By Will Hernandez
The intent of this blog is to provide a brief update on the state of the domestic and international stock and bond markets, as well as provide insight into our sector weightings.
The S&P 500 Index (US large cap stocks) gained 0.6% in June and 9.3% the first half of the year. Smaller firms (S&P 600) posted a 2.79% gain for the first half, but only because June posted a 2.9% gain. Overseas, developed markets gained a modest 0.2% in June but are up 14.3% year-to-date, with emerging markets up 16.7% year-to-date.
Bonds and the Federal Reserve
Barclay’s Capital Aggregate Bond Index lost 0.1% in June but is up 2.3% year-to-date. The 10-year treasury rate yield began the year at 2.45%, hit a new low of 2.14% in June before recovering to 2.31% by June’s end. This confirms a continuation of interest rate volatility as the long-term trend for rates continues to be up. The upward move in rates is a good sign for equities, but not bonds. Bond like equity investments such as Preferred stocks and alternative bond investments (eg. bank loans, interest hedged bonds and floating rate or variable rate securities) have performed better than the overall bond market during the first half of 2017.
The Federal Reserve has now raised rates for each of the last three quarters. Not surprisingly the 10-year treasury increased almost .75% (3 times .25%) as well. Note that as interest rates increase those bonds with longer maturities will suffer most. As a result, investors can expect this to translate to a bond tilt towards shorter durations. This is especially important as the Federal Reserve now has $4.2 trillion of bonds, especially $1.7 trillion of Mortgage bonds considered temporary. About $16.5 billion in treasuries currently matures every month and is reinvested. As a commonly cited Morgan Stanley report has estimated, allowing these to mature could equal another two to three rate hikes. This first quarter we began reducing exposure to longer dated bonds; note, higher exposures to floating rate, variable rate, bank loans, as well as interest hedged bonds, are all designed to reduce these risks in our clients’ portfolios.
Within equity sectors, Tech and Health Care led the way with returns of 16+% for the first half. In contrast, the Energy and Telecom sectors posted double-digit negative returns. While only 5% of firms have reported so far for the 2nd quarter, indications are towards another strong Earnings (12% growth so far) and Revenue (8.5% growth so far) quarter. As a follow on to the first quarter’s 14% revenue gains, the estimate has been for a respectable 6.6% earnings growth in quarter two. Tech finally took a breather in June from its tremendous 2017 growth. Note that for our domestic markets in a late cycle, normally financials, materials, and energy will outperform - this has not yet occurred. Tech, Industrials, Utilities, interest sensitive sectors, have all benefited from the falling interest rate environment. Expect Financial firms to benefit as interest rates rise. As with our bond portfolios, our tilt might be early, but our portfolios are poised to take advantage of these moves.
We have patiently increased our international stocks as the international recovery continues. While not expected to begin till early 2018, even the European Fed has begun talk of ending their quantitative easing program. Note that the U.S. is now two steps ahead of this as we are now into monetary tightening. Note that unemployment, with the exception of a couple of Nordic countries and Germany, remains high in non-U.S. developed markets. Even Japanese firms, a multi-decade disappointment, are finally joining the western world by beginning to acknowledge their stockholders’ concerns as their stock market finally shows signs of life. In the long-term, expect international exposure to reduce risk, however, do not confuse that with short-term risk reduction. Again, expect little risk reduction short term, but longer term the IMF has re- estimated to a rosier 3.5% global growth for 2017 and beyond.
Source: States Street Global Advisor’s Quarter one 2017 Analyst estimates versus actual results.
First quarter US growth has been revised up again to 1.4%. Official data for the second quarter isn’t in yet, but telling is the core Inflation (ignores Food & Energy) of 1.7% for May. This is below the 2% target the Fed looks for, but higher than the 1st quarter’s 1.5% figure. Housing data, homebuilder sentiment, consumer as well as business confidence (all forward measures of economic growth) are improving. As consumer spending represents 70% of our economy, the revision to 1.1% growth for the first quarter marks a better than expected start of the year.
U.S. unemployment edged up slightly to 4.4% as more participants begin to look for work. June saw 222,000 more jobs, a great number as the prior two months were disappointing. Housing figures are mixed, as building permits and confidence have declined. Existing and new home sales increased in May after a slower April. Existing housing stock is currently at 1982 levels with concerns over building costs seen as the culprit here. Manufacturing and Non-Manufacturing indices are both healthily above 50; the demarcation separating a growing versus contracting economy. As the consumer represents the majority of this country’s spending, again note that consumer confidence notably remains at the highest level since 2001.
As we stated for the first quarter, growth continues internationally and our domestic economy’s slow growth continues. As always, economic expectations can adjust down on weaker data, and political and geopolitical risks remain. More importantly, an appropriately diversified portfolio matching your goals to your risk tolerance remains the best way to invest for the intermediate and long-term.