May 5, 2017 – Following all of the uncertainty of the presidential election and other surprises of 2017, many people suddenly seemed very certain about what would happen next. President Trump’s agenda would sail through Congress relatively unchecked, bringing GDP growth, possible inflation, and high-level debt. An isolationist foreign policy and a growing trade war with China would ensue, and the Fed would quickly change course as President Trump would move on from Janet Yellen’s leadership. None of those things came to pass in the first quarter. Those certainties, just like so many before them, were, in fact, anything but. In the remainder of 2017 and beyond, we would be wise to learn a little something from Mark Twain, who said “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
If the results of the 2016 election weren’t enough, the beginning of 2017 has been another powerful reminder of the danger of falling into these certainty traps. While we’ve seen events that have had a huge impact on the world, they haven’t always had a direct impact on the markets. History has shown us time and again that even the geopolitical events that do impact markets only do so for short periods of time. More often than not, they serve as red herrings. That appears to be the case once again this year.
Overall, most of the actual economic numbers in the US look good. We’re seeing positive movement in soft indicators like consumer confidence, and the hard data is beginning to catch up. (See Chart A.) At the end of the day, this information, along with your own personal goals and financial plan, should guide investment decisions, not unfounded fears that drive us to make change just for change’s sake. The key is to remain focused on the knowns and stick to the plan.
So, what do we know specifically? Let’s take a closer look.
Rare Synchronization in Global Economies
It’s been a long time since we’ve seen this level of synchronization in global economies. Even as recently as a few months ago, this did not seem likely. A year ago, many had concerns that China was on the verge of economic decline that could drag the world economy down with it. We were skeptical of this viewpoint and believed that fears about China were overblown. Not only did this prove to be correct, but China beat forecasts in the first quarter of this year with 6.9% GDP growth.
China was not the only emerging market that beat expectations in the first quarter. Brazil’s prolonged recession seemed to be deepening in the fourth quarter of 2016, but it has made a surprising turnaround so far this year. In February, economic activity in Brazil grew at its fastest pace since 2010. Combined with positive signs of growth in Argentina as well, many of the world’s emerging markets seem to be vastly improved.
In Europe, the economic climate is in many ways mirroring that of the US concerns over Brexit, and the populist and nationalist movements in many European countries has had a limited impact on the European economies. Unemployment rates and many of the other fundamental metrics continue to improve across the European Union (EU). While many fear the potential results of a Marine Le Pen win in the upcoming French election and its implications for France leaving the EU, we continue to believe that despite any risks in the market, economic conditions look very positive for Europe at the moment. We anticipate continued positive momentum in the global economy during the rest of 2017. If the results of upcoming European elections show that the expansion of the populist political movement is slowing, this can only help to solidify that trend.
Growth in the US, but How Much?
With Republicans controlling all three branches of government following the election, it seemed there would be few checks on their policies and on the president’s agenda. Many hoped it would signal an end to political gridlock in Washington and significant economic expansion. Markets rallied in response to this optimism at the end of 2016. But instead of a runaway Trump train in these first few months, many of the president’s policies seem stuck in the station. Checks and balances, both from the courts and from within different factions of the Republican Party already seem to indicate that while the make-up of the government has changed significantly, the results and gridlock will not. The failure to repeal the Affordable Care Act shows that even on issues where there is mass agreement within the Republican Party about the final outcome, there can be wide differences on the details. We anticipate that legislative change will remain slow. As a result, economic growth will remain slow as well, much as it was under the Obama administration.
One legislative issue where we expect at least some change by the end of 2017 is tax reform. This is another issue with wide agreement among Republicans about the overall goals: lowering taxes and simplifying the tax code. The way to navigate to that end result will again be the subject of fierce debate. It is hard to see all of the massive reforms that the president and other politicians have promised happening before the end of the year. Changes to corporate tax policy seem the most likely, but we believe that whatever action we get is likely to be a watered-down version of what’s been proposed. The economy may get a quick jolt from this type of move, but incremental changes may not have a significant long-term effect.
