Quarterly Market Commentary – First Quarter 2017

A tradition unlike any other. No, not the Masters, but another positive quarter for equity markets as March 2017 marked the eighth anniversary of the U.S. equity market low. Equity markets posted positive returns during the first quarter of 2017, further adding to our 93-month expansion. While most economists are more uniformly beginning to describe this expansion as “long in the tooth” or “in the later innings,” the data shows that there is still room for growth not only here in the United States, but certainly overseas as well.

November’s election momentum (or Trump Trade, as it is being called in the press), continued as most major asset classes remained on a positive trend into 2017. The Dow Jones Industrial Average and S&P 500 indexes were up 4.6% and 5.5% respectively, while the NASDAQ led the pack with a 9.8% return for the quarter. Additionally, forecasts of corporate profits and revenues are positive, and consumer sentiment appears to be trending upward.

The rally began to subside during the latter half of the quarter, as focus shifted from anticipation of new Trump policies to potential implementation hurdles. With the new health care legislation failing to make it to the floor of the House for a vote, investors faced increased angst and uncertainty as to what parts of the Trump agenda will come to fruition. We see this as a possible foreshadowing of other potential fiscal, political and economic roadblocks to come as the administration begins to shift focus to other initiatives, such as tax reform.

The Federal Reserve was the other big attention grabber of the quarter. Though it came as little surprise, the Fed raised the overnight federal funds rate by 0.25% in March, the second hike in three months. The rate increase brought the target range to between 0.75% and 1.00%. The Fed is expected to make at least three rate hikes in 2017, barring a major macroeconomic event. Most economists and financial analysts are predicting the next rate hike in June, with a third hike in December.  

Another point of debate is the speed with which the Fed may act to reduce its balance sheet in an attempt to divest some of the treasury and mortgage-backed securities it purchased as part of its Quantitative Easing program from 2009 to 2013. The Fed committee is fairly unified in its belief that interest rate changes – not the balance sheet – should be the primary tool for monetary policy management. There is some disagreement among the Fed committee members, however, about the speed and process for reducing the balance sheet.  We know the Fed would like to begin the process later this year, possibly resulting in an increase in interest rates all along the treasury yield curve. Since increasing interest rates represents a tightening of the money supply, this process could have a dampening effect on future economic activity right at the time our expansion is reaching its latest innings. With so many foreign investors seeking AAA-rated bonds with a positive yield and pension plans looking to reducing their equity market exposure as rates rise and pension liabilities drop, the demand for longer-dated securities may be easily fulfilled by the Fed’s actions, thus diminishing the impact to interest rates.

As far as economic data goes, the current state of the U.S. economy is at or above all of the Fed’s major forecasts with year-over-year GDP growth at 2.1%, unemployment at 4.5% and PCE (personal consumption expenditures) inflation at 1.9%

Equity Market Review

U.S. equity markets were led by large cap growth with a return of 8.9%. This is a reversal of last year, when large cap growth was the worst performing U.S. equity style box for 2016. Small cap value, the best performing U.S. equity style in 2016, was the worst performer during the first quarter with a -0.1% return.  

In the 11 sectors of the S&P 500, investors saw a wide dispersion in returns. The technology, health care and consumer discretionary sectors performed the best (with returns of 12.6%, 8.4% and 8.4% respectively) while energy, telecom and financials lagged (with returns of -6.7%, -4.0% and 2.5% respectively).

Coming off a solid 2016, emerging markets equities continued to lead the way from an international equity standpoint during the first quarter 2017 with a return of 11.5% (as measured by the MSCI EM Index). International developed markets (as measured by the MSCI EAFE Index) also posted strong returns for the quarter with 7.4%.

Fixed Income Review

Investors saw a flattening in the U.S. fixed income yield curve during the first quarter of 2017 as interest rates on the short end of the yield curve increased while rates on the long end of the curve decreased, albeit slightly. The yield on the 10-year U.S. Treasury note decreased from 2.45% on December 31 to 2.40% on March 31. Meanwhile, the yield on the three-month note increased from 0.51% to 0.76%.

The Barclays Aggregate Bond Index, a measure of investment grade debt, experienced positive returns for the first quarter with 0.8%, a much-needed comeback after a -2.98% return during the fourth quarter of 2016. High-yield debt continued with its upward pace with returns of 2.7% for the quarter.

Diversification

As always, diversification is a topic that we stress to retirement plan participants through communication and education meetings. A diversified asset allocation portfolio is meant to smooth out returns over the long term without having huge positive or negative swings. The following chart shows an example of the long-term results of diversification.

Diversification Table Q1 2017

1 Source: J.P. Morgan Asset Management’s Guide to the Markets