Market Commentary: 1Q 2017

To no one’s surprise, the U.S. stock market has been on a tear. Over the last eight years, the S&P 500 index has returned more than 300% and the tail-end of this run seems to have accelerated the trend. The first quarter of 2017 provided the highest returns for U.S. large-cap stocks since the last three months of 2013. Additionally, the Nasdaq index has booked its 21st record close of the year so far and the index has recorded a whopping 30%-plus rise over the past 14 months, marking the fastest advance since 2006.

In addition to the great domestic stock returns, international investments have been soaring through the start of the year, especially in U.S. dollar terms. European stocks gained 8.6% for the quarter and EAFE’s Pacific ex-Japan Index gained 11.8%. In aggregate, the broad-based EAFE index of companies in developed foreign economies gained 7.4% in the first three months of calendar 2017. Emerging market stocks of less developed countries, as represented by the EAFE EM index, rose an impressive 11.5%.

Here are the broad index returns through the First Quarter of 2017:

U.S. Large Cap Stocks 6.0% Emerging Market Stocks 11.5%
U.S. Small Cap Stocks 2.5% Commodities -2.3%
U.S. Real Estate 1.0% U.S. Aggregate Bonds 1.0%
Overseas Stocks 7.4% International Bonds 2.4%

Across a wide range of measures, the global economy is in its best shape in many years. Economic growth in most countries and industries has been accelerating, albeit modestly. In fact, the Global Manufacturing Purchasing Managers Indexes, which have been correlated with global equity returns over time, recently made new multiyear highs in the United States, the eurozone, and China. A quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months. While unexpected macro shocks can occur at any time, the global macroeconomic backdrop offers reason for optimism that many of the reflationary trends that have benefited our portfolios in recent quarters can continue and the likelihood of an imminent U.S. or global economic recession appears low right now. Without a recession, history suggests a bear market in stocks is unlikely.

The European economy seems to have turned an important corner. Last year, for the first time since the 2008–2009 financial crisis, Europe’s economy grew faster than that of the United States. Improving economic growth ultimately leads to better sales growth and gets consumers and corporations to borrow and spend, furthering the cycle. According to the Bank Credit Analyst, private sector credit growth in Europe is up at the fastest rate since the financial crisis. The European Central Bank has revised upward both its inflation and growth projections for 2017–2018.

High current valuations will likely be a headwind to U.S. stock market returns looking out over the next five years but international stocks look attractive. Corporate earnings in the U.S. have not kept pace with the fiery stock market returns of the last few months and valuations have risen. In stark contrast to one another, it appears that European earnings are cyclically depressed while U.S. earnings are near cyclical highs and this relationship does not appear to be adequately reflected in their respective valuations. In Europe, corporate earnings have barely grown since the 2008–2009 financial crisis primarily due to the onset of a regional debt crisis in 2011. Meanwhile, U.S. company earnings have grown strongly, exceeding prior cyclical highs due to historically high profit margins, stock buybacks, and low interest expenses. This results in European stocks appearing to be relatively less expensive than U.S. stocks and more attractive for the long-term. It is impossible to know the precise timing or exactly what catalyst will lead investors to close the gap and begin shifting from U.S. investments to international holdings but history teaches that in time, there will be periods of international stock out-performance.

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