Investment Review for First Quarter 2017

Emerging market stocks shook off their post-election woes and posted a double digit return for the first quarter of 2017. This gain far outpaced global stocks that as a whole appreciated 6.9%. In contrast, U.S. small caps gained a mere 1.1% after their rapid 26.6% increase in 2016, which led many investors to believe the category may be a bit expensive.

Core bonds (safer bonds) advanced modestly during the first quarter. The category was led by municipal bonds, which recovered from their year-end sell off as investors began to realize that tax cuts (which make municipal bonds less attractive) would not materialize in early 2017. Non-core bonds (riskier bonds) added to their spectacular gains of 2016. First quarter gains now bring emerging market, high yield corporate, and leveraged loan returns into double digit territory for the trailing 15-month period.

Major asset class returns.

Future interest rate hikes.

In 2008, the Federal Reserve reduced short term interest rates to near zero. Short term interest rates remained at that level until December 2015, when the Fed began the process of increasing interest rates and slowly reducing the extraordinary levels of monetary stimulus. This process continued in March, as the Fed increased short term interest rates by 0.25% for the third time (Dec 2015, Dec 2016, March 2017), bringing the target range to 0.75% – 1.00%.

With the unemployment rate, economic growth, and inflation all near the Federal Reserve’s longer run targets, it is likely that we will see more interest rate increases from the Fed in 2017. In fact, bond market pricing currently indicates an 87.6% probability of at least one additional interest rate increase and a 51.1% probability of two or more additional interest rate increases this year.

Non-core bonds are no longer cheap.

Investors willing to accept the risks associated with high yield corporate bonds (riskier bonds often referred to as “junk bonds”) are compensated with higher interest payments than they would otherwise receive from government bonds with similar maturities. Currently, the amount of additional interest is roughly 3.4%, which is much lower than the 25-year average of 4.7%. As such, high yield bond investors are receiving less compensation today than they have historically for the added risks they are taking.

Similar to high yield bonds, emerging market bond investors are also receiving less compensation as well. Currently, the amount of additional interest is roughly 3.1%, which is much lower than the 20-year average of 4.2%.

The price of oil.

Amidst booming shale oil fields, domestic oil production increased 22% between 2013 and 2015. With demand increasing only modestly and other producers unwilling to curb production, the supply/demand imbalance led prices to fall from mid-2014 through early 2016. While OPEC countries had hoped to bankrupt U.S. shale producers, a combination of technological innovation and increased efficiency led to reduced costs for domestic producers and a rebirth of stronger shale producers as oil prices stabilized in 2016.

Hard data soft data, and U.S. stock valuations.

When surveyed, both small business owners and purchasing executives paint a very rosy picture of the U.S. economy. In fact, the recent surge in optimism of both groups puts them at levels not seen in years. Optimism, however, does not yet seem to be translating into increased economic activity. When looking at hard data (quantifiable data), such as capital goods orders and non-residential construction spending, there has been little improvement since the November election.

The lack of hard data has not stopped domestic stocks from surging 11.4% since the election. With no significant improvement in economic conditions, corporate profits, or favorable stock valuations, the only explanation for investor optimism is hope: hope for corporate tax reform, lower tax rates, reduced regulation, a healthcare fix, and massive infrastructure spending. Unfortunately, hope cannot support domestic stock market valuations at these levels indefinitely without improved economic fundamentals and increased company earnings to accompany them.