Cautious, but Continued Optimism
August 8, 2017 – To paraphrase Shakespeare from a market perspective, the first half of 2017 was filled with sound and fury, signifying nothing. There was a lot of outside “noise,” but the markets entered the second half of the year in surprisingly strong shape. Following the 2016 presidential election and the early months of the Trump administration, we saw 2017 as a year where it would be very difficult to both give and take investment advice. We believed that the unpredictable nature of geopolitical events might cause some to pull out of the markets regardless of the underlying data and indicators.
Through a little more than two quarters of 2017, we are happy to say that’s largely untrue. Political uncertainty has dominated much of the conversation, but that speculation and doubt has not impacted the markets the way most predicted. We attribute that to continued strength in global economies and strong corporate earnings here in the US.
Even in the context of the second longest bull market in history, some of the statistics we’ve seen over the past year are pretty staggering – we’re approaching 300 days without a 5 percent market decline. The S&P 500 has hit 25 record highs through July. It’s safe to say we are in a rally not just in the US, but around the globe.
But despite the continued good news, the challenge for the remainder of 2017 will be keeping that geopolitical noise in check and maintaining disciplined and diverse investments while keeping a close eye on the Fed. It’s easier said than done, but
it’s encouraging that we’ve seen little panic from investors so far this year.
As we look now to the future, the data seems to support the idea that this economic cycle is not near ending and could continue for months, or even years. What exactly does the data show? Here’s a more in-depth review.
Global Rally Shows Continued Strength
Both global economic and equity market growth has been notably strong over the last quarter. Global developed markets are up 4.3 percent for the quarter and 11.5 percent for the year as reported by the MSCI ACWI Index. Emerging markets saw a 6.3 percent uptick over the last quarter and are up 18.4 percent in 2017 as reported by the MSCI EM Index. Concerns that this rally is in danger may be putting political concerns ahead of market fundamentals concerning growth and earnings, especially on a global scale.
In Europe, all eyes were on France at the close of the first quarter. Everyone was focused on a geopolitical event that ultimately never came to pass. Marine Le Pen was not elected, and there is little threat of France exiting the European Union anytime soon. The story out of France more recently has been better economic numbers than expected driven by strong core growth. Today, the French economy has been the biggest surprise and far outpaced expectations. Throughout Europe, markets were impacted by the recent hawkish comments from Mario Draghi, President of the European Central Bank. Overall, that’s a good indicator of where the European market is today. Six months ago, we can’t imagine Draghi would have dared talk about tapping on the economic brakes.
Around the rest of the globe, we saw continued synchronization over the last quarter. China exceeded expectations with 6.9 percent GDP growth against the prior year, reassuring investors that the world’s second-largest economy is not pulling us into a worldwide recession. Across the globe, people seem to be pivoting away from the unprecedented uncertainty coming out of Washington and the fluid geopolitical situations around the world. Perhaps it’s out of sheer exhaustion, perhaps for other reasons, but the result is a refreshing focus on actual issues for the remainder of the year, including Fed policy, interest rates, economic growth, inflation, and the strength of the dollar.
Are We at the End of a Cycle?
With a focus on the Fed, it’s safe to assume many think we may be nearing the end of the current market cycle. We don’t see data to support that conclusion for several reasons. One sign we are not on the brink of a Fed induced recession is the relative weakness of the dollar. If the market believed the Fed was about to engage in a relentless series of interest rate raises, the currency market would reflect that. Speculation about action from the Fed would be driving the dollar up, not down. Finally, a weak dollar often drives strong prices in commodities like oil. We’re not seeing that this time around. Oil prices are down, which may have more to do with specific circumstances in the Middle East, rather than speculation on global economic activity.
Domestically, profits are up and employment is looking good – more signs that the cycle is not coming to an end. Actual GDP growth for the quarter is 2.6 percent annualized year-over-year, which falls into the Goldilocks zone where it’s strong enough to imply growth without creating inflation concerns that prompt a reaction from the Fed.
Fed policy and the lack of a robust growth rebound from the 2008 recession have also driven a long cycle of recovery. As we see this cycle continuing, it’s important to note that economic cycles have been getting longer. (See Chart A.) While that certainly doesn’t mean this cycle will never end, it could easily go another 12 to 24 months.
Ultimately, it comes down to the Fed. As the saying goes, “Old age doesn’t kill bull markets; the Fed does.” Janet Yellen is well aware of this, and thus far her comments have allayed concerns of significant spikes in interest rates, creating optimism for the remainder of this year. Overall, the data we’re seeing suggests we are in less danger of a recession now than we were a year and a half ago. Without significant inflationary pressure in the short run, Yellen has the latitude to stay focused on data throughout the balance of the year. That should keep the pressure off having to raise rates if any of the underlying growth data fails to match expectations.
