The post-election rally extended through the first quarter, and financial markets continue reacting positively to economic growth and promises of infrastructure spending and tax cuts. Political clashes continue to roil the waters, but markets are apparently downplaying these disruptions and delivering favorable results for yet another quarter.
Last month, the Federal Reserve Bank raised key rates by 0.25%1, as widely expected. This move follows a similar increase in December 2016. We believe the recent uptick was previously "priced in" to the bond markets during the sharp market-rate increase following the November election. Recent positive economic news intensifies the odds for more increases during 2017, and possibly into 2018.
Economic news remains upbeat with decent earnings and low unemployment. Job creation picked up, energy firms are back on solid ground, and the housing market remains strong. The negative news, including rising interest rates and the demise of brick and mortar retailers, seems to be moderated by optimism from consumer confidence and promised tax cuts. We believe the threat of a recession remains low, but corporate earnings should be monitored closely for hints of a slowdown. Also, any interest-rate increases by the Fed that are more severe or more frequent than market expectations will accelerate any oncoming slowdown.
EFFECTS ON ASSET CLASSES
Global stock markets generally moved higher in the first quarter. The anticipation of tax cuts and infrastructure spending moved U.S. markets to new highs. Here are the numbers. Large-cap funds were up but varied in strength: Growth funds gained 6.5%2 on average and value funds gained 4.0%. Mid-cap funds were similar, with growth at 5.5% and value gaining an average 3.0%. Small-company funds performed very well for the third quarter in a row, gaining 8-10% for growth and 0-2% for value. Foreign stocks were mixed: Core funds gained 7-8%, while emerging-market funds grew by 10-12%. Natural resources provided the only negative news by falling 3-7% after gaining 28% in 2016. REITs finally stabilized and gained 2-3% since year end. Gold funds rallied with a gain of more than 8% during the quarter.
Bond markets reacted to the March rate increase with a yawn, and rates finished Q1 at or near their post-election values. The Fed continues to talk further hikes, but the bond market has not shown concern and actually posted nice returns in Q1. Short-term bondswere slightly higher, with gains of less than 1%. Our mid-long positions yielded 1-3% returns on average. Foreign bonds had small gains while emerging-market debt gained nearly 4%. High-yield bonds had yet another good quarter with solid gains over 2%. Municipal bonds rebounded after a lackluster 2016 by posting gains of 1-3%, despite the action of the Fed. Bond values likely will see some stress with rate increases, but they continue to provide key portfolio stability during times of high stock-market volatility.
Economy: Solid U.S. economic growth continues to dominate the news and create a backdrop for increasing rates. We hit the Fed’s inflation target of 2.0% in 2016; now, avoiding runaway inflation is a key goal and could dictate more rate increases if inflation rises. Conversely, we can look for the start of a possible economic slowdown through corporate earnings, inventories, and labor statistics data. Neither scenario is imminent, so our outlook continues to favor a full allocation to both stocks and bonds while minimizing cash. We’re also holding less foreign stocks and bonds than our target.
Equities: We continue to focus on U.S. stocks until we see an increase in global growth or some momentum in foreign economies. U.S. stock valuations are relatively high, so caution needs to be taken with any purchases in this asset class. The recent increase in value companies compared to growth companies has leveled the field based on current prices and expected earnings. Earnings growth will be a key factor to sustain current price levels
Bonds: The real question remains: How fast will the Fed raise key interest rates? Until we see a dramatic change in direction, we will continue to own bond funds that are resilient to rate increases and avoid low-rate, long-term bonds. On a macro level, the demand for income has continued to drive the flow of funds into bond funds, while a muted inflation cycle is also good for bonds. Investors have $12 trillion in cash on the sidelines — when that money is put back into play, it will have an effect on stock or bond prices.
Other: The recent volatility in REIT and energy prices does not overshadow the potential long-term benefits of owning these asset classes. We believe they both provide a quality income stream with excellent potential to hedge inflation. Owning these positions is a way to diversify, create income that is independent of the bond market, and own something with growth potential.
We publish these insights quarterly for our clients, with further detail on specific asset classes. Our personalized investment management strategy is built around each client’s personal Financial Plan and Investment Policy Statement. We review both as we make changes to each client’s portfolio, working to ensure their investments match their personal risk tolerance, return goals, and tax picture.
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1 The Federal Reserve raised key interest rates by 0.25%. Reported in the Wall Street Journal, March 15, 2017, "Fed Raises Rates; Yellen Holds Press Conference.”
2 All asset-class quarterly data pulled from Barron's Lipper Quarterly Performance Report, dated 4/4/17.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline. Stock investing involves risk including loss of principal.