Market Watch (October 2017)
Written by Rick Welch on October 2, 2017
We are pleased to provide you with our quarterly newsletter featuring the status of our investment class weightings, our interpretation of recent data and our outlook for the future. If you have any questions about any topic, we hope you will not hesitate to contact us.
Status of our Investment Class Weightings
Changes from our July 2017 Market Watch are noted in italic.
US Large Cap Sectors –
Overweight – Financials, Health Care (↑) and Technology
Neutral – Consumer Discretionary, Consumer Staples, Industrial and Materials
Underweight – Energy
No Weighting - Utilities
US Mid and Small Cap – Maintain all weightings.
International Developed Markets – Maintain all weightings. Consider increasing exposure in Q4.
Emerging Markets – Maintain all weightings. Consider increasing exposure in Q4.
Alternative Strategies – Maintain all weightings.
We will continue to target an average fixed income portfolio duration in the short-to-intermediate term, or about 3 to 7 years.
Multi-sector Bond Funds – Maintain all weightings.
Investment Grade US Corporate Bonds – Maintain all weightings.
High Yield US Corporate Bonds – Maintain all weightings.
Investment Grade Municipal Bonds – Maintain all weightings.
Data – During Q3 the equity markets remained resilient in the face of a devastating flood to the nation’s fourth largest city, a powerful hurricane that caused havoc along the entire length of the state of Florida, an escalation of tensions with a belligerent North Korea and the announcement by the Federal Reserve that it will soon begin unwinding its historic program of quantitative easing. For 2017, we see the following equity benchmark YTD returns: US Large Cap – DJIA (+13.37%) and S&P 500 (+12.53%), US Small Cap - Russell 2000 (+9.98%) and International - ACWX (+20.06%). On the earnings front, for Q3 we currently see an estimated earnings growth rate of +6.0% for the S&P 500 (revised downward from +7.5% on June 30), with all but two sectors (Telecommunications and Consumer Discretionary) expected to report earnings growth. GDP, the broadest measure of economic output, for Q2 showed an annualized growth rate of a strong +3.1%. Volatility (as measured by VIX) remained low finishing Q3 at just 9.53, far below the long run average of 20.0. Domestic economic data for Q3 was generally positive, though some fall off is expected in the aftermath of hurricanes Harvey and Irma. During the quarter, the yield on the benchmark 10-year US Treasury was range bound (ending at 2.32%), though it did dip as low as 2.03% in early September. Thus far in 2017, the Barclays US Aggregate Bond Index has risen +1.2%. Monthly job growth averaged 198,000 in June, July and August as the national unemployment rate remained at 4.4%. New weekly unemployment claims averaged 251,615 in Q3 (compared to 240,800 in Q2) providing a positive outlook for the domestic job picture. Unemployment claims did, however, jump to 298k and 284k in the weeks immediately following the hurricanes only to return more to trend by the end of September. Job growth and unemployment data continue to suggest that the US economy may very well be at or near a theoretical level of full employment. Consumer confidence, as measured by the Conference Board, increased during Q3 and remains at an elevated level. Responses to the September Manufacturing Business Outlook Survey “showed increases in general activity, new orders and shipments and suggest a broadening of growth.” Retail sales data was good in June (+0.3%) and July (+0.3%) before falling in August (-0.2%). Data from the housing sector was again choppy as Housing Starts started strong in June (+7.4%) only to fall off in July (-2.2%) and August (-0.8%). New Home Sales disappointed in July (-5.5%) and August (-3.4%). CPI rose +0.4% in August and over the last 12 months the all items index increased 1.9%, a level just below the Fed target of 2.0%.
Outlook – On September 20th, the Federal Open Market Committee (FOMC) voted unanimously to start the shrinking of its balance sheet which now stands at $4.5 trillion, of which over $3.7 trillion came during the three phases of quantitative easing known as QE1, QE2 and QE3. Initially, the process of unwinding the QEs (which process is known as quantitative tightening or QT) is simply to let bonds mature and runoff the balance sheet rather than the past practice of reinvesting the principal payments of maturing bonds into new securities. At the start of QT later this month, the monthly runoff is expected to consist of $6 billion of Treasury securities and $4 billion of agency debt and mortgage backed securities. This $10 billion monthly target will be increased by $10 billion every quarter in 2018. By 2019 the monthly runoff rate of $50 billion will still be below the $85 billion of monthly purchases which predated the tapering of QE starting in 2014. What the new Fed balance sheet will look like is not clear, though several FOMC members have expressed the view that about $2.5 trillion would be normal under current circumstances. If $2.5 trillion is indeed the goal, it would take more than five years to bring the Fed’s balance sheet down to that level. With a better understanding now of how balance sheet normalization will proceed, we can now return our attention to additional interest rate hikes. Following the September FOMC meeting the likelihood of another rate hike this year (probably in December) stood at 63%. In her recent remarks Fed Chairwoman Janet Yellen said that “the basic message here is that US economic performance has been good. The American people should feel the steps to normalize monetary policy are well justified given the very substantial progress we’ve seen in the economy.” Those calming remarks notwithstanding, we will renew our view that the dual strategy of interest rate normalization and balance sheet reduction will be a difficult one for the Fed to execute and that the potential for a policy misstep remains the biggest risk to future US stock price growth for the remainder of 2017 and into 2018.
For the first time since 2007, the world’s major economies are growing in synch as recently reported by the International Monetary Fund which projected that global economic output would reach 3.5% this year and 3.6% in 2018, up from the 3.2% growth in 2016. Macroeconomic volatility remains low as global growth remains broad-based and steadily above trend. A reversal in the 2014 global commodities plunge is now aiding natural resource rich countries like Brazil revive their dormant economies. The Eurozone has benefited from the recovery in global trade and Asian economic growth, which suggest that the global economy is finally in a period of synchronized expansion. This cyclical upswing is in contrast to what we see for the US economy, itself in a more mature phase of the business cycle. We will continue to look for opportunities to increase exposure to International Developed and Emerging Market equities.