Neither Rain nor Snow nor Stumbling Politicians
Stocks continued to rally during the first quarter, shaking off the new president’s rough start and the associated bad press, as the mainstream media circled like sharks smelling blood. The failure of Congress to repeal and replace the Affordable Care Act and the consequences of such failure for tax reform hardly caused a ripple. Even the unexpected March arrival of the first of three anticipated Federal Funds rate increases this year didn’t faze investors.
The Federal Reserve’s more serious move towards interest rate normalization this quarter did impact returns by capitalization. The least speculative, large cap stocks led the market higher with the S&P 500 climbing more than 6%, similar to the Russell 1000 Index. As market caps diminished, so too did rates of return, with the Russell 2000 Small Cap Index rising 2.5%. At the speculative end of the spectrum, microcap stocks gained just 0.4%, a far cry from the Quantitative Easing induced frenzy in 2013, when they returned more than 45%, and the Federal Reserve’s interest rate procrastination incented trade in 2016, when they gained more than 20%.
Also reflecting the change in monetary policy, growth stocks outperformed value shares across the market cap spectrum, beginning to unwind the torrid relative performance that value exhibited last year. While some may regard growth as speculative due to its above average valuation, easy credit over the last few years had diminished the cyclical, leverage and business model risks associated with value stocks, causing their relative values to rise. As interest rates increase, these risks gain more attention and the levers that cheap companies have used to bolster their stock prices, such as dividends, stock buybacks and acquisitions become less appealing to investors.
International stocks also participated in the rally. In Europe, despite concerns regarding populist political campaigns in the Netherlands and France, a modest acceleration of the gradual economic recovery combined with diminished concerns regarding bank credit quality allowed the market to gain almost 8%. While Japan rose only 5%, other countries in the Asian region jumped almost 12%, helping the EAFE Index to rise more than 7%. In contrast to the more speculative stocks in the U.S., emerging markets climbed more than 11%, in response to stronger global economic activity.
A Tale of Two Consumers
For consumers and the businesses that serve them it should be pretty close to the best of times. March’s 4.5% unemployment marked this cycle’s low and monthly job creation has averaged about 185,000 over the last year. Although inflation has accelerated somewhat, weighing on real wages, nominal wages have also accelerated, aided by minimum wage increases and a tight market for educated workers. With the best economy in years and a new administration in Washington promising even faster growth based on tax cuts, infrastructure spending and deregulation, it is no wonder that consumer confidence spiked in March, hitting the highest level this century.
For many retailers, however, if this is not the worst of times, it certainly feels that way. Although the U.S. Census Bureau estimated that retail spending grew 5.7% in February from a year earlier, few retailers reported strong holiday results and many have commented that same-store-sales in February and March slowed sharply. Admittedly, winter weather can impact spending and tax refunds were delayed by four to six weeks while the IRS validated taxpayer identities, but on average the winter was mild and tax refunds had caught up by early March.
Certainly the penetration of ecommerce, still growing rapidly and estimated at over 9% of retail sales, continues to take an ever larger bite out of bricks and mortar revenues, but nowadays most retail chains have some form of online presence that they include in their comparable store results. Even if ecommerce is to blame, that does not explain why other forms of consumer spending have softened. Many restaurant chains have reported weaker sales over the last few months and light vehicle sales clearly disappointed in March, falling 1.6% from a year earlier and annualizing at a SAAR rate of 16.6 million units, well below the 18.3 million rate reported in December, despite higher incentives.
Housing remains one of the brighter spots in the economy. Although starts have lagged historical recoveries this cycle, reaching fewer than 1.2 million units in 2016 compared to the 1.4 million unit annual average since 1959, recent results have proved more encouraging. Starts for the last three months averaged closer to 1.3 million units and Evercore ISI’s weekly homebuilder’s survey* recently hit its highest level since 2004, despite rising mortgage rates. Further supporting housing demand are homeownership rates that have hit their lowest level in more than 45 years and the months of supply for sale that is the lowest since 1982, when data collection started. With household formations lagging trend by more than 3 million units since the financial crisis** and biological clocks ticking, perhaps millennials have started to save their money for down payments.
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Declare Victory and Go Home
As mentioned above, inflation rates continue to gradually accelerate and have begun to pressure real wages. Although core CPI rose only 2.2% in February, the full CPI including food and energy accelerated to a 2.7% pace. Similarly, although the core PCE deflator, the Federal Reserve’s favorite inflation measure, remained below the 2% target, the 3-month average accelerated to a 2.5% annual pace, suggesting that inflation is a growing concern. With labor scarce, inflation rising and the Federal Funds Rate, now 0.75%, still at least 100 basis points below the lowest inflation measures, the move by the Fed governors to raise rates sooner than expected in March should have come as little surprise.
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One Down, Two to Go
What did cause some surprise was that the Fed governors maintained their forecast of three rate increases in 2017. However, with three quarters of time and seven meetings to make decisions left this year, the central bankers have room to change their views. If the economy remains strong and inflation on the rise, they can raise rates again in June and September and add a fourth in December in response to the “data”; and, as became clear in early April, the bankers may have wished to preserve their flexibility so that they could finally embark on the unwinding of the central bank’s balance sheet.
Bloated by numerous Quantitative Easing (QE) programs, the Fed’s balance sheet holds more than $4 trillion of treasury and mortgage backed securities. Although the last QE program ended in late 2014, portfolio maturities continue to be reinvested. Amounting to almost 20% each of the treasury and mortgage backed securities markets, even gradually unwinding the portfolio though maturities could put upward pressure on longer-term interest rates, potentially slowing the economy. Just as important to investors, if the effect of the QE programs was to inflate asset values, the unwind can hardly fail to have at least a somewhat deflationary effect.
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As the U.S. central bank contemplates the pace of its continued exit of its non-traditional monetary policies, major international central banks continue their QE programs, rapidly growing their balance sheets. There too, however, inflation is starting to rear its head. Although the Eurozone CPI dipped to 1.5% in February, the OECD inflation rate, capturing 35 developed counties, continued to rise sharply, reaching 2.5%. The gradually strengthening Eurozone economies and creeping inflation have started investors asking when the ECB will end its bond buying and start to raise rates, actions that will need to commence within a few quarters if the Euro is to not weaken further against the dollar. More broadly, President Trump’s objective of creating jobs by reducing the trade deficit could easily be undercut if disparate monetary policies cause the dollar to persistently strengthen.
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Three months ago we wrote that “Luck Counts” with regard to the gradually accelerating global economy that President Trump inherited following his election. That luck still seems to be playing out, even if the new administration continues to have teething pains. The large jumps in business and consumer confidence since the election are typically leading indicators that are followed by real economic activity within about eight months. That suggests that by calendar year end the strong sentiment should translate into stronger growth.
Stronger growth is very important to the equity markets in terms of driving earnings growth, the long-run creator of value. It is also important for the nature of which stocks perform best. As CCI has witnessed during the period of non-traditional monetary policy, artificially low interest rates distorted the market’s reward system, attracting investors to fixed income-like stocks and distracting them from strong, but low-yielding, growth names. As long as the Federal Reserve is able to continue normalizing monetary policy, the market reward paradigm should continue to revert to historical norms, benefitting CCI’s discipline.
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* Evercore ISI, April 3, 2017, pg.18
** Rosen Consulting Group, and the Fisher Center for Real Estate & Urban Economics, Haas School of Business, University of California, Berkeley, March 27, 2017