Investment Review for Second Quarter 2017

Building on the strong performance of the first quarter, financial markets continued to show optimism about the future. Global stocks, led by foreign developed and emerging market companies, increased 4.3% during the past three months bringing the year-to-date return to 11.5%. In contrast, falling oil prices depressed returns for commodities and energy infrastructure assets.

Major asset class returns.

First 100 daze.

The first few months of Donald Trump’s presidency has been awash with off-the-cuff tweets, unorthodox press briefings, and claims of misinformation, leaving many Americans dazed, confused, and unsure what to believe. Regardless of one’s political views, with no significant progress on tax reform, health care, immigration, or the border wall, it is clear that President Trump is finding it difficult to move his agenda through Congress and away from the courtroom.

Normalizing the Fed’s balance sheet.

In total, the U.S. Federal Reserve (Fed), European Central Bank (ECB), and Bank of Japan (BOJ), have purchased over $10 trillion in assets since early 2008 to help increase confidence in the financial system and stimulate economic growth. While the Fed concluded its purchases some time ago, the ECB and BOJ continue to purchase over $110 billion in assets every month.

Later this year, the Fed is likely to start shrinking its $4.5 trillion balance sheet. With hopes of minimizing adverse effects on the economy and financial markets, initial reductions will be limited to $10 billion per month. With a goal of increasing these monthly reductions to $50 billion over time, it is clear that this process will last for years to come. What is not clear, however, is how this will affect interest rates and risky asset prices.

Macron wins.

Emmanuel Macron’s victory over far right candidate Marie Le Pen led to an immense sigh of relief for European Union (E.U.) citizens and investors. Prior to the election, it was widely believed that a victory for Le Pen and her “French First” policies would put further strain on an already fractured European Union and strengthen extremist political movements elsewhere on the continent. With the potential for a FREXIT (French exit from the E.U.) off the table, an additional impediment to E.U. economic growth and job creation has been removed.

The U.S. dollar – blessing or curse?

Contrary to general expectations, the U.S. dollar has fallen nearly 6% thus far in 2017. This is welcome news for U.S. investors whose overseas assets have suffered over the past few years as the dollar rose.

Domestic vs. foreign valuations.

Domestic stocks have risen sharply over the past few years causing their valuations to become elevated. In fact, domestic large, mid-sized, and small companies have appreciated 91.2%, 121.3%, and 119.4% respectively from the prior market peak in 2007. In contrast, foreign developed stocks have gained only 11.8%, while emerging market stocks are up only 4.2%. As a result, foreign stock valuations are relatively cheap compared to both historic measures and their domestic counterparts.

The low volatility paradox.

2017 has been characterized by a great deal of political and economic uncertainty. With historically low interest rates and several years of rising domestic stock prices, it is widely acknowledged that domestic asset prices are a bit stretched. Yet fear and uncertainty (as measured by the CBOE Volatility Index) are extraordinarily low.

In fact, during the first half of 2017, there were seven occasions where the volatility index ended the day below 10. Prior to 2017, this occurred only nine times in over 6,800 trading days. With volatility remaining low for such a long period of time, many investors have become complacent and have been lured into believing that volatility will remain low. As a result, money has poured into U.S. stocks, causing some portfolios to become increasingly aggressive. Unfortunately, previous prolonged stock market declines were often preceded by periods of abnormally low volatility and complacency about risk and valuations. Only time will tell if this proves to be such a period.