This Is No Joke
Doug Walters
In the face of extreme adversity and uncertainty, the S&P 500 has had a strong start to the year, up around 6%. While it felt like April Fools’ at times, the first quarter of 2017 was no joke.
Market Review
Contributed by Doug Walters
Sitting here on April 1st, one would be forgiven for thinking the first quarter was one great April Fools’ prank. This year has been packed with unprecedented adversity: a new and untested administration, confirmed Russian election meddling, Presidential tweet attacks on corporations, a failed health care repeal, London terror attacks, Washington intelligence investigations, North Korea escalation, a rising Fed Funds rate (shall we go on?). Yet we finish the quarter with the S&P 500 up nearly 6% and perhaps most surprisingly, equity volatility is low. This is no joke; it is the conundrum of Q1 2017.
Behind the Curtain
To what do equities owe their performance? We see two primary drivers.
- Optimism: The economy has been steadily strengthening for some time, providing confidence for both corporations and consumers. In addition, we have a new administration with a very corporate-friendly agenda. Lower regulation, lower taxes and higher infrastructure spend are all positive for stocks.
- Demand: With bond yields historically low, investors have a natural preference for equities. Also, corporations have been issuing vast quantities of low-interest bonds and using the proceeds to buy back their shares.
Don’t Be Fooled
As we enter the second quarter, investors face elevated equity and bond valuations. Should investors be running to gold? No. At Strategic, we are:
- Focusing on Quality and Value which we believe can weather adversity and outperform in the long run,
- Prepared to rebalance well-diversified portfolios to take advantage of any market pullbacks, and
- Modestly favoring cash as a holding place for asset sales when value does not present itself.
What investors should not do, is panic. If the administration makes good on its tax, deregulation and infrastructure promises, there could still be significant upside in equities. Trying to time a pullback can do more damage than good.
| Indices & Price Returns | Week (%) | Year (%) |
|---|---|---|
| S&P 500 | 0.8 | 5.5 |
| S&P 400 (Mid Cap) | 1.5 | 3.6 |
| Russell 2000 (Small Cap) | 2.3 | 2.1 |
| MSCI EAFE (Developed International) | -0.3 | 6.5 |
| MSCI Emerging Markets | -1.1 | 11.1 |
| S&P GSCI (Commodities) | 2.7 | -2.5 |
| Gold | -0.1 | 8.3 |
| MSCI U.S. REIT Index | 0.6 | 0.0 |
| Barclays Int Govt Credit | 0.0 | 0.3 |
| Barclays US TIPS | 0.2 | 1.3 |
Economic Commentary
Attacking Trade
President Trump signed two executive orders attacking the nation’s trade deficit this past Friday. These orders target trade agreements, intellectual property theft and $2.8 billion in unpaid anti-dumping dues. The United States has borrowed foreign money to finance the trade deficit which has pushed the nation deeper into debt.
Some economists are alarmed with America’s trade deficit as it continues to rise. One school of political thought is that there should be an import tax to help close the trade gap. The theory implies that if we tax imports, we would import less, protect American jobs, and balance imports with exports. But this could be very dangerous for the economy. While American manufacturing jobs may benefit slightly from protectionist taxes, distributors, that rely on imports to provide value to their customers, may lose their jobs. Import taxes would lead to higher costs which may result in excessive inflation and be a tax on people that have saved, but not invested their devalued U.S. Dollars. Also, American exporters would be concerned with retaliatory measures.
Lawmakers must analyze the impact of an import tax on all sectors of the economy, not just manufacturing, to ensure it creates more benefits than harm to Americans.
Week Ahead
April FOOLS’
Factory production is expected to remain in high gear with the ISM Manufacturing Index at 57 in March, a bit lower than the prior month’s 57.7.
- An index reading above 50 indicates that economic activity is generally expanding; below 50 declining.
Oversupply of leased vehicles is taking a toll on auto manufacturers. Investors will be tracking motor vehicle sales data for the month of March.
- February sales were 17.5 million.
