There seems to be no stopping the upward momentum of stocks both domestically and overseas. We continue to ride the rising wave of synchronized global expansion that we have discussed in earlier communications. That, combined with an easy liquidity environment and extremely low market and economic volatility, can lull investors into complacency. We have yet to see a month of negative S&P 500 returns in 2017. According to Hartford Fund’s research, we have never experienced a full calendar year without at least one down month which begs the question: Are we about to chart new territory or will we see a resurgence of choppiness or even a sell-off greater than the tepid 3% which has been our largest drawdown to date in 2017? It’s impossible to know without a crystal ball, but we’d place our bet on at least one down month before year end.
Third quarter 2017 saw a series of record all-time highs in both large-cap and small-cap stocks. The S&P 500 added 4.5%, bringing its year-to-date return to a strong 14.2%. Small-cap stocks showed even more strength during the quarter due primarily to the release of the Republican tax reform plan. Smaller companies, on average, have higher effective tax rates than larger companies which makes them larger beneficiaries of anticipated lower corporate tax rates. In response to tax reform announcements, the Russell 2000 returned a lofty 5.7% with all of the gains for the quarter coming in September. YTD, small-caps have returned 10.9%. By style, Growth extended its year-to-date outperformance over Value as investors focused on which companies delivered the greatest earnings momentum during this later stage of our expansion.
The international markets, both Developed and Emerging, continued to shine during the third quarter. A combination of improving fundamentals and lower relative valuations than the S&P 500 drove performance for the three months and the first three quarters of the year. Developed Markets (DM), as measured by the MSCI EAFE, rose 6.2% for the quarter bringing year-to-date returns to 20.0%. Emerging Markets (EM) were the star of the quarter with the MSCI EM index turning in 7.9% which brought nine-month returns to a whopping 27.8%. Emerging Markets benefited particularly from optimism regarding global economic growth which should spur continued fundamental improvement, generally stable commodity prices and a further decline in the U.S. Dollar.
In speaking with clients, we’ve found that the stellar performance of the S&P 500 in recent years has led some to question the value of portfolio diversification. This quarter’s outperformance of small-caps, DM and EM serves as a reminder that diversification still adds value. There are periods, like Q3, when diversification is outright additive to performance. But blending asset classes offers the added benefit of lowering risk and smoothing returns, which is particularly important in the later stages of a market cycle when valuations on the S&P 500 can become extended, leaving the market more vulnerable to a correction.
Bonds, again, turned in a somewhat surprising performance for Q3, with the Barclays Aggregate Index posting a positive 0.9% return which brings the YTD return to 3.1%. At their September meeting, the Fed predictably decided against raising their benchmark interest rate, maintaining the target range of 1.0%-1.25%. However, the Fed did officially announce the October lift-off of its plan to begin shrinking its balance sheet. The plan does not involve the actual sale of securities. Instead, it calls for reducing the reinvestment of principal payments received from securities currently held on their balance sheet, initially by $10B per month and moving up monthly until it hits $50B in October 2018. The gradual nature of the plan is in keeping with the Fed’s overall moderation in dealing with the normalization of rates. We expect the Fed to raise rates a quarter point at their December meeting and likely three times next year, which would put the Fed Funds rate in a 2.0%-2.25% range at the end of 2018, still very low historically.
We’re in the midst of what many would term a “goldilocks” global environment of expanding economic and corporate profit growth, low interest rates, upbeat consumer sentiment and low asset price volatility. Markets have responded to upbeat estimates with higher valuations. We’re often asked whether markets are overvalued. Although numerous metrics on an array of markets are above their historical averages, we’ve certainly seen valuations at more extreme levels in other cycles. The S&P 500 has been at a higher P/E level 26% of the time over the past 30 years. We’re also heartened to see correlations within the S&P 500 decline. The greater dispersion in stock returns suggests that stocks are being driven less by knee-jerk “risk-on, risk off” behavior and more by company fundamentals.
Despite that positive backdrop, we feel it’s prudent to point out that the somewhat perfect environment that we’re in, over eight years into an economic recovery, has likely been significantly discounted in equity prices. We’ve already seen U.S. growth forecasts for 2018 lifted due to anticipated tax relief. And, growth projections for global growth have recently been revised upward for 2017 and 2018 by the IMF. The probability of upside surprises on economic growth is diminishing. On the other hand, potential risks, such as geopolitical tensions, less accommodative central banks and more difficult earnings comparisons as we move into 2018 haven’t gained traction with investors to date. This mismatch causes us to feel that investors need to approach the market with some caution as we move through the ninth year of our bull market. We’re not negative on the stock market—economic and earnings growth prospects remain sound—we’re just realistically cautious after our dynamic run.
Please reach out to us if you have questions regarding our thoughts on the global economy or financial markets. As always, we value the trust and confidence that you place in First Western.
Debra B. Silversmith, CFA
Managing Director
August 2017
