Signs of a Shift in Momentum?
The first quarter of 2017 was remarkable for its noticeable absence of drawdowns. The S&P 500 traded for 109 days without a downside move of more than a percent beginning in November 2016 and ending in March 2017 when the rally in U.S. equities lost considerable steam. Even so, the S&P 500 Index still managed to gain 5.5% in the first quarter of 2017 and finish within 2.0% of its all-time high.
Despite its low level of volatility, the quarter was, however, certainly not absent of negative news, uncertainty, and caution. In the U.S., investors watched as new political leadership took the reins, and the Federal Reserve debated over the path of interest rates. Globally, elections in Europe, deliberations over ‘Brexit’, and geopolitical tensions in Asia raised concerns for investors, and still, equity markets pushed higher.
Perhaps, financial markets were able to surmount these concerns and keep ascending on the continued belief of market-friendly reforms. Possibly, the underlying fundamentals and economic data drove investors. Or maybe, investors are being swayed by so-called “animal spirits”. It’s likely to be some combination of all three, but no matter the mix, we are still constructive on equities and risky assets.
U.S. equity market momentum slowed significantly as investors began questioning the Trump reflation trade. Executing Trump’s “America First” agenda is proving far more difficult than many at first thought. Moving forward, U.S. equities might yet experience a correction, but if this were to happen, we expect equities to find their footing again before long and progress to new highs. In small measure, that belief is attributable to our judgment that the Trump reflation trade is merely delayed, not dead. Health care reform is complex with no easy fixes and no consensus around the more difficult choices. We do not believe that future legislative action will be similarly doomed. Already, significant steps have been taken toward deregulation of both the financial and energy sectors.
While we, of course, welcome constructive legislative action, of greater importance to us, is the coming economic data. Global and domestic surveys of manufacturing are roaring. CEO Confidence is on a sharp upswing. The NFIB Small Business Optimism Index is up over the last year on its largest gain since the early 1980’s. And, despite a sharp one percentage point rise in mortgage rates, the NAHB survey of home builders surged forward. In the coming weeks, we expect this survey data to translate into hard economic data and rising corporate profits. This should ultimately bode well for stock prices.
High yield spreads over Treasuries have tightened significantly, and rightfully so, given the growing economy, improving corporate profits and a rebound in commodity prices. While the value proposition is not what it was a year ago, we still see evidence for strategic investors to hold onto this asset class. Default rates are starting to slowly taper off – a dynamic we expect to continue. Spreads are tight but will remain tight as long as underlying fundamentals hold up and international investors hunt for yield.
Given some signs of a shift in momentum, the balance of risks and rewards in Europe may be turning in favor of investment opportunities. The growth outlook in the Euro-area has also accelerated significantly surprising many that monitor the region. At the same time, however, most major European countries currently have above average policy uncertainty, including the U.K., France, Germany, Spain, Italy, and Ireland. For us, this helps explain some of the weakness in the Euro as well as the hesitation to invest in its equity market. However, our base case for the Euro area is that the populist, anti-EU leadership will remain subdued in the coming months and economic fundamentals will begin to move to the forefront of investment decisions. Using current valuation levels, European equities may have good upside potential if political uncertainty clears.
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