Q2 2017 April 13
ECONOMIC FORECAST
DBFitzpatrick
REGISTERED INVESTMENT ADVISORS
INSIDE THIS ISSUE:
Investors Look On the Bright Side, For Now
4-5
Trouble May be Ahead for Equities
5-6
Fixed Income: Fed’s Balance Sheet the Focus
6-7
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 (208) 342-2280 www.dbfitzpatrick.com
4
ECONOMIC FORECAST | Q2 2017
INVESTORS LOOK ON THE BRIGHT SIDE, FOR NOW The bull market for equities continued in the first quarter, as the U.S. economy showed strength and investors remained hopeful that policy reform in Washington D.C. would be achieved. Industrial production ticked up in the first quarter and retail sales showed solid growth, while the unemployment rate in the U.S. has fallen to 4.5%. The low unemployment rate doesn’t tell the entire story, as the labor participation rate is near multidecade lows, but the improvement in the labor market is real and important. The strengthening of the housing market has been a major factor for the U.S. economy during the last several years. Home ownership has declined since the crisis period of 2007-2009, but a house remains the biggest item on the balance sheet for tens of millions of Americans, and its value has great impact on people’s saving and spending decisions. Home prices, as shown by the Case-Shiller Home Price Index, are up dramatically from 2012 and could approach precrisis levels within two years. Higher prices have led to increased home construction, as housing starts rose again in the first quarter, and new homes sales also exhibited solid gains. The strengthening housing sector has buoyed consumer confidence and, ultimately, consumer spending, which has rippled through to many areas of the broader economy.
This dynamic is likely to continue for at least the rest of 2017, with the housing sector remaining a positive force.
Even with a stronger housing sector and improving economy, however, there are good reasons to doubt whether the equity market will continue its recent
excellent run. An important part of the explanation of the stock market’s strong performance since November has been investor belief that President Donald Trump would be able to push economic reforms through Congress. Tax reform, which investors hoped would lead to increased business investment, was viewed in the
5
weeks after the election as a real possibility (and even likelihood) in President Trump’s first year in office. Increased infrastructure spending, which would be especially beneficial for industrial companies, was also thought to be possible. The details of what reforms would ultimately be instituted were never clearly explained, but investors remained optimistic throughout the first quarter that policy reform of some kind was likely to occur. These hopes are dimming as the second quarter gets underway. The administration’s lack of clout with Congress, as revealed in the failed attempt to repeal the Affordable Care Act, has virtually eliminated the possibility of
increased infrastructure spending, and the prospect of tax reform this year (or next) is diminishing by the week. With this backdrop, we believe the equity market is vulnerable to a pullback as investors reassess the political realities in Washington. Economic data are likely to remain positive in the second quarter, but it may
not be enough to justify the elevated valuations of the equity market. The MSCI All Country World Index is trading at 16.3x expected 2017 earnings, while the S&P 500 is trading at 18.2x. Valuations as high as these make equities vulnerable to changes in investor sentiment, and some sectors are especially exposed.
TROUBLE MAY BE AHEAD FOR EQUITIES The stock market had a great first quarter, with the MSCI All Country World Index (which measures the global stock market) returning 7.0% and the S&P 500 (U.S. stocks) up 6.1%. The underperformance of U.S. stocks can partially be explained by currency movements, as the U.S. dollar fell in relation to a broad basket of global currencies after dovish comments from Federal Reserve policymakers in mid-March. The U.S. economy is strengthening and this usually bodes well for stocks, but will this be enough to counter investor disappointment if policy reform in Washington fails to materialize? We believe the answer is likely to be ‘no’. Valuations in the stock market are becoming stretched. The Dow Jones U.S. Industrial Sector
Index, for example, which has been a great performer since last November, is trading at 18.9x expected 2017 earnings. This figure is up significantly during the last few months and today is (somewhat atypically) above broad market index valuations. Industrials would be big beneficiaries of increased infrastructure spending and it appears that many investors believe there is still hope that such fiscal stimulus might occur. These hopes are likely misguided. Other cyclical equity sectors have also risen significantly during the last few months. Basic materials stocks, for example, have jumped since November and the Dow Jones U.S. Basic Materials Index is now trading at 17.4x expected 2017 earnings.
6
ECONOMIC FORECAST | Q2 2017
We see more value in non-cyclical sectors of the equity market, which are trading at more reasonable valuations. The Consumer Staples Select Sector Index, for example, whose members tend to have stable underlying businesses and consistent results, is trading at 20.2x forward earnings. This is close to historical averages, and reasonable given the dynamics in the market today. Certain areas of the healthcare sector, such as medical device stocks, also exhibit good value. The Dow Jones U.S. Select Medical Equipment Index is trading at 22.2x forward earnings, which is an appropriate premium to the market given the stability and growth prospects of the businesses that make up the sector. The valuations of these equity sectors are not dependent on any policy reform occurring in Washington, and are likely to outperform if the broader stock market dips.
in broad equity indices. This recent underperformance might be the proverbial ‘canary in the coal mine’, and a harbinger of trouble ahead for the general stock market, and especially its more cyclical sectors.
