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From the start, 2017 has been an intriguing year. With another rate hike under its belt, the Federal Reserve has accelerated from its previous tentative pace and has even begun to talk about removing some of the final vestiges of the Great Recession—the assets purchased during its quantitative easing programs. The debate between the efficacy of hard data (employment, retail sales, and so on) and soft survey based data raged as the two indicators of economic health diverged. In the final weeks, healthcare and tax reform came to the forefront, calling into question the timing of potential stimulus and growth. In the end, many details of the Trump Administration’s economic agenda remain to be seen.
After being caught off-guard last year by Brexit, the Fed raised rates sooner rather than later with its March hike. This gives the Fed a greater probability of achieving its tightening target for 2017. Moving forward, a key question will be the strength of the Fed’s trajectory. It appears the rate hike cycle is well anchored around the current target.
What may not be so firmly set is the tentative rhetoric around the Fed’s balance sheet. Some Fed officials have stated their preference to begin normalizing the Fed’s balance sheet by allowing assets purchased during quantitative easing to roll off without reinvestment by the end of this year. Critically, some Fed officials have stated that they have "penciled in" tax reform and/or fiscal stimulus to their projections of economic growth. If there is a delay or disappointment, the Fed will be one to watch. The rhetoric around balance sheet reduction will likely be the first step, and the Fed will try to maintain the three hikes this year. However, the content of the speeches may become less hawkish.
Exiting the first quarter, the data is mixed and the GDP trackers are showing the difficulty of parsing the direction of the economy. The data appears to be skewed—in some ways—to the upside, but the caveats are significant. The health of the consumer will be paramount to the outcome of the economy, and the incoming data shows better income dynamics but weaker spending. Construction spending is a surprise headwind, but manufacturing is healthy.
One of the more encouraging data points has been employment. February ADP payrolls were much better than expected, driven almost entirely by the goods-producing sector—specifically construction. The gain of 66,000 construction jobs is an unequivocal positive. But the number is highly volatile and seasonally weather dependent, and the strength of the other sectors will be critical in coming months. There are reasons to believe the strong print is not a singular anomaly, however. According to the Bureau of Labor Statistics, February wages rose 2.8% from a year ago—a positive print, but below longer term averages. The labor market remains in good shape.
Outside the United States, the ECB seems to be preparing markets to taper beginning at the end of its current QE program, without guiding about rate hikes. In many ways, this appears to be a similar exit strategy to the one orchestrated by the Federal Reserve. It is worth remembering that following the May 2013 announcement that the Fed would begin to taper its bond purchases, US bond markets reacted sharply with the US 10-year rising from 1.6% to nearly 3% in 4 months. The ECB does not want this type of reaction.
This is the delicate balance the ECB is going to have to strike. If its exit strategy causes a “taper tantrum” event, it risks slowing its economy and losing its inflation pressures. Once underway, tapering and tightening too rapidly could result in a much stronger euro. The balance of exit will be critical, and the Fed’s exit provides a sort of playbook for the timing and potential consequences.
Toward the end of the month, the momentum behind some of the Trump Administration’s initiatives had slowed. Following the decision to pull the health care bill, a few of the more "Trumponomic" sensitive assets reacted significantly. The reasoning was the possibility of a slower and more difficult legislative process for tax reform and fiscal spending.
In part, the tax reduction and reform proposals are reasons the Fed feels it has room to raise interest rates. Several members of the Fed have stated that their forecasts take fiscal policies (including tax reform) into account when making their forecasts for growth and inflation. With inflation expected to materialize, GDP growth was projected to accelerate, and the US economy to regain some “normality” in terms of interest rates, growth levels, and employment.
Media reports stated that some GOP lawmakers were skeptical that an overhaul of the tax system could take place due to lawmaking rules. The Ryan plan gets around this by instituting the "border tax," which many in his party are reluctant to support. However, without a border tax, revenue neutrality is difficult to achieve.
A suggested temporary cut is a clear fallback option. Genuine tax reform is still the clear goal, and, in some ways, this is encouraging. Instead of an all or nothing, it is an all or something.
At any rate, there is little reason to believe that tax and fiscal reform will not occur. Not repealing the Affordable Care Act does keep its taxes in place for now, and that is a setback. Granted, there is a likelihood of a delay to the latter part of 2017 or early 2018, but it is a priority. In the meantime, the Fed's reaction will be interesting to watch.
In contrast to the first quarter of 2016, which featured a sharp decline to begin the year, the S&P 500 index featured a 109-day streak without experiencing a 1% decline, its longest in over 20 years. On a total return basis, the S&P 500 rose just over 6% for its best start to the year since 2013, and the third best since 2000, per Ned Davis Research. Also of note, large caps outperformed small caps, while growth outperformed value at all three cap levels.
Most dividend strategies lagged during the period including long-term dividend growers, which lost more than 4%. Producing the strongest aggregate returns were companies defined by profitability measures such as high sales growth and return on assets (ROA), along with efficiency and quality; momentum factors outperformed during Q1, somewhat reflecting mean reversion from 2016.
Sector performance varied significantly. Information technology was the top-performing sector with a total return of 12.5%, while both consumer discretionary and healthcare each posted gains in excess of 8%; energy and telecoms, after posting 2016 gains of more than 20%, lost 6.7% and 4%, respectively. The Alerian MLP Index, after a fast rise of more than 8% through mid-February, settled for a gain of just under 4% by the time the quarter ended. The MSCI US REIT index finished the period positive thanks to dividends (+1%), while the S&P 500’s REIT sector registered a gain of 3.5% on a total return basis.
Samuel E. Rines
Senior Economist and Portfolio Strategist
Jeffrey S. Phelps
Partner, Head of Equity, Portfolio Manager – Equity Income
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April 29, 2016
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Quarterly and Monthly Notes
Third Quarterly, 2017
Second Quarterly, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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The opinions expressed herein are those of Avalon Advisors, LLC investment professionals at the time the comments were made and may not be reflective of their current opinions. Nothing herein shall be construed as investment advice or a solicitation or offer to purchase or sell any securities.