If you live in my hometown, Milwaukee, you know that the last two weeks have been difficult because of the weather. While winter was mild, spring has been typical, which means no sun, a lot of rain and temperatures in the 40s. The forecast for the next three days is more of the same. We get through it by focusing on the benefit of those April showers, May flowers, and the promise of warmer spring and summer weather. The anticipatory nature of Midwesterners, longing for the next season, should make them good investors.
Future prospects are what investors try to discount into today’s asset prices, so we can look at how markets did during the first quarter to understand where we are headed.
Stock investors benefit from the reality of stronger economic data as well as rising business and consumer sentiment. This has positively affected the labor market as unemployment remains at 4.7%, wage growth has accelerated to over 2.5% and unemployment insurance claims have declined by more than 8% since the beginning of the year.
Consumer confidence is up over 24% in the last nine months. This has resulted in stronger spending. Consumer installment credit is up over 6% in the last 12 months, and new home construction has risen almost 7% in the last nine months. One area that provides a note of caution about future consumption is auto and light truck sales, which have declined by 4.66% since the beginning of the year. This is likely due to lower incentives and higher interest rates.
Businesses, too, have seen some improvement. During the fourth quarter of 2016, corporate earnings for the companies in the S&P 500 Index rose more than 5% from the previous year. Earnings are expected to grow over 9% during the first quarter of 2017, when compared to first quarter of last year. This acceleration in earnings has come from stronger revenue growth—something we haven’t seen for some time. While some of this earnings growth is energy sector related (keep in mind that oil prices are double where they were one year ago), it is still real growth.
We’ve also seen improvement in manufacturers’ new orders and total sales, suggesting improvement in this segment of the economy as well.
All of this has resulted in better U.S. economic growth. In fact, the economy is expected to grow during the first quarter of 2017 by 1.7% versus only .9% during the first quarter last year.
The U.S. stock market rose 5.74%, using the Russell 3000 Index of stocks, during the first quarter. As always, there is more to the market story as just the broad index’s performance. There were some market segments that did better, some worse. The best was large cap growth stocks, which were up 8.91%, and the worst, small cap value stocks, which were actually down .13%. However, this segment of the stock market did extremely well during the fourth quarter as it is heavily laden with financial services companies which are expected to benefit from higher interest rates and less regulation.
Looking at performance for the individual sectors of the stock market during the first quarter also provides some insight into how investors feel about the future. Two out of three of the best performing sectors were consumer related. The staples sector (companies that make or sell the goods consumers use every day, like Proctor & Gamble, Coca–Cola and Wal–Mart) was up 6.4%, and the discretionary sector (companies that sell what we want, not need, like Amazon.com, Walt Disney and Starbucks) was up 8.4%. Technology led all 11 groups, with a return of 12.6%. This group includes companies that are intertwined with our electronic lives such as Apple, Microsoft, Facebook and Alphabet. All of these companies have one thing in common: They benefit from a strong employment market, higher wages and more consumption. Their strength also suggests that investors feel better about the economy’s ability to continue to grow at a modest pace this year. Finally, their outperformance suggests that investors look forward to a reduction in individual income taxes brought about by tax reform.
International stocks also rallied during the first quarter. We use the MSCI All Country World ex–U.S. index as our benchmark for these stocks, and it was up 7.86% during the quarter. Abroad, growth stocks also did better than value. This is likely a result of some similar trends in economic growth. While economic growth has improved in Europe and Japan, it is still in the modest 1–2% range. Employment trends have also improved in Europe, lifting consumption and buoying the same kinds of companies. One especially bright spot in global market returns during the first quarter was the emerging markets, where stocks were up almost 11.5% as a result of a stable dollar and less action on trade policy.
A lot happened on the interest rate front during the first quarter. In March, the Federal Reserve raised the range of the Fed Funds rate by .25%, and we now have money market funds paying a return near .5%. Bond investors took the move in stride, however, and the Bloomberg Barclays Intermediate Aggregate bond index returned .68%. This was largely because the market anticipated the move and rates rose almost 1% during the fourth quarter of last year. In fact, after the Fed’s interest rate hike, intermediate and long–term bonds have actually seen rates fall. One of the reasons for this is that the Fed noted it needs to understand how changes to fiscal policy (e.g., tax reform and federal government spending) will impact the economy before moving too far.
We view the Fed’s hikes as positive because they reflect a return to a more normal interest rate policy and, to some extent, a hand–off from those in control of monetary policy to those in control of fiscal policy. For now, it appears that a period of normalizing interest rates will lift short–term interest rates more quickly than long–term rates, which means less of a yield difference between short and long bonds. This could produce the best outcome for bond investors, one in which they earn higher interest income which can be reinvested at higher rates without a major dislocation in bond prices.
Given our outlook for modest economic growth this year and a slowdown in the year–over–year increase in inflation, we view higher interest rates as a policy change reflecting the Fed’s acknowledgment that the economy doesn’t need extraordinary measures any longer, not because growth is taking off but because it’s sustainable at these levels.
All in all, the first quarter of the year was a positive one for balanced investors. Stocks and bonds rallied as investors discounted the news that the Fed was returning to normal, fiscal policymakers were likely to reduce regulation and cut both corporate and individual taxes, and corporate earnings were finally rising due to some revenue growth. Of course investors will continue to keep an eye on policymakers’ progress and, if disappointed, adjust prices accordingly. Let’s hope policymakers don’t deliver a Midwestern–like April!