Finally, it should be noted that small cap stocks (as shown by the Russell 2000 Index), which jumped spectacularly in November and December of last year and tend to be highly cyclical, were virtually unchanged in the first quarter despite healthy returns generated
FIXED INCOME: FED’S BALANCE SHEET THE FOCUS The U.S. Treasury yield curve rose and steepened slightly during the first two weeks of March, as speculation mounted that the Federal Reserve could soon begin the process of shrinking its balance sheet. The Fed holds assets worth
$4.5 trillion, including $2.5 trillion of U.S. Treasuries and $1.8 trillion of agency mortgage-backed securities. The $4.5 trillion figure has been roughly unchanged since 2014, as the Fed has reinvested the proceeds of maturing bonds back
into Treasuries and MBS. Fed policymakers will eventually seek to shrink the balance sheet, though the market does not view the outright sale of Treasuries and MBS as a viable option (at least not in the near term). Choosing not to
7
reinvest some of the proceeds of maturing bonds is a real option, however, and the question for bond investors going into the Fed’s mid-March meeting was the timing of such a move and the rate of reinvestment. The 25 basis point hike of the fed funds rate announced during the meeting was widely anticipated and viewed by bond investors as a nonevent.
Fed President William Dudley illustrated the thinking in late March by stating that the Fed wanted the process of lessened reinvestment of principal ‘running in the background’, and ‘not a big deal for markets’. This dynamic argues for a further flattening of the yield curve during the remainder of 2017.
Corporate spreads rose slightly in March, though Fed chair Janet Yellen had previously stated that she they are still down significantly from their levels last did not want to begin shrinking the balance sheet year. Select corporate bonds offer good value, but until the process of raising rates was ‘well we see the most value in agency MBS, especially in underway’. During a press conference March 15 lower coupon buckets. 2.5 coupon MBS, for Yellen further explained that the Fed wouldn’t begin example, are trading at a discount to par and offer shrinking the balance sheet until it had ‘confidence in yields of more than 3.0%. Their higher duration the economy’s trajectory’. This comment was presents interest rate risk in the short term, but their viewed by investors as dovish, with an immediate convexity is low, the risk of duration extension is nil, move to shrink the balance sheet seemingly off the and the roughly 3.0% yield they offer is very likely to table. After the comment the U.S. Treasury yield be realized however interest rates evolve. Higher curve flattened as longer-term rates fell. coupon MBS, which trade at a premium to par, are less attractive. 4.0 and 4.5 coupon MBS, for How the Fed telegraphs its thinking regarding example, have high convexity, are likely to balance sheet moves and further interest rate hikes underperform if interest rates fall, and do not offer will be a major issue for bond investors during the more yield than lower coupon MBS should rates rise. rest of 2017. Tackling both issues concurrently would be risky, and this Fed leadership team has proven to - Brandon Fitzpatrick be very cautious and wary of causing dislocations in the bond market. The most likely outcome, therefore, is that the Fed will take the safe course of continuing to raise the fed funds rate, likely two more times this year (something already widely anticipated by bond investors), while putting off shrinking the balance sheet until 2018. When the balance sheet issue is finally tackled, the Fed is likely to begin with small and cautious adjustments to present policy. New York
8
ECONOMIC FORECAST | Q2 2017
THIS PUBLICATION IS FOR INFORMATIONAL PURPOSES ONLY. THIS PUBLICATION IS IN NO WAY A SOLICITATION OR OFFER TO SELL SECURITIES OR INVESTMENT ADVISORY SERVICES, EXCEPT WHERE APPLICABLE, IN STATES WHERE D.B. FITZPATRICK & COMPANY IS REGISTERED OR WHERE AN EXEMPTION OR EXCLUSION FROM SUCH REGISTRATION EXISTS. INFORMATION THROUGHOUT THIS PUBLICATION, WHETHER STOCK QUOTES, CHARTS, ARTICLES, OR ANY OTHER STATEMENT OR STATEMENTS REGARDING MARKET OR OTHER FINANCIAL INFORMATION, IS OBTAINED FROM SOURCES WHICH WE AND OUR SUPPLIERS BELIEVE RELIABLE, BUT WE DO NOT WARRANT OR GUARANTEE THE TIMELINESS OR ACCURACY OF THIS INFORMATION. NEITHER WE NOR OUR INFORMATION PROVIDERS SHALL BE LIABLE FOR ANY ERRORS OR INACCURACIES, REGARDLESS OF CAUSE, OR THE LACK OF TIMELINESS OF, OR FOR ANY DELAY OR INTERRUPTION IN THE TRANSMISSION THEREOF TO THE USER. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS PUBLICATION. NOTHING IN THIS PUBLICATION SHOULD BE INTERPRETED TO STATE OR IMPLY THAT PAST RESULTS ARE AN INDICATION OF FUTURE PERFORMANCE. ALL RETURNS ARE MODEL RETURNS FROM A COMPOSITE.
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280