We will also continue to watch Fed policy closely in the coming months. After heavy attacks from President Trump during his campaign, many people were sure that Fed Chair Janet Yellen would be out the door when her term expired. But in the last few weeks, the president has softened his position toward Yellen. When asked by The Wall Street Journal if she would be “toast” when her term ends, President Trump responded: “No, not toast.” This may be in part because the Fed has started to move away from its more dovish policy of years past to a moderately more hawkish stance. The Fed seems committed to two more rate raises this year. Whether or not they have the data to support those moves seems a little less certain than it did three months ago. GDP forecasts for this quarter ranged anywhere from 0.6% to 2.7%, with the actual figure reporting 0.7% growth for the first quarter. We would like to see forecasts up and above 3% before the Fed raises rates.
Regardless of what the Fed does, what has become obvious is that the days of the Fed coming to the rescue with quantitative easing and other stimulus programs are over. The economy must grow or decline on its own. Consumer confidence, a leading economic indicator, hit a 16-year high in the first quarter, but we are still waiting for hard economic data to catch up. It remains to be seen if it will, but it is a good sign. While there may not be as much growth as people had hoped for in the rest of 2017, we believe that the overall environment will remain positive.
Diversity in Equities Paying Off
We have long favored the risk mitigating benefits of diversity in portfolios. In the last few years, international equities have lagged US equities, but we are starting to see our strategy pay off in significant ways. Emerging markets took off in the first quarter led by growth in China. Surprisingly, Argentina and Brazil equity markets also saw solid growth despite continuing struggles in each economy. European markets were on par with US equities and we saw solid returns in the low 7% range across most of the continent. We continue to believe that diversity in international investments will pay off in the long run.
Looking to US equities, the S&P 500 has performed impressively since election day as it is up 11% as of the end of the first quarter. In fact, US equities are the best performing post-election stock market in modern history. The first quarter saw 6.1% growth. But despite all of the fanfare, we are still in an aging bull market. While some might say that after eight years of growth, the only place to go is down, we see both upside and downside risks in the marketplace. Certainly, there is the possibility that many of the geopolitical risks that exist reach some sort of tipping point that does ultimately impact markets. But there is also the possibility that some of the policies implemented by the new administration lead to some growth, even if they are less transformative than promised. The market will likely look favorably upon decreases in regulation, however they appear.
But given risks on both sides and the somewhat unpredictable nature of our current political environment, we also anticipate much higher volatility than in years past. Equity market volatility is at record lows with days without a market move of more than 1% marking the longest stretch since 1982. (See Chart B). We have always recommended a mix of passive and actively managed investment approaches, and that becomes even more important in times of high volatility as we are likely to see in the near future. While many have focused on the massive inflows into passively managed funds, we anticipate that active management is poised for a comeback. We will continue to use both strategies where appropriate and understand that each has its merits.
There was fear in some circles that there would be a big sell-off when the Fed finally started to ramp up its interest rate hikes. But after the second hike in three months in March, the sell-off never materialized. In fact, we saw an increase of buying on the longer-term markets. The conditions finally seem right for the Fed to make the two raises mentioned earlier. Obviously, we will continue to guard against the downside risk and be cautious about allocations in this area. Yet the end of the first quarter reminded us of our core belief that we should devote some allocation to fixed income. Some bond categories outperformed expectations for the quarter. Corporate debt was up 1.2%, below investment grade bonds gained 2.7% and emerging market bonds posted gains of 3.9%. These return numbers validated our core belief in diversity, particularly late in the quarter when equities faltered a bit.
Keeping out of Trouble
At the beginning of this year, we predicted 2017 would be a difficult year for investors to stay focused on long-term performance. For better or worse, we are seeing that play out. Global markets are up, but it certainly doesn’t feel that way watching the news. Pundits and analysts are already moving on to the next wave of potential disruptors, from the ultimate results of the French election to North Korea to Trump’s predicted attempts at tax reform.
In the end, focusing on these unknowns is speculative business. At Pitcairn, we remain focused on the knowns. You cannot make wise investment decisions based on unfounded fear and so-called certainties that never come to pass. We are sticking to the long-term vision and diverse portfolio strategy that have helped families keep and grow their wealth for generations. Today’s market environment offers plenty of opportunities to get into trouble, but we believe focusing on the knowns rather than the unknowns, and paying attention to investment fundamentals, will keep that trouble to a minimum.