US economic growth slowed in the first quarter of 2017, but less sharply than initially thought. Market participants didn’t appear to be put off by the weaker than expected economic data, however, because the S&P 500 advanced more than 3% during the second quarter.
With the market’s steady upward march since the US presidential election in November 2016, it’s prudent to be aware of the potential for increasing volatility. While we anticipate economic growth to accelerate in the second half of 2017, we have a cautious view on the capital market entering the third quarter.
Top Factors Impacting Markets
Despite the sustained upward trend in the stock market, volatility could increase because of influencing factors not directly related to economic data, especially as the political environment continues to create uncertainty in investors’ minds.
The US Department of Commerce’s third and final revision of first quarter US gross domestic product (GDP) increased at an annual rate of 1.4% instead of the 0.7% pace initially reported. While that number is twice as high as the first estimate released by the US Department of Commerce, it’s still 0.7% lower than the 2.1% GDP increase that occurred in the fourth quarter of 2016.
This reduction in GDP growth was probably a short-term setback amid the backdrop of a strong labor market, which is near full employment. Economic growth was also hindered during the first quarter by a sharp drop in consumer spending, which was at its lowest levels since the fourth quarter of 2009, and a marked reduction in the pace of inventory accumulation by businesses.
The singular data point of GDP might not accurately represent the health of the economy for a few reasons, however. The first is a reoccurring issue in which the US GDP historically disappoints during the first quarter each year because of the difficulties the US government has admitted it has calculating data from the months following a new calendar year. The second reason is specific to current data underlying the headline numbers.
While the US stock market performance—as measured by the S&P 500—slowed from gaining 6.07% in the first quarter to 3.02% in the second quarter, domestic retail sales numbers increased 4.4% over the same period in 2016. The strength in consumption, which accounts for approximately 70% of US GDP—could mean the US economy is stronger than what the market suggests.
For the second half of 2017, we anticipate economic growth to be better than the first half of the year, and that earnings growth should follow. Any potential downturn in the market isn’t likely to be caused by earnings disappointments, but rather future uncertainty that is geopolitical in nature.
The market reacted positively to President Donald Trump’s ascendency to the White House, which has stretched equity market valuations in the United States relative to most historical metrics. However, every significant proposed policy change to health care, immigration, and tax reform—all central issues during the campaign—have since stalled out in Congress. The decreasing prospect of either tax or health care reform occurring in 2017 could be a catalyst for increased market volatility as investors react.
Investigation into Russian Interference in 2016 US Presidential Election
Special Counsel Robert Mueller’s investigation into Russian interference in the 2016 US presidential election has expanded to include President Trump, as reported by the Washington Post.
Although the White House administration’s legal counsel has denied these claims, even the prospect of a potentially impeachable offense could create uncertainty in investors’ minds and increase the likelihood of market volatility.
On June 14, 2017, the Federal Open Market Committee (FOMC) raised interest rates by 25 basis points to a range of 1.00% to 1.25%. This is the second rate increase implemented by the FOMC this year, following a previous 25 basis points increase in March, and only the fourth interest rate increase since the Great Recession.
There are no meaningful signs of inflation outside of the housing markets, and wage growth has stagnated. This means it may become more difficult for the FOMC to raise rates again in the second half of the year. If the US economy doesn’t show a meaningful increase in economic growth, there may be little room for the Federal Reserve to maneuver, delaying their assumed plans to increase the overnight lending rate a third time later this fall.
Given the inverse relationship between interest rates and bond values, the assumption is that as interest rates rise, bond values fall. The recent rise in interest rates has had relatively little negative impact on the bond market so far, though.
The FOMC can only control the short end of the Treasury Yield Curve, so despite the increase among short-term interest rates, the demand for longer maturity US Treasuries continues to be strong. This is causing the shape of the yield curve to flatten.
The demand for US Treasury issues is currently strong because they provide greater yields than European and Japanese bonds, but are viewed as a better credit risk.
The flatter yield curve also suggests investors don’t believe future economic growth will be strong enough to create a sustainable inflationary environment that would warrant higher interest rates.
US equities have steadily appreciated through the first half of 2017, which has led to the record low volatility we’re experiencing. The Chicago Board Options Exchange (CBOE) Volatility Index, which is traditionally used to track near-term market volatility expectations and is often referred to as the Fear Gauge, has been historically low for almost the entire year. As of June 30, 2017, the index was at 11.18—nearly half the 10-year average of 20.63.
The combination of elevated equity market valuations relative to their historical averages and historically low volatility suggests investor caution. It doesn’t mean a correction or crash among stocks is imminent, but odds do point to an eventual return to historical averages.
Given the increasing likelihood of a rise in market volatility, it’s important to create an investment plan to deal with it.
While the US economy is strong overall and continues to grow, that growth is being driven by a decreasing number of stocks. This means that only a narrow sector of the market is increasing in size and value, creating what’s known as a shallow market breadth. This is an indicator of a late-stage economy and could point toward a potential correction in the market at some point in the future.
Global Growth Acceleration
Europe’s economy continues to steadily accelerate as European stocks performed better in the second quarter of 2017 than the US stock market overall. The euro currency decline has also made European goods and services more competitive, which is in part fueling increased earnings growth there.
The European Central Bank is now contemplating a stop to its current stimulus program and it’s possible that the European Central Bank could raise interest rates and cease their bond purchase program before the end of 2018, which would be a sign of strength for Europe’s economy because it would no longer require government support to avoid contracting.
While valuations in the United States remain stretched, European stocks appear relatively attractive. We continue to believe European stocks will outperform their domestic counterparts because of their more attractive valuations and stronger earnings growth.
Like the European Central Bank, the Bank of Japan is also moving away from negative interest rates. This helps Japanese banks by raising yields—and, therefore, bank profitability—which in turn leads to more credit lending and economic growth. With the weaker yen boosting the country’s exports, investors can likely expect future economic gains in Japan too.
While the United Kingdom has appeared to so far economically benefit from enacting Article 50 and its decision to leave the European Union, the country’s prime minister, Theresa May, has significantly weakened her position by calling a snap election three years early and inadvertently losing her party’s majority within parliament.
The snap election has resulted in a hung parliament. This means no party in the United Kingdom now has enough lawmakers to establish control of the country’s government.
The situation doesn’t bode well for the prime minister’s ability to negotiate favorable terms for the United Kingdom moving into Brexit, especially since Europe doesn’t have many incentives for negotiating favorable terms for countries leaving the union to begin with.
Valuations in emerging and foreign markets are more compelling than US valuations because they’re offering the best potential for long-term growth. For these reasons, and because of increasing political uncertainty, it may be wise to consider expanding your portfolio to reflect markets outside of the United States.
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