The second quarter saw financial markets deliver further gains, which was a continuation of the animal spirits that were unleashed in the wake of the U.S. election. Both stocks and bonds rose during the quarter with the S&P 500 making its latest record high in mid-June. Outside of the U.S., international stocks have picked up steam and are outperforming for the first time in several years. Commodities were the exception, as they were dragged down by crude oil prices that tumbled again. By the end of the quarter, stocks had drifted ever so slightly off their highs, but remained firmly in positive territory on the year. Meanwhile, interest rates were beginning to creep higher again.
Where’s the Hangover?
Earlier this year we wrote about how we’ve been anticipating a market hangover from the euphoria that started late last year. A hangover was evident in some areas of the market like bonds, gold, and other safe havens that rallied. But so far, equities have been a bastion of strength, as the S&P 500 Index hasn’t had a drawdown of even 3% this year. While the broad market has remained relatively calm, it has masked a dramatic difference in performance between so-called “growth” sectors (like Technology and Health Care) that have led by a wide margin and “value” sectors (like Financials and Energy), which have trailed. It has been a stark reversal from what occurred immediately following the election, when value sectors soared into the end of the year. In other words, so far, the hangover may have taken the form of an internal rotation within the market, as opposed to a decline in the index itself.
While the market’s resiliency is impressive, the potential for a hangover has not completely gone away. Contrary to expectations from just a few months ago, very little progress has been made on the political front. From a market standpoint, a big reason that stocks rallied immediately following the election was the result of investors quickly anticipating the likelihood of several business-friendly pieces of legislation being easily passed with a Republican controlled White House and Congress. However, priorities of the administration that have been discussed (health care reform, fiscal stimulus, and infrastructure spending) are all on hold at the moment.
For now, investors seem to be recalibrating their expectations, but not abandoning hope that these items will still get done. However, if it becomes more apparent that some of it may not be achievable after all, it could cause a sudden setback in the market. Indeed, there are reasons to believe that the market may be overly complacent about the possibility of major political disappointments. For instance, measures of market volatility sank to multi-year lows during the quarter, which is often a contrary signal that things are ‘too quiet.’ If a correction does materialize, it may be an opportunity to nudge portfolio equity weightings a little higher, as we don’t believe this would halt the economy in its tracks. Growth may continue along at a more sluggish pace, but the market outlook doesn’t depend solely on assistance from Washington.
On the economic front, after another weak performance in the first quarter with GDP growth of only 1.4% (revised up from only 0.7% initially), all indications are that a rebound occurred in the second quarter. In fact, a forecasting model produced by the Atlanta Federal Reserve Bank suggests growth climbed back to 2.6%. Looking ahead, the economy should continue to be supported through the remainder of the year thanks in part to a recent improvement in overall financial conditions caused by a fall in both interest rates and oil prices during the quarter. Along with ongoing steady gains in the labor market, this should help to lift consumer spending over the second half of the year.
Perhaps more importantly, while the overall trend in growth still has not meaningfully accelerated, corporate earnings have recovered significantly. The growth rate in earnings jumped to nearly 15% in the first quarter from a year earlier—the third consecutive quarter of gains after the earnings recession that occurred in 2015-16. Corporate America has displayed a remarkable ability to grow earnings (thanks largely to rapid technological innovation that has helped lower costs), even though revenue growth has been restrained by low GDP growth. If any progress is made on corporate tax reform along the lines of what has been proposed, that could give another boost to earnings and help prolong the cycle.
Shifting Sands with Central Banks
The U.S. Federal Reserve continued its campaign of gradual interest rate increases by hiking rates a quarter point for a third time in June. The bigger news came from their announcement that later this year they intend to reduce the size of their massive $4.5 trillion balance sheet. Just as large-scale asset purchases had never been attempted before, reversing them is also untested, and therefore the possibility for unintended consequences causing volatility certainly exists. So far, market participants have taken the Fed at their word that they’ll continue to proceed cautiously in removing the punch bowl. But business cycles have historically ended due to the Fed becoming overly restrictive, so investors will need to be on guard despite assurances from central bankers.
Another big change during the quarter came from the European Central Bank, which began to lay the groundwork for an announcement regarding the winding down of their own monetary accommodation. If true, it would be a significant development in that another major central bank would be joining the Fed in reigning in the monetary support that markets have become accustomed to. However, for the time being, overall stimulus will continue to increase, even if the ECB decides to taper their asset purchases next year. For the next several quarters at least, both the ECB and the Bank of Japan will be providing plenty of liquidity to global markets, despite the Fed moving further down the path of tightening. All told, it does not appear that the actions of global central banks will translate into a restrictive posture for the next 12 months or so. Beyond that, it could be a different story.
Overall, portfolio volatility is being kept close to neutral. While there is still plenty to be encouraged about, late in an expansion with elevated market valuation is not the time to be taking unnecessary risk. However, there are areas of relative value to take advantage of within asset classes. For instance, within the U.S. equity allocation, we continue to carry a tilt towards cyclical sectors like Financials and Homebuilders, while remaining underweight in defensive and late cycle sectors like Utilities and Materials.
In addition, we increased our allocation to international equities to a modest overweight during the quarter. There have been notable improvements in many global markets this year, such as an uptick in economic growth, a reduction in political risk, and rising earnings growth. When combined with more attractive valuation, it may finally be time for international stocks to play catch up after several years of underperformance.
Within fixed income, we are carrying an underweighted position to interest-rate sensitivity through a reduction in the highest quality bonds that are the most exposed to potential losses if rates rise. We are also positioned to be overweight to credit-sensitive areas and very short-maturity bonds, both of which should defend much better in a rising rate environment.
In commodities, we continue to carry an over weighted position to gold, relative to the broad commodity index which has significantly outperformed this year. However, with liquidity possibly peaking due to central bank tightening, it may be a candidate to be reduced in the second half.
The second quarter was another positive one for financial markets. Longer-term, we continue to believe that stocks are in the midst of a cyclical bull market that began in February 2016, and should be able to proceed as long as the business cycle remains intact.
Of course there are potential risks to guard against that could cause a correction at any time, including Fed tightening, lack of progress on business-friendly legislation, and overvaluation. But there still seems to be a healthy dose of skepticism which has prevented many participants from fully embracing this move in the market, suggesting that outside of short-term pullbacks, there is more room to run before this bull finally tires.
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