The first quarter of 2017 saw a continuation of the “Trump Trade” that fueled markets at the end of last year. This was especially evident in risk assets, as growing investor optimism about the health of both the US and the global economy was reflected in broad market results. The S&P 500 surged 5.5% during the quarter, while in a welcome reversal following several years of mediocre performance, international stocks actually outperformed their domestic counterparts with an 8.1% advance.
Unlike worldwide stock markets, defensive assets delivered a much more muted performance, as interest rate sensitive investments were negatively affected by the Federal Reserve’s resumption of short-term rate hikes and the growing expectation of higher inflation. Fixed income markets delivered a 0.3% advance; Real Estate Investment Trusts (REIT’s) produced a similarly lackluster return.
The question now confronting markets at the beginning of the second quarter is whether investors’ enthusiastic expectations for the Trump administration have exceeded what realistically might be delivered in a still dysfunctional American political landscape. The first indication of this may have been demonstrated by the Republicans’ failure (at least for the moment) to deliver on the campaign promise to reform the nation’s healthcare system.
Some of the same ideological roadblocks that undermined the health care effort – the inability of the conservative and moderate wings of the Republican Party to find common ground, concern about the fiscal impact of the administration’s key programs, to name just two – are very likely to hinder efforts to cut corporate income taxes and implement a comprehensive infrastructure investment program. And of course the increasingly unstable geopolitical backdrop, notably in North Korea and the Middle East, represents a “wild card” that could shake market confidence with little warning.
On a more positive note, there have been signs the Trump administration is recognizing that widespread trade barriers, rather than promoting job growth in the manufacturing sector, are more likely to throttle the global economic recovery and contribute to higher inflation in the US. Improving economic conditions worldwide may offer the most fundamental reason for investor optimism, as evidenced by the impressive performance of international stocks during the last three months.
Here in the US, corporate profits in last year’s fourth quarter finally broke out of an 18-month slump, and the general expectation is that profits will continue to improve through the remainder of 2017. And while US stocks can hardly be considered undervalued, the hope is that the Federal Reserve’s very gradual program of interest rate hikes will allow improving corporate profits to support and sustain what is now an 8-year bull market.
Developed overseas economies are generally thought to be earlier in the business cycle than the US, suggesting that international stocks may have more upside potential than US stocks. Consequently we are maintaining a meaningful exposure to international stocks in all client portfolios. With US stocks continuing to trade near all-time highs, there is a good chance that during the remainder of 2017 superior returns will be produced by an investment strategy which emphasizes global diversification.
We’d like to close with a comment on expectations. When you consider that 2016 was the eighth consecutive year in which the S&P 500 recorded a positive return, statistically it seems a US stock market pullback in the short-term is increasingly likely … prior to this impressive run, the “record” had been six years in a row. We don’t offer that perspective to raise alarm, but rather to emphasize that investor focus should be on the medium and long-term instead of the short-term.
We’ll offer several examples that reinforce this point. Since the turn of the century, two events stand out as “black swan” catastrophes: the 9/11 terrorist attacks, and the 2008 global financial crisis. In the weeks immediately following these two very different but equally frightening events, panic was the dominant investor emotion. The natural reaction was to flee the markets … which proved to be absolutely the worst decision that any investor could make. Unfortunately countless investors did choose this course of action, and locked in losses from which many have yet to recover. But investors who maintained a longer term perspective, and who remained committed to a well-diversified investment strategy, have seen their portfolios multiply many times over.