05/23/2018: Market Commentary – Quarter 1 2018
Q1 2018 Market Commentary
Stock and bond valuations adjust. Although stocks currently look attractive relative to bonds, recent price movements (stocks up, bonds down) have combined to narrow the gap. We see this as a healthy development and are taking the opportunity to modestly reduce risk and trim our equity overweight.
Volatility is likely to remain elevated. Equity market volatility has risen substantially this year from levels that were unusually low. Dollar (currency) volatility is also higher – in part due to tough talk on trade.
U.S. earnings are outpacing international peers. U.S. earnings are now growing noticeably faster than either of their international developed or emerging market counterparts and we expect to see markets price this in over the medium term. In particular, we are focused on domestic growth themes, which have been rewarded recently.
The strong labor market may keep Fed policymakers on edge. Counter to policymakers’ intuition, low levels of unemployment have yet to produce outsized wage gains this cycle. We worry about the potential for an overreaction by the Federal Reserve should inflation rise or unemployment fall further.
US equities began 2018 strongly, buoyed by ongoing strength in economic data, robust earnings and the confirmation of a major tax reform package. Macroeconomic data remained broadly positive throughout Q1. US business confidence reached an unexpected, multi-decade high in March. GDP for Q4 2017 was revised upwards to show growth of 2.9%, and while industrial activity slowed – as measured by the ISM manufacturing index, it continued to indicate expansion.
However, the latter part of the quarter saw a marked increase in volatility. Investors first digested the destabilizing potential of an elevated US inflation reading and the possibility that the Federal Reserve (Fed) may need to become more proactive in raising interest rates in order to keep upward price pressures under control. The Fed did indeed raise rates by 25 basis points (bps) in March, to a range of 1.5% to 1.75%. It did not, however, alter its overall rate projection of three hikes for 2018. The announcement quelled some concerns, but escalating US-China trade sanctions precipitated a renewed bout of turbulence in March.
Eurozone equities delivered negative returns in the first quarter, with the bulk of the declines coming in March. The region’s stock markets began the year on a firmer footing but worries about the path of US interest rates and the outlook for global trade led to declines for the period. The worst performers in terms of sectors were healthcare and telecommunication services. These sectors are typically thought of as “bond proxies” offering stable returns and are much sought after when bond yields are low. However, amid expectations of rising US rates, and therefore rising bond yields, such sectors fell out of favor in the quarter. Energy was the only sector posting a positive return while information technology and consumer discretionary saw only modest declines.
Emerging markets equities showed a positive return in the first quarter, despite a rise in market volatility stemming from tensions over global trade. The MSCI Emerging Markets Index recorded a positive return and outperformed the MSCI World.
US Treasury yields rose markedly across the curve over the quarter as expectations of growth, inflation and interest rates shifted higher. Volatility returned to markets, picking up sharply from low levels and impacting risk assets. In March, sentiment was negatively impacted by rising trade tensions between the US and China.
The US yield curve continued to flatten modestly with shorter-dated maturities impacted by a rate hike and substantial issuance in March. Ten-year yields increased from 2.41% to 2.74%, reaching a high of 2.95% in February, five-years from 2.21% to 2.56% and two-year yields from 1.88% to 2.27%.
Overall, the S&P 500 declined in the period. Cyclical sectors performed more strongly in January and February, when the market was focused on faster rate hikes. In March, the broader decline in risk appetites saw more defensive areas outperform. Over the quarter, the weakest performance was in telecoms and consumer staples, although most sectors fell. Technology and consumer discretionary stocks were the only positive sectors over the quarter.
Headline and Structural Risk
Heavy handed political rhetoric and tactics are nothing new to Washington, but rarely has the public been exposed to these raw conversations in the way that President Trump uses tweets and the media. That, coupled with tense negotiations around trade, has created quite a bit of headline risk. The problem with headline risk is that it is very speculative and highly emotional.
We focus much more on the structural side of the equation, such as the core economic data that drives global commerce. Despite the headlines, the economic and market data remain strong. When we look back at events such as the Russian invasion of Crimea, the Brexit, the US presidential election, and the “oil crisis” we saw intense market volatility on what “might” happen. As we know now, heavily de-risking a portfolio at any one of those junctures without a mechanism to quickly re-enter markets would have been disastrous.
Headline risk is completely unpredictable. There is no successful model or approach that deals with utter randomness. Given the options, we design our math around what we believe to be a structurally sound approach that understands there are two levels of risk management:
- An investors risk tolerance that blends asset classes is designed to manage “normal” volatility, which mathematically is where we are at in equity markets today (for now).
- Once volatility becomes “abnormal,” our investment process seeks to add additional layers of volatility management.
In short: In our opinion, hang tight. There is no great way to manage headline risk other than to stay true to your risk tolerance and ride out the storm. It’s not fun, but history shows us it’s the most effective choice.
We continue to prefer equity over fixed income; however, we are modestly trimming equity exposure across the portfolios. Economic growth currently appears strong globally but political risks loom and sentiment indicators suggest a slight reduction in risk may be warranted. Additionally, the rise in interest rates has made fixed income appear relatively more attractive.
U.S. Equities: We continue to favor U.S. equities and are increasing our overweight position across the portfolios. This move is driven by a strong pickup in earnings momentum relative to other regions. Within the U.S. we are maintaining our overweight to small and mid-cap stocks and modestly increasing our momentum allocation. We think small and mid-cap companies could benefit disproportionately from stimulus and policy that is primarily aimed at domestic growth. The expansionary environment currently appears supportive of momentum trends.
International Developed Equities: We are further reducing exposure to international developed equities. Despite strong valuations, earnings momentum is weak relative to other regions which is driving the move. Also, we are eliminating our currency-hedged allocation. Although we do not have a strong view on the dollar, there has been heightened currency volatility which we believe is likely to persist in the near-term as discussions develop surrounding U.S. proposed trade tariffs.
Emerging Market Equities: We are maintaining a positive outlook for emerging market equities but are modestly reducing our overweight position as part of overall portfolio risk management. Emerging market economies are at a much earlier stage of expansion, and currently exhibit attractive valuations as well as solid corporate fundamentals.
Fixed Income: We remain cautious on duration while migrating to a more defensive stance on credit across the portfolios. Although spreads have widened, some of the move likely reflects an increase in the risk of defaults. At the margin, we prefer to take risk in equities at this stage in the credit cycle.
Satellite Allocation – Tactical
Within our tactical allocation we remain overweight Emerging markets based on valuation, and relative strength. We also continue to hold Financials, and Global Technology sector ETF’s based on relative strength. During the quarter we reduced the overall equity exposure and increased defensive holdings by adding exposure to Long/Short, and Trend Following based on high volatility readings. The addition of these holdings will add defensive exposure with low correlation to equity markets, and further reduce risk.
** Oregon Pacific Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Information is provided solely for informational purposes and therefore are not an offer to buy or sell a security. Information is not warranted to be correct, complete or accurate, and only reflect the opinion of our investment manager at the time of writing. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance**