A Solid Quarter

Global equity markets had a solid first quarter, continuing the trend that started after November’s U.S. election.  U.S. stocks, as measured by the S&P 500 Index, advanced 5.5% in the quarter.  The Stoxx Europe 600 Index was also up 5.5%.  The first quarter, from a volatility perspective, was the calmest quarter in U.S. markets since 1967, with the S&P 500 posting an average daily move of just 0.32%.  Stocks reached their best levels at the beginning of March and have drifted lower since.  

Bonds, after losing lots of ground as interest rates spiked up during the post-election stock rally, flattened out in the quarter.  The ten-year U.S. Treasury note yield fell to 2.396% from 2.446% at the beginning of the year.  Even with two Federal Reserve Bank 25 basis point Fed Funds rate hikes in the quarter, longer rates didn’t budge.  The stable yields on longer-term Treasury debt in the face of two rate hikes reveal investors’ slightly increasing skepticism about the trajectory of the economy.

Tempering Influences

The enthusiasm investors had for stocks as the new year arrived now seems to have been tempered somewhat by three factors: the new administration’s challenges thus far to move its legislative agenda forward, already-rich valuations for equities and a darkening geopolitical situation.

Agenda Challenges

The Trump administration’s setback with regard to health care reform has cast some uncertainty on the administration and its ability to push through its agenda.  Investors are probably foreseeing tougher battles ahead in Congress for Trump and probably also a lengthening timeline on things like tax reform and an infrastructure bill.

Rich Valuations

Since the election, investors have accorded many stocks higher price-to-earnings (P/E) multiples—essentially giving stocks credit for growth that is yet to be realized.  But the underpinnings of the recent market strength are strong nevertheless. U.S. companies are now beginning to report their earnings for the first quarter, which is expected to be the strongest quarter for profit growth in six years. (Profits may be 9% higher than last year.)  Earnings have been in a strong recovery for six months now, but now revenues are also expected to be significantly higher.  In the years following the 2008-09 crisis, companies bolstered their profits largely by cutting expenses, not growing their sales.  Corporate revenues, which are expected to grow by 7.1% this quarter, should help to meaningfully increase the profits of companies that have spent the last eight years becoming more streamlined and efficient.

Souring Geopolitics

The geopolitical situation has soured in recent weeks, and investors have accordingly pulled back somewhat from risk assets (stocks) and moved some money into safe havens (bonds, cash and gold).  There are three specific situations that investors are monitoring closely.

First, the launch of 59 Tomahawk missiles onto a Syrian airfield in retaliation for the Assad regime’s recent chemical weapons attack marked a change in U.S. policy toward Assad and increases the likelihood of a butting of heads with Russia, a Syrian ally.  Just in the last day, Secretary of State Rex Tillerson was in Moscow, presumably, to try to convince Putin to abandon Assad.  Russia, which enjoys its influence and military presence in the region due to its relationship with Assad, is highly unlikely to play ball.

Second, tensions between the U.S. and North Korea are on the rise.  Pyongyang has conducted several missile tests in recent months, seemingly trying to demonstrate its military prowess to the new administration in Washington.  President Trump, in a recent meeting with Chinese President Xi Jinping, asked for China’s help with tackling the North Korea matter.  Whether any cooperation from China is forthcoming is unknown.  In any event, he told Xi that the U.S. would deal with the problem alone if China were unwilling to help.  (The Syria missile barrage may have convinced both China and North Korea to take him more seriously on this pronouncement.)  USS Carl Vinson, an aircraft carrier based in my hometown of Coronado, is now on its way to the region.  

Third, the French Presidential elections are set to begin in two weeks.  Normally, global investors would pay very little mind to this event.  However, this time the National Front candidate, Marine Le Pen, has, if she wins, promised to hold a referendum in France as to whether or not the French should remain in the European Union.  If she were to win the election, investors would have to seriously contemplate the prospect of France hiving off from the EU.  The polls have her moving into the run-off round but ultimately losing the election to Emmanuel Macron.  We’ll see.

The stalled rally in stocks shows investors are looking for more meat on the bone – tax reform, regulatory reform, a feasible infrastructure plan, solid corporate profits – before they push the market higher.  2017, at its outset, seemed like it would be an interesting year.  So far it has not disappointed.

Please do not hesitate to contact me if there is anything about the markets or your portfolio that you would like to discuss.