On behalf of the Altium Investment Committee;
We hope this note finds you well.
In March the current U.S. economic recovery, which began in June 2009, officially became the third longest period of expansion since 1850. Periods of expansion and contraction are simply part of a normal business cycle, with each full cycle lasting nearly 5.5 years on average from trough to peak. While it may be comforting to know that the longest expansionary period of all-time lasted 10 years (from 1991 to 2001), we can appreciate that there is an uneasy feeling surrounding the current state of our economy and its impact on the equity and fixed income markets. For the remainder of 2017 we believe domestic policy risk remains at the forefront and that investors will be searching for clarity on the current stage of the U.S. economic business cycle.
Key Headlines During Q1 2017
U.S. stocks made new highs, but were outperformed by their international counterparts
Large Cap U.S. stocks rose 6.1% in the quarter while international developed market stocks rose 7.3% and emerging market stocks rose 11.4% *.
Positive economic data overseas, a decline in the U.S. dollar and reduced populist party momentum in foreign elections helped drive this outperformance.
“Trump Rally” fades in March
Failure to reform the Affordable Care Act, a.k.a. “Obamacare”, thus far in 2017 has investors lowering expectations that Trump’s other “pro-growth” agenda items will get done (i.e. tax reform, infrastructure spending & financial services deregulation).
Perhaps the biggest risk to the market is that tax reform fails to materialize, as polls currently show high expectations that reform is completed by Q1 2018. A delay past the 2018 mid-term elections adds risk that Republicans lose control of the House and Senate and the ability to pass the reform.
Bond yields stabilize
The Fed raised short term interest rates 0.25% and reiterated a gradual pace of rate hikes during 2017.
Bonds showed signs of stabilization with the Barclays U.S. Aggregate Bond Index ending up +0.8% for the quarter. This was a material improvement from the Q4 2016 reaction of -3.0% to the Trump victory and December rate hike.
What We Are Watching Now
Where are we within the current business cycle and what does it mean?
The U.S. economy is well past the initial recovery and early expansion stages that followed the 2008 recession. As with most early stage recoveries we experienced bottoming bond yields and short term interest rates, a highly accommodative government and rising stock prices.
We believe that the economy is in the late expansion stage, which is typically characterized by high levels of confidence, rising short term rates and bond yields and stock prices making near-term highs (all-time highs in this case) with increased volatility and risk. This stage can last many years and will typically result in rising inflation and an economy that is at risk of overheating.
The first stage of economic contraction is defined as a slowdown. This stage, which can last a few months to a year or longer, is typically characterized by declining confidence, rising inflation, a peak in short term interest rates and an inverted yield curve (where long term yields fall below short term yields). We will continue to monitor these indicators for a sign the economy has begun contracting. Stock prices have historically started to decline in advance of a recession (the last business cycle stage).
As we stated in our last commentary, recessions are part of the economic cycle and are to be expected. They have historically lasted from six months to a year and are typically represented by declining confidence and corporate profits, increased unemployment and falling short term rates and bond yields. Inflation tends to peak during a recession and stock prices tend to rise in anticipation of the end of the recession. For additional commentary regarding the market’s reaction to the last two recessions please click on the following link to our Q4 2016 commentary (Altium Q4 2016 Market Perspective).
Consumer Confidence as an indicator
The Conference Board’s Consumer Confidence Index hit 125.6 in March (up from 116.1 in February) reaching its highest monthly reading since December 2000. In modern history this level has only been exceeded by readings in the low 140’s, which occurred during the late 1990’s. The chart below illustrates the relationship between consumer confidence (shaded blue area) and recessions (shaded red area). Consumer confidence tends to peak and begin declining prior to recessions (indicated by the arrows). While it is difficult to predict the peak, it is clear that confidence is still rising, which offers some indication that we remain in this late expansion stage of the economic cycle.
Source: Bloomberg; Conference Board Consumer Confidence Index. Red shading (recessionary period); Blue shading (confidence)
Treasury yield curve as an indicator
The Fed has raised interest rates twice in the last 4 months and is expected to raise them again two more times over the balance of 2017. Rising short term rates are therefore expected, but what has not been anticipated is that long term rates have actually declined. As measured by the spread (or difference) between the rate on 2yr. Treasuries and the 10yr. Treasuries, the yield curve shifted down (“flattened”) by 0.12% during Q1. We believe that this decline, while small, may be indicating that bond investors are beginning to expect future inflation to fall and may also expect future GDP growth to slow. These are key indicators to watch for signs of an economic slowdown. The U.S. Treasury yield chart below illustrates this “flattening” effect that has occurred over the past 7 years (current yield curve in green vs. 2010 yield curve in blue). The red arrows show the decline of long term bond yields and the green arrow shows the increase in short term yields during this period of time. We will continue to monitor this “flattening” effect, understanding that an inverted yield curve could indicate that the economy is contracting.
Source: Bloomberg; U.S. Treasury Yield Curve as of 04/06/17 (green) and 04/06/10 (blue)
Whether 2017 is your first year with Altium or if you have been working with us for over a decade, you know that we remain committed to our investment philosophy. We believe that maintaining your strategic portfolio allocation, as determined by your personal investment policy statement, will yield you the most favorable results over time. We know that domestic policy reform (or lack of changes) will impact specific asset classes differently over the next few months and that the economic business cycle in the U.S. will eventually reach its latter stages. However, the timing, scale and ultimately the market’s reaction to these events is unpredictable and therefore we continue to recommend staying on the designed course.
We will continue to provide you with our thoughts as these events evolve. As always please reach out to us if you have any specific questions about your plan and we look forward to seeing you at your next review.
Gregory Slater, CFA, CFP®
Chief Investment Officer
* LC US stocks = S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
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