US Equities – The Reassertion of Active
We’ve seen some very important changes in the US equities market that are beginning to crystalize in second quarter data. A year ago, investors heavily favored high-dividend stocks with less of a focus on growth. That preference hurt actively managed accounts, which infamously suffered compared to passive management. Today, we’ve seen a reversal. Whereas 2016 was a year for small cap value, 2017 is shaping up to be a year for large cap growth. Large cap growth stocks are up 14.0 percent on a year-to-date basis, while small cap value counterparts are almost flat at 0.5 percent. We’ve seen a move toward more traditional growth sectors and away from the safety trades that dominated the marketplace a year ago.
The swings between active and passive are cyclical, but the tremendous amount of money flowing into ETFs and away from individual stocks may not be. We have prioritized staying ahead of technological changes in the way we invest and, going forward, this change is one to which we will give our full attention.
We’re also keeping a close eye on shifts in the retail market space, particularly Amazon’s announcement that it intends to purchase Whole Foods. This “Amazonification” of the marketplace, as some have dubbed it, is likely to impact retailers like Macy’s and Nordstrom along with big box stores in a serious way. This doesn’t necessarily mean aggregate consumption will be negatively impacted, it simply means that consumption may be happening in different places. While shifts like this often lead to pessimism, as Amazon and others continue to act as disruptors to the retail sector, it could offer significant opportunities.
Some of the current overall pessimism about the market is driven by comparisons to the tech bubble of the late 1990s. Netflix’s strong quarterly earnings only added fuel to this speculative fire. These concerns are not unfounded – Netflix does lose money, and its price/earnings ratio is in triple digits (the trailing twelve-month is at 217). There have been some staggering valuations of late. But we note some key differences between 1999 and today. A decade ago, the 10 largest companies on the S&P 500 accounted for 26 percent of the marketplace. Today, the top 10 accounts for approximately 19 percent. This is a strong indication that we’re in a healthier, broader market and we’re seeing mid-cycle activity, not late-cycle activity.
A Favorable Fixed Income Environment
At the close of the second quarter, we’re seeing circumstances more favorable to fixed income than we anticipated. This, in light of Yellen’s subtle shift in her comments about low inflationary pressure, is creating opportunities in fixed income markets.
Globally, we witnessed strong bond market performance for a portion of the second quarter until the markets reacted quickly to Draghi’s comments alluding to the end of a deflationary period. Despite that, bond market performance held relatively strong overall during the second quarter.
We’re seeing a similar story with tax-exempt bonds in the US markets, which are up 3.6 percent as measured by the Bloomberg Barclays Municipal Bond Index. Higher-yielding bonds are up 6.1 percent year to date. Despite negative headlines around Puerto Rico defaulting and concerns in Illinois, performance has remained impressive. That shows investors are looking past potential credit risks and are focused instead on opportunities from a yield and tax-exempt yield basis. We’re also seeing a sustained willingness for international investors, particularly from Japan, to buy US municipal bonds. Even though they aren’t receiving the tax benefits US investors get, they’re still willing to buy for the yield. It’s another indication there is still support for the market despite some of those negative headlines.
We are actively managing these municipal bond portfolios. This selection process is becoming even more critical as specific segments see rising levels of risk. But it’s important to reiterate that there are significant opportunities across the fixed market sector. We are remaining true to our belief that a diverse portfolio is an effective counter to trying to time the market, which as history has shown, is almost impossible. We continue to keep a portion of portfolios in fixed income to keep volatility low. Diversity is the path to success.
Cautious, but Continued Optimism
Our message in this report has been largely bullish, which is logical considering we are in the midst of a record bull market. That’s not to say we’re ignoring excessive valuations in some sectors of the market or the fact that this market cycle, like all others, will end at some point. We will continue to consider the micro- and macro-economic environment around all of these factors as we evaluate our positioning. That said, we are confident we will see more record market highs before the end of the year.
Yet, what we’re increasingly hearing is that investors are waiting for the other shoe to drop and are anticipating the next pullback. It’s not an unreasonable sentiment after eight years of a bull market, but we still believe the data suggests the pullback is still a ways off. What’s more, while 5 percent or 10 percent pullbacks are inevitable at some point, the next downturn is unlikely to be on the scale we saw in 2008. And we’ve seen over many cycles that, despite the potential for significant gains, it’s difficult for investors to put investments back in the market during a downturn. (See Chart B.)
We believe there’s as much risk to being underinvested right now as there is to being overinvested. We’ll continue to hear political noise for the remainder of the year, but thus far we’ve been encouraged by the market’s ability to filter this out. For Pitcairn, our strategy to focus on a disciplined, diverse portfolio remains unchanged. It’s been proven successful over the last several years, and we expect the next few years to continue to support that approach.