Q1 2017 – “Trump Trade Fade” (Part 1)

April 7, 2017

The first quarter ended with the stock market completing its eighth year of the current bull market, with the Standard and Poor’s 500 Index advancing 6.07%, marking the sixth quarter in a row the index closed in positive territory. Not only was the past quarter one of the least volatile quarters in some 50 years, the sectors that performed well were the stocks that lagged during the fourth quarter last year, as the “Trump Trade” faded. As long as the world economy continues to strengthen, inflation inches upward in a controlled manner, and Congress makes headway on U.S. tax reform and an infrastructure investment bill, we anticipate a favorable environment for investors throughout the world. We believe the market is poised to continue to produce positive returns this year as U.S. companies are also expected to report the strongest quarterly earnings in years for the first quarter.

During March, the Federal Reserve raised the federal funds rate by 25 basis points to a range of 0.75% to 1.00%. This move was widely anticipated by the market, and as the economy continues to remain healthy, another two rate increases are expected by year-end. Assuming that there are two additional 25 basis point increases before year-end, the federal funds rate would range between 1.25% – 1.50%. This would mark the first time since 2008 that the federal funds rate has risen above 1.00%. While there is a chance that the Fed could raise rates at a faster pace than three increases this year, most believe that a gradual path of rate increases is most likely.

Contrary to the visibility provided to its plan of raising rates through the fed funds, the Federal Reserve has been much more guarded with the plan to shrink their balance sheet. Before the financial crisis of 2007 – 2008, their balance sheet was less than $1 trillion, but through multiple quantitative easing programs, it has ballooned to a $4.5 trillion portfolio of treasury and mortgage securities. During its March policy meeting, the Federal Reserve officials discussed that they would likely begin to shrink the portfolio later this year. The most likely scenario in reducing their balance sheet would be to reinvest only a portion of the maturing principal amount instead of reinvesting the full amount into similar securities. We believe their balance sheet plan will be a measured and cautious reduction over time in conjunction with walking the tightrope of maintaining a systematic approach in returning interest rates to a more “normalized” level to increase the optionality for the Fed to stimulate a slowing economy during the next down-cycle.

Equity markets outside of the U.S. also produced a strong showing during the quarter as global economic data has been consistently improving so far this year. In December, the European Central Bank announced that it would dial back its monthly bond buying program in April 2017 from 80 billion euros ($86 billion U.S.) a month to 60 billion euros a month until at least December 2017. And with the tapering of the buying program in sight, underlying sovereign interest rates are starting to increase. For example, the yield on Germany’s 10-year government bond more than doubled, rising 18 basis points year to date to 0.39%. But even with the doubling of the yield on the German Bund, foreign buyers continue to struggle to find attractive absolute yield within the Eurozone. In fact, strong foreign investment in U.S. Treasury’s is keeping a lid on government bond yields and while the U.S. Treasury yield curve is higher than last year, it is down from levels seen last month (see yield curve below). The consensus expectation is that the yield on the 10-year Treasury will be 3.00% to 3.50% by year-end (compared to its current yield of 2.37%) but that is dependent on the economy continuing to be strong, and assumes the Fed will continue to follow its plan of two additional rate increases before year-end.

Click here for Part 2.