- Ford has already lowered their production guidance for 2017 and 2018.
Openings in non-farm jobs are expected to shrink if the March Non-farm Payroll report shows that another 180,000 expected workers have joined the labor force.
- The U.S. National Unemployment Rate of 4.7% translates to 7,528,000 unemployed persons.
- 2,156,000 non-farm jobs have been created in the past 12 months.
Leading economic data from the Euro-Zone include manufacturing production, orders as well as trade balance figures. Most EU countries are expected to post flat growth in manufacturing production.
- Germany is expected to grow manufacturing orders in February by almost 4% vs. negative 7.4% growth in January.
Spending on construction is expected to grow by 1.1% in February. A further increase in construction spending may improve growth expectations for real estate.
- Buyers are expected to rush into the housing market before mortgage rates advance any further.
Strategy Updates
Contributed by Max Berkovich ,
STRATEGIC ASSET ALLOCATION
Quality Achievement
The Vanguard Dividend Appreciation Index Fund (VIG), which tracks an index of stocks that have grown their dividends for ten consecutive years, had a good first quarter. The mandate is similar to our Equity Income strategy. Sometimes these funds get lumped with value investing, yet most these indices do not focus on dividend sustainability, and therefore investors often end up with higher risk and lower quality companies. In particular, troubled businesses that trade at a lower earnings multiples tend to find themselves in the value index.
- VIG contains quality companies that have paid and grown their dividends through one of the worst economic recession in 2008.
- VIG’s top 3 sectors are Industrials 23%, Consumer Staples 23% and Healthcare 15%.
- VIG underperformed the Russell 1000 Value Index (IWD) by nearly 5% in 2016 but is now outperforming by over 3% year-to-date.
Bond Check
International Bonds are the clear fixed income leader so far in 2017 due to the U.S. dollar’s decline from the year-end 2016 highs. Tax-exempt bonds have also outperformed taxable bonds so far this year, despite hopes for tax cuts out of Washington. Reversion to the mean is the culprit as the tax-exempt bond sector was a major laggard in 2016.
- Despite a ¼ of 1% rate hike from the Federal Reserve thus far this year, the difference in yield between the 2 year and 10 year U.S. Treasury bonds has narrowed to 1.11%, leaving little compensation for extending bond maturities.
- High Yield (i.e. junk bonds) have continued to produce better returns than investment grade bonds and continue to track equity markets higher. We caution that weakness in retail may hit high yield a lot harder than the energy space did last year.
STRATEGIC GROWTH
How Do You Like Them Apples?
The Technology sector was king for the first three months of the year, while the Energy sector was the sad court jester.
- The top stock for the strategy was the semiconductor Skyworks Solutions Inc. (SWKS), as consolidation in the chip space, the continued growth of mobile telecom, expectations for a lower tax rate and the strong performance from a major end user, Apple Inc. (AAPL), created a strong tailwind for the company.
- The bottom stock for the quarter was also a semiconductor. Qualcomm Inc. (QCOM) found its business model under attack this year. Major mobile telecom companies claim the company is charging unfair royalties for the use of its intellectual property. One plaintiff is Apple Inc. (AAPL). Also, the company has been unable to gather enough shareholder approval to acquire fellow strategy holding NXP Semiconductors (NXPI).
STRATEGIC EQUITY INCOME
Oil Kidding Aside
Here too the Technology sector led the way, while the Energy sector lagged.
- The top stock for the strategy was the previously mentioned iPhone maker Apple Inc. (AAPL). The company stands to benefit from a tax repatriation break and lower corporate tax rate if the legislation comes to pass. Also, excitement keeps building for the pending next iteration of the iPhone.
- The race to the bottom of the pack was down to the wire, but all the contestants were in the same business: oil and gas exploration. We will give it to Occidental Petroleum Corp. (OXY). Oil prices, measured by the NYMEX WTI Crude, have fallen by nearly 10% in 2017 bringing oil stocks down by with it.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on client assets of over $1.8 billion.
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