest bonds outperforming sharply. The strongest performers were emerging markets bonds, convertibles, and high yield bonds. High yield has been performing well as defaults rates continue to decline.
The Bloomberg Commodity Index was off -2.3% for the quarter. The slight decline was led by
natural gas, which fell by 14.3% over the quarter. Gold, on the other hand, was the largest positive contributor to the index. Gold has been testing highs recently, rising to almost $1,250 at quarter end. Inflation data has been supportive for precious metals prices, as inflation (as measured by the personal consumption expenditures price index) is now meeting, and even slightly exceeding, the Fed’s 2% target.
While valuation metrics suggest stock prices are high based on price to earnings measures, the market is reacting to positive momentum in corporate earnings and revenues as well as positive forward-looking economic indicators. Consumers are not overly leveraged – in fact, consumer debt payments as a percent of disposable income are near record lows (9.98% for Q4 2016, compared to 13.21% in Q4 2007). Lower debt levels suggest the US economy has stronger foundations than in other rallies we’ve seen recently.
There has been concern that the lack of Republican unity shown in the failure of the American Health Care act means that President Trump will have a harder time passing his tax and regulatory agenda. We have not seen any substantial negative impacts on the market, which we attribute partly to the strength in corporate fundamentals, as mentioned above, and at least partly to greater clarity from President Trump’s first 75 days in office. The regulatory agenda continues to be a priority. Tax cuts may be delayed, but the worst-case scenario for companies seems to be that at least there will be no increases. Importantly, fears that Trump would start a trade war have lessened as his early approach seems to be the opposite of President Teddy Roosevelt’s mantra of speak softly and carry a big stick – so far President Trump’s mantra has been to speak loudly and carry a small stick as far as trade is concerned, and the market can get on board with that.