Financial markets experienced a volatile opening quarter of 2018, however the underlying economic conditions appear to remain robust according to recent releases. Following back-to-back quarters of greater than 3% economic growth, the final reading of fourth quarter GPD was reported to show 2.9% growth, with strong consumer spending offsetting a trade deficit. For the full year of 2017, the US economy grew 2.3%, which was an acceleration from the 1.5% reported in 2016.
News from Washington DC continues to impact the markets and economy. The recently passed Republican-led tax reform bill is expected to raise corporate earnings as well as workers’ take-home pay, but the White House recently prompted fears of potential trade war after announcing its intentions to implement certain tariffs targeting China. While the announced tariffs are expected to have only a modest economic impact, the risks of an escalation by the US or any of its trade partners could have deeper repercussions on the global economy.
Synchronized global growth continued with most world economies reporting data indicative of expansionary conditions. GDP in the European Union rose 2.5% for 2017, its fastest growth since 2007. Eurozone unemployment recently fell to its lowest level in nearly a decade, and Japan’s jobless rate is sitting at levels not seen since the 1990s. Economic growth around the world was strong for 2017, although some worries of slowing growth have emerged.
US consumer confidence hit an 18-year high during February, before retreating slightly in its March release. The number of Americans filing new applications for unemployment came in at the lowest level since 1973 per a late March reading of the Department of Labor’s initial jobless claims report. Employers have added 242,000 jobs on average per month over the past three months, and the unemployment rate remained at 4.1% for five consecutive months.
Despite a rise in mortgage rates, the housing market appears to be in good shape for the time being. Pending home sales increased 3.1% in the February release, while housing prices remain firm with the S&P/Case-Shiller national home price index indicating January home prices rose 6.2% from the previous year. The continued surge in home prices appears to be driven by lean inventory in the housing market.
The manufacturing side of the economy continues to perform well. The Institute for Supply Management’s Purchasing Managers Index (PMI) registered at 59.3 for March, down slightly from the February reading of 60.8, which marked the PMI’s highest level since 2004. A reading above 50 indicates that the manufacturing economy is expanding; below 50 indicates contraction. Construction spending is up 3% over last year, although the rate of increase has slowed in recent months.
Crude oil prices reached their highest levels since mid-2015, with WTI crude oil closing the quarter just under $65 per barrel. Other commodities were mixed, with industrial metals mostly lower, corn and soybeans rising approximately 10%, and gold managing a small gain for the quarter.
As we head into the balance of 2018, whether or not the recent economic momentum persists will be closely monitored. The Trump administration’s goal of reaching 3% economic growth may well be buoyed by tax cuts and an increase in government spending. However, slowing retail sales and a trade deficit at nine-year highs may be pointing to a challenging first quarter when data is released.
As expected, the Fed raised rates to a range of 1.50%-1.75% at its March Federal Open Market Committee meeting, which was the first meeting led by the new Fed Chairman Jerome Powell. In its statement, the Fed noted that the labor market had continued to strengthen and that economic activity has been rising at a moderate rate. Importantly, the Fed lifted its economic growth projections for 2018 and 2019, and forecasts now call for at least two more rate hikes for the balance of 2018.
Longer-term rates moved up during the first quarter of 2018. The yield on the 10-year Treasury hit a four-year high of 2.95% in February before falling to end the quarter at 2.74%, compared to the 2.41% where it ended 2017. The overall rise in interest rates pushed bond prices lower and led to negative bond market returns for the quarter. The widely tracked Bloomberg Barclays US Aggregate Bond Index dropped 1.5% during the first quarter.
Despite the reasonably strong economic data suggesting continued expansion, the yield curve (the spread between the 2-year and 10-year Treasury issues) ended the quarter flatter than it began. Corporate bond spreads (the yield gap between corporate and government bonds of the same maturity) widened during the quarter amid an increase in volatility.
