Market Commentary: 2Q 2017

The second quarter proved to be another very strong period for global stock and bond markets but commodities struggled. Larger-cap U.S. stocks surged to 9.3% for the year while international indexes were each up in the mid-teens. Core bonds also delivered solid returns, rising 1.5% for the quarter. But since higher bond prices correspond to lower bond yields, the yield curve “flattened” considerably and the difference between the 10-year and 2-year Treasury yields ended the quarter at close to a post-2008 low. Conversely, commodity prices and energy stocks detracted from the quarter’s returns and remain a weak spot amid a global rally in risky assets due to a 14% decline in oil prices.

The calm, as manifested in low measures of volatility across global markets, was briefly interrupted during the last few days of June. Global stock and bond investors were rattled by comments from the heads of the European Central Bank and the Bank of England suggesting they may be considering the potential end to bond buying policies designed to stimulate markets and a move to raise interest rates, respectively. They were further jolted by Fed Chair Janet Yellen’s statement that “by standard metrics, some asset valuations look high.” In response, bond yields quickly spiked higher, while currency markets saw large swings. Nevertheless, at quarter-end, the S&P 500 was only about 1% below its all-time high.

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

U.S. Large Cap