The stock market surged into the new year as investors continued to bet that tax reform, the rolling back of regulations, and an infrastructure spending program under the Trump administration would boost business and improve corporate earnings. Nevertheless, the rally stalled on March 1st when the S&P 500 went over the 2400 mark for the first time and closed that day at 2396. The S&P drifted lower during the month and ended the quarter at 2362.72, a gain of 5.5%.
The euphoria about what Trump could accomplish began to fade especially after the Republicans withdrew the health care reform bill for lack of support. The fact that Republicans were willing to take the political heat to oppose that bill challenges the assumption that the GOP will unify to pass tax reform and fiscal stimulus.
Domestic Equity Markets
The torrid rise of the Dow Jones Industrial Average in the fourth quarter slowed as investors moved into technology growth stocks from financials. The Dow gained 4.6% in the first quarter while the NASDAQ Composite gained almost 10% and that average has scored 21 record closes in 2017. Healthcare stocks have been some of the best performers, as well, after falling in the fourth quarter over health care reform fears.
Energy stocks were the worst performers in the quarter as oil prices fell in March despite OPEC’s production quotas. U.S. oil inventories swelled as shale producers cut production costs in order to cope with lower oil prices. Energy companies may be hard-pressed to increase profits if prices remain at current levels.
International stocks, after lagging for several years, have posted solid gains so far in 2017. Developed international stocks, as measured by the MSCI EAFE Index, rose 6.5% in the first quarter, while emerging markets gained 11.1% per the MSCI Emerging Markets Index. Nevertheless, those indexes remain about 9% and 12% respectively below their highs reached in 2014.
The purchasing managers index (PMI) of global manufacturing has risen for six straight months and stands at its highest level since 2011 per Ned Davis Research. In addition, the proportion of countries reporting higher readings compared to a year earlier was 86%.
Still, the formal BREXIT declaration by the British government and the upcoming French elections could cause political upheaval.
The Federal Reserve, as expected, raised interest rates at its March meeting, and Fed Chair Janet Yellen stated that she expects the U.S. economy to expand at a moderate pace over the next several years. The Fed also forecasts inflation to move up to 2% and stabilize. This outlook shows that the Fed expects to implement a slow, steady increase in interest rates over the next several years; however, the economy rarely cooperates that well.
U.S. Treasury rates, which had moved up sharply at the end of last year, traded in a narrow range in the first quarter. The U.S. 10-Year Note moved up to 2.6% in the days leading up to the Federal Reserve meeting in March, but fell thereafter due to the mild tone of the Fed’s comments. The 10-Year ended the quarter at 2.39%.
Economic indicators continue to look good. The ISM Purchasing Managers Index for the manufacturing sector stands at 57%, with any reading above 55% showing strong growth. In addition, the New Orders Index for manufacturing is currently 65%, particularly promising for future growth. The readings for the service sector, which makes up roughly two-thirds of the U.S. economy, are also favorable. The Business Activity Index of the ISM Service Sector is 59% while the New Orders Index is also 59%. Unemployment claims are at the lowest level since 1973.
Nevertheless, multi-year highs for these indexes could be precursors of inflation if the economy overheats. The U.S. labor market is at or near “full employment” as defined by the Fed and labor costs could accelerate. The Fed may be behind the curve in increasing rates, and a sharp rise could spell the end of the bull market for stocks.
Stock market gains over the past year have brought the price/earnings ratio for U.S. stocks to 17.5, 10% above the 25-year average of 15.9, per J.P. Morgan. Margin debt has exploded and stands close to its highest level in history. Also, auto sales, one of the bright spots in this recovery, fell in March despite heavy dealer incentives.
Therefore, while economic indicators are encouraging, there are warning signs as well. As always, we will closely monitor all developments affecting your investments and keep you advised.