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July 10, 2017
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August 30, 2017

2017 Second Quarter Market Review

John Fischer, CFA®, CFP® | Chief Investment Officer

In the classic movie Groundhog Day, Bill Murray plays a troubled character who is forced to relive the same day over and over again.  Though Murray wakes up to a new day, he has the same daily experiences and endures the exact same challenges.  The second quarter was reminiscent of the movie.  Similar to the first quarter, we saw solid corporate earnings growth, respectable economic numbers, a persistent low interest rate environment, and continued hope by investors that the pro-growth policies proposed by the Trump administration would eventually provide a boost to the U.S. economy.  The second quarter also brought more of the same in terms of returns with every major asset class finishing in positive territory again.  However, the challenges from the first quarter also carried over to the second quarter in the form of policy uncertainty of President Trump’s administration, geopolitical risks, and the direction of the Federal Reserve’s future monetary policy.

Seventy-five percent of S&P 500 companies exceeded their earnings per share estimates for the first quarter, which tops the five-year average of 68%.  First quarter S&P 500 earnings grew at a rate of 13.9%, its fastest rate since the third quarter of 2011.  The strong earnings helped the S&P 500 index post its seventh consecutive winning quarter in spite of the aforementioned market headwinds.  As of the end of June, S&P 500 earnings for the second quarter were estimated to grow at a rate of 6.6%, which is below the 8.9% projection for earnings growth in the first quarter.1

In continuing first quarter themes, international markets outperformed U.S. markets again in the second quarter.  International developed and emerging markets have each posted double digit gains year to date, outpacing both the Dow and the S&P 500.  Europe was a bright spot in the second quarter following Emmanuel Macron’s victory in the French presidential election.  His victory quieted investor concerns that the French election could further destabilize the Eurozone and the euro currency on the heels of the populist movement that has followed last year’s vote by the U.K. to leave the European Union.  Economic numbers continue to improve in Europe (albeit from a low base) to provide another reason for investor optimism.

The U.S. stock market has outperformed the international market in seven of the past nine years.  However, if we expand the lens to a longer-term view, history shows us that performance tends to be cyclical suggesting that now could be a good time to take profits from U.S. stocks and rebalance your portfolio by buying international stocks.  More importantly, history shows us that adding international investments to a portfolio provides better diversification that gives your portfolio a smoother ride toward your financial goals.

The Federal Reserve continued its quest towards a more normalized interest rate policy by raising their key overnight rate by another 0.25% in the second quarter.  This rate increase was the Fed’s fourth such move since December 2015.  The Fed also gave the market some insight into its intentions to reduce its balance sheet, which has ballooned to more than $4 trillion due to its bond purchases as part of its quantitative easing strategy.  This strategy was enacted to keep interest rates low, thereby lowering the cost of borrowing for individuals and businesses to help support the weak U.S. economy following the Great Recession.  In the most recent Fed minutes, indications were that the Fed would begin to wind down its bond buying program as soon as September.  This decision could put upward pressure on bond yields as one of the biggest consumers of bonds puts their fork down and steps away from the table.  Ironically, the news had little effect on long-term bond yields given the sustained demand from international bond buyers and the skepticism surrounding tax and regulation reform amid an economic environment in which inflation continues to be below the Fed’s target range.

A consistent source of investor concern since President Trump’s election has been the expectation of higher interest rates and its potentially negative impact on bond prices.  Interest rates and bond prices move opposite of one another.  Despite the fact that the Fed has raised its short-term rate by a total of 0.75% since President Trump was elected, 10 and 30-year bond yields have not followed suit continuing to trade in a tight range.  This fact is an important reminder to all investors that while the Fed’s decisions strongly impact short-term bond yields, the Fed has little control over long-term yields.  Rather, the two predominant factors that drive long-term bond yields are economic growth and the expectation of future inflation.  The Bloomberg Barclays U.S. Aggregate Bond index has actually posted small positive returns in each quarter of 2017 despite the Fed rate increases.  While stocks have outperformed bonds year to date, investors should remember the value of owning bonds in their portfolio is for their risk mitigating benefits.  When stocks fall in value, bond prices often rise offering ballast to portfolios.

As investors conclude the first half of the year, they see a familiar picture of a rising U.S. market at a valuation above its long-term average.  Yet its elevated valuation does not appear to be as significant when considered within the context of the prevailing low interest rate environment.  Like Bill Murray’s character in Groundhog Day, investors can’t seem to shake the seemingly daily market challenges of rumors of President Trump’s involvement with Russia, North Korea tensions, or the inability of Republicans to secure the first victory of their pro-growth agenda.  The third quarter will offer additional risks in the form of finding a resolution to raise the federal debt ceiling and the beginning of the Fed unwinding its balance sheet.  Despite these ongoing concerns, the market continues to persevere thanks to an improving economy, strong corporate earnings, and a low interest rate environment.  Our optimism on the general direction of the market remains intact given these strong market fundamentals, however, investors should be prepared for the elevated risk of a short-term market correction.  Investors can be well-prepared for this risk by making sure they own an appropriate balance of stocks and bonds that aligns with their tolerance for risk and the time horizon of their financial goals.  Investors who choose to ignore this counsel run the risk of repeating their same mistakes from the last market correction, which reminds me of a movie I once saw.

Source: FactSet

John Fischer, CFA®, CFP®

Chief Investment Officer

 

 


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