The first quarter continued the stock market rally that began following the Presidential election. For the quarter, U.S. stocks advanced, with the S&P 500 returning 6.1%. International stocks fared better, with the MSCI EAFE rising 7.3%. Bonds also gained, with the Barclays Aggregate Bond Index returning 0.8%.
Since the election, the S&P 500 has gained over 10%. The rally has been fueled by improving investor and business optimism, a notable change from the pessimism that has clouded investor sentiment in recent years. This shift in mood has altered the complexion of the market. The recent rally has been led by cyclical sectors, such as materials, consumer discretionary, and financials. This is a significant change from the defensive tone in recent years, when stocks with high dividend yields, such as utilities and consumer staples, led the market higher.
In addition to positive investor sentiment, there are encouraging signs of improvement in the economy. The “earnings recession” that began in 2014 has finally ended. S&P 500 earnings grew 5.7% last year and are expected to grow by more than 20% this year. U.S. GDP grew by 2.0% in 2016 and is expected to accelerate. The employment picture has improved as well, with unemployment falling to a 10-year low of 4.5%.
There has been good news in the energy sector as well. Oil has risen to $52 per barrel from a low last year of $31. As energy prices have risen, profits for energy companies have rebounded. While still not as good as the period from 2011 to 2014, when oil held steadily above $100, there is hope that the worst of the sector’s decline is now over and that oil prices will continue to move higher from here.
Following the recent rise in the stock market, concerns are growing among investors that stocks are becoming overvalued. The S&P 500 now trades at 17.5x times expected earnings, slightly above the long-term average of 15.9x. There has not been a correction in the market since early last year, and many are beginning to worry that we are overdue for a pullback. At current levels, further gains in the stock market will largely depend on continued growth in the economy and in corporate earnings.
The recent market surge has been widely attributed to improving investor sentiment following the election. The primary reason for this optimism has been the expectation that President Trump will successfully implement sweeping policy reforms in many key areas, such as healthcare, taxes, and business regulations. However, Trump’s reform initiatives appear unlikely to occur as quickly as hoped. In March, following a hard-fought debate, an attempt to implement healthcare reform failed to pass. The President’s focus is now shifting to tax reform. While corporate tax reform has broad support, personal income tax reform may be much more difficult. The timetable for any tax reform looks likely to be sometime next year, at the earliest.
After years of disappointing returns, international stocks have enjoyed an impressive turnaround this year, with the MSCI EAFE up 7.3% in the first quarter. Emerging Market stocks have performed even better, with the MSCI EM Index up 11.5% so far this year. There is strong evidence that the global economy is beginning to recover and, in some areas, growth has been dramatic. The Global Purchasing Managers Index (PMI), a widely followed measure of business activity, has improved to 53.0 from 50.7 one year ago (a reading over 50 indicates growth). Germany has experienced the largest improvement over the past year with their PMI increasing to 58.3 from 50.7.
With the economy improving, the Federal Reserve has begun to normalize their monetary policy. They announced interest rate hikes in December and March, increasing their benchmark rate to 0.75%. Many expect they will raise rates two more times this year. They are also considering their options to begin reducing the size of their $4 Trillion balance sheet. These moves to tighten their monetary policy evidence the Fed’s confidence in the strength of the U.S. economy.
The Fed’s recent moves have caused short-term rates to rise, as the 3-month T-Bill rate has risen from 0.5% to 0.8% since the December rate hike. Surprisingly, long-term rates have moved lower as the 10-Year Treasury rate has gone from 2.4% to 2.3%. As the Fed continues to raise their benchmark rate, we expect long-term rates to eventually rise as well. More generally, rising rates for high quality bonds have created a headwind for bonds, with the Barclay’s Aggregate Bond Index up only 0.4% over the past year.
Although returns have been modest for high quality bonds, riskier high yield bonds have posted very impressive returns, with the Barclay’s High Yield Bond Index rising 16.4% over the past 12 months. Returns were helped by improvements in the energy sector as the rebound in energy prices has eased fears of default.
Following a multi-year expansion, we believe that recent improvements in the economy and corporate profits will continue. Despite concerns that the market has become somewhat overvalued, we remain optimistic that ongoing economic growth along with renewed optimism will lead to continued positive market returns in the coming years.
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Horizon Advisors is a Houston based fee-only wealth management firm. Horizon specializes in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.