Apr 06, 2017
A Strong Start:
The momentum from last quarter carried into the New Year as the broad based equity averages completed their sixth straight quarter of positive returns. Investors’ attention was pulled between growing uncertainty coming out of Washington and more reassuring data about global economic growth. The quarter ended with confidence still intact, but the strength behind this year’s gains reflected a more circumspect view of the cyclical reflation trade that initially drove stocks higher.
For the quarter, the S&P 500 gained 6.1%. The broad market was led by strong outperformance of growth stocks over value stocks. In contrast to the prior quarter, investors retreated from bank and infrastructure plays back into more stable earnings growth companies in sectors like Technology and Health Care. This reversal also included outperformance from larger companies over small and mid-cap stocks and non-U.S. stocks over domestic issues, aided by a decline in the value of the dollar.
The moderation theme was reinforced by the bond market. Interest rates declined slightly over the quarter, resulting in modest gains for most bond strategies.
In Search of the Old Normal
The Fed’s recent interest rate hike (the first of three expected this year) received a generally supportive response from the market. It is worth remembering that a year ago, talk of three or four rate hikes helped trigger the first correction in stocks in five years. This changed perspective underscores that Fed policy is no longer the only game in town. Investor focus has broadened to economic and investment fundamentals and these have more to do with tax policy, regulatory policy, fiscal policy, and trade policy. This shift has significant implications to both the upside opportunity for stocks and the risks associated with that opportunity.
The timing of this shift was fortuitous since monetary policy (low interest rates, quantitative easing) had largely run out of steam as the primary catalyst for higher stock prices. The path to justify higher stock prices had been unclear given that valuation multiples on expected earnings had already exceeded the levels reached prior to the financial crisis. More recently, that path, which now encompasses earnings growth, has become better defined with the pro-growth policies of the new administration.
The transition from exclusive reliance on monetary policy makes the equation for higher stock prices more complex. For much of the current bull market, monetary policy served as a crutch, giving investors the illusion of the Fed as the ultimate backstop. If conditions deteriorated, there was confidence that the Fed would respond with additional assurances of keeping interest rates lower for longer. This helped suppress normal volatility and provided comfort, whether real or not, that the downside was limited.
Policies that work to compress normal risk and volatility may seem productive at the time, but when overextended, have the potential of exposing markets to non-normal risks, especially when instabilities build under a seemingly calm surface. In the absence of the Fed in this safety net role, the perceived floor under stocks is removed, as it should be in a more normal, less central bank-managed, investment environment.
The transition to an economy healthy enough to absorb higher interest rates is a precondition to a more typical business cycle pattern. There are components of normalization that investors will welcome (like the eventual return of attractive bond yields for savers), but this shift reintroduces the kind of risks that typically accompany a mid to late-stage economic cycle, most of which have been off the radar for some time.
On balance, though, this natural transition in moving to a more seasoned stage of the business cycle should provide a good backdrop for equity markets. Beyond that, risks of increased inflationary pressures, higher interest rates, and Fed tightening to keep the economy from overheating will likely mark the normal end-cycle developments, followed by recession, followed by the next cyclical recovery.
Extended bull markets and all-time highs often raise concerns of an imminent correction. Data to support those concerns are ample: elevated growth expectations, record investor confidence levels, the extended duration of the current bull market, stretched valuations, high debt levels, and unconventional political and geopolitical uncertainty. We’re sure there are other reasons not listed.
While some of these issues may appear more acute than usual, investors who have actively played these hunches over the past eight years have most likely hurt their return prospects. We assume a correction can happen at any time, however, in the absence of a recession, we believe that any correction would not signal the end of the bull market. Thus, our focus remains on investing in companies for fundamental reasons that are not challenged by the prospect of periodic pullbacks.
It is difficult, if not mind-numbing, to parse the day-to-day news flow out of Washington. Distractions and noise from every imaginable source look to be a permanent part of the landscape for the foreseeable future. We don’t belittle the importance of political issues that consume the daily bandwidth of different media channels, but we find the market’s lens serves as an effective filter to help us distinguish what is and is not relevant to our job as portfolio managers.
Stepping back to evaluate the policy picture, progress in tax reform and regulatory change will matter most to the markets. Politics notwithstanding, the most important guidepost for investors today is continued signs of economic growth and earnings growth, here and around the world.
As a firm that pays particular attention to valuation, we believe that current stock prices already reflect some of the expected good news in these areas. As such, this leaves us a little more subdued in our short to intermediate-term outlook, given where the markets are today, but still a better outlook for stocks than we had expected six months ago.