Highlights:
· During a quiet quarter in terms of volatility, global equities continued to climb on the heels of strong economic growth and corporate earnings.
· The U.S. Federal Reserve raised short-term rates while other central banks around the world held tight during the quarter. This marks a significant change from the first quarter of 2016.
· The new administration in the U.S. is learning it is not so easy to effect change in Washington after all, while also dealing with geopolitical issues in North Korea and Syria that flared up during the quarter.
· Equities have generally performed well in rising interest rate cycles due to the underlying strength of the economy that supports rate increases.
Commentary:
In what was the least volatile quarter for both the Dow Jones Industrial Average and the S&P 500 since the mid-sixties, global equity markets continued to surge. Shaking off geopolitical worries and trading tensions, investors pushed stocks higher on the underpinnings of strong corporate earnings and economic growth. The Federal Reserve also pointed to a more robust and resilient economy and healthier labor market by determining to raise short-term interest rates during the quarter and setting the table for further rate increases later this year. Other central banks around the world, including Europe, Japan and the U.K. amongst others, are generally expected to leave borrowing costs unchanged in the near term and avoid enacting any further stimulus measures as the risks of deflation are waning. This marks a significant turnaround from a year ago, when the U.S. central bank was holding rates steady and other central banks were cutting rates or expanding their bond-buying stimulus efforts amid deflation fears and weak growth.
Much of the appreciation seen in the domestic equity markets since last November’s election has been driven by optimism surrounding President Trump’s pro-growth agenda. However, President Trump is learning first-hand just how difficult it is to “change” Washington and the vast difference between proposing big ideas and turning those ideas into actual laws. In a major defeat for the new President, House Republican leaders withdrew legislation to repeal Obamacare during the quarter in the face of stiff opposition from lawmakers in his own party. Issues such as tax reform and infrastructure spending plan aren’t likely to prove any easier for the new administration and will likely be tackled later this year while the administration focuses on rebounding from the healthcare defeat in the near term.
International equity markets have lagged relative to the U.S. during the recent 8-year bull run, but there are signs that this might not persist much longer. First, it was announced that the Eurozone economy kept pace with that of the U.S. for the first time since 2008 last year. Coupled with an improving labor market, this has allowed the European Central Bank to defer any further stimulus measures for the time being and comes at a good time on the heels of Brexit and with the pending French presidential election. Meanwhile, China recently reported its first back-to-back quarters of accelerating GDP, powered by strength in housing, infrastructure investment, exports and retail sales. This strength in Chinese growth should benefit emerging markets through commodities demand and support for commodity prices, while the Asian manufacturing supply chain should get a boost from stronger Chinese growth as well.
Despite strong equity market returns, geopolitical threats and political tensions have heightened over the last couple of months. Tensions have widened between the U.S. and North Korea over North Korea’s development of nuclear weapons and ballistic missiles. This is coming shortly after a U.S. missile strike in Syria in response to Syria’s suspected chemical attack that that added friction to relations between the U.S. and Russia, who has to this point supported Syrian President Bashar al-Assad. The world will also be closely watching the French presidential election this spring to see just how far the populist movement has travelled after last year’s surprises of Britain’s secession from the European Union and the election of Donald Trump as U.S. president. Populist ideologies have led to trading tensions that threaten the progress made by globalization over the last several decades.
If major geopolitical crises can be avoided, trade tensions alleviated and the global economy continues to improve, inflation will likely continue to accelerate (so-called reflation). In this case, central banks are likely to gradually increase interest rates and try to reduce their balance sheets in as non-disruptive a manner as possible, and easy money will be slowly drained from the financial system. As they say in mountaineering though, the descent is always more dangerous than the ascent and in this case shrinking the balance sheet will be the descent.
There is a commonly held belief that increasing interest rates is bad for stocks since bonds look relatively more attractive and rates used for discounting future cash flows also go up, which drives near term stock values down. However, another reason interest rates increase is underlying strength in the economy, which drives up the cost of money for everyone. An accelerating economy leads to faster growth in corporate earnings and cash flows, which is a positive driver for stock values. An analysis of the tradeoff between the downside of higher rates and the upside of faster growth shows that equity markets generally outperform historical averages during most rising interest rate cycles. One downside of a strengthening economy is inflation, which eats away at the purchasing power of consumers. However, this is also not detrimental to long-term equity investors as equity markets generally outpace inflation during risking interest rate cycles by more than long-term averages while bonds fail to outpace inflation during these periods.
This does not mean that investors should abandon their fixed income investments in anticipation of a rising interest rate cycle. The fixed income portion of a portfolio for investors that have near-to-intermediate term withdrawal requirements is a critical part of a prudent investment policy that avoids all forms of market timing and emphasizes diversification and downside protection. Bond prices do go down as interest rates rise, but this does not impact passive (buy-and-hold) fixed income investors who lock in a yield-to-maturity when they purchase a bond and are then able to reinvest bond maturity proceeds at higher rates. The objective of a diversified fixed income portfolio is generally to keep up with inflation and maintain purchasing power, while allowing the equity portion of a portfolio to grow over time.
Thus, we continue to suggest that investors adhere to an investment policy based on core principles including: 1) avoiding all forms of equity market and interest rate cycle timing, 2) employing effective diversification, 3) maximizing the benefits of tax-deferred growth, and, 4) portfolio insulation through the use of cash and fixed income positions where withdrawals are anticipated over the near-to-intermediate term. This policy may not result in compelling cocktail party stories, but it likely will continue to provide a propensity for compelling longer-term performance.
Urban Financial Advisory Corporation - April 2017