Even with a robust labor market and increasing economic activity, the Fed continues to feel comfortable with current levels of inflation. However, the Fed’s preferred measure of inflation increased 1.8% year-over-year in its most recent release, still within the Fed’s comfort zone but nevertheless, its highest level in nearly a year. Most economists expect inflation to continue to gradually rise in 2018 as low unemployment and continued economic expansion put upward pressure on wages.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 3/29/18)|
|Barclays Capital US Aggregate||1.20%||Merrill Lunch US High-Yield||3.67%|
|Barclays Intermediate Government||-0.14%||Merrill Lynch US Municipal Index||2.77%|
|Dow Jones Corporate||2.31%||JP Morgan EMBI Global||3.34%|
The S&P 500 snapped a nine-quarter winning streak by falling 0.8% during the first quarter of 2018. Likewise, the Dow Jones Industrial Average dropped 2.0%, also its first decline in over two years, while the tech-laden NASDAQ Composite managed to post a gain of 2.6%, its weakest advance in over a year. The momentum of strong performance in 2017 for the major market indices continued into early 2018 with the S&P 500 setting an all-time high in late January, but concerns about rising interest rates, stock valuations, and potential ramifications of protectionist trade policies sent the S&P 500 and Dow Jones Industrial Average markets into a correction (defined as a 10% drop from a peak) in early February. The selling continued into March, with all the major US large cap indices in the red for the month. The heightened volatility to begin 2018 was a marked change in sentiment, as the CBOE Volatility Index ended the quarter at nearly twice the level where it stood through much of 2017. Put another way, the first quarter alone saw roughly three times as many days with a move of greater than 1% in the S&P 500 index than what occurred during the entire previous calendar year.
Within US large cap equity markets, growth stocks continued to significantly outperform their value counterparts, with the S&P 500 Growth Index finishing the quarter 5.5% ahead of the S&P 500 Value Index. This dispersion was most notably evident among mega-cap tech and consumer discretionary stocks. According to a recent article in the Wall Street Journal, at their peak valuation during the first quarter the five largest companies in S&P 500 (all tech-related) accounted for roughly 15% of the index’s market value – which is a higher percentage than every other entire sector of the market outside of technology.
Smaller capitalization stocks slightly outpaced the S&P 500, with the Russell 2000 Index (small cap) dropping just 8 basis points for the quarter. The S&P 400 (mid cap) Index fell 0.8%, in-line with the S&P 500. International equity markets also took a breather, with the benchmark for developed foreign stocks down 1.4% for the quarter. Emerging market stocks continued to be a relative bright spot and tacked on a 1.4% gain after ending 2017 with an impressive 37.5% gain.
While the S&P 500 continues to trade at slightly elevated price-to-earnings (P/E) multiples, its valuation levels are still well below those seen at the March 2000 market top. Further, corporate earnings are projected to show considerable strength in 2018, in part due to a boost from lower corporate tax rates. In short, despite the uptick in volatility, the earnings and economic backdrops largely appear to remain favorable for stocks as we progress further into 2018.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||1st Quarter 2018|
|Dow Jones Industrial||-1.96%|
|S&P 500 Growth||1.93%|
|S&P 500 Value||-3.58%|
|Russell 2000 (small-cap)||-0.08%|
|MSCI/EAFE (developed international)||-1.41%|
|MSCI/EM (emerging markets)||1.38%|
At the sector level within the S&P 500, Technology and Consumer Discretionary retained their 2017 leadership positions and were the only sectors to finish ahead of the S&P 500 for the quarter. The move higher in interest rates had ramifications among sectors as well, with Financials, generally beneficiaries of higher rates, faring relatively well versus other sectors for the quarter, while interest rate sensitive sectors including Utilities and REITs finished lower. The biggest laggards for the quarter were varied. The cyclical and commodity-linked Energy and Materials sectors both experienced drops, while the worst performing sectors were the traditionally defensive Consumer Staples and Telecom sectors, which both dropped over 7% for the quarter.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||1st Quarter 2018|
|1. Information Technology||3.53%|
|2. Consumer Discretionary||3.08%|
|4. Health Care||-1.22%|
|7. Real Estate||-5.02%|
|10. Consumer Staples||-7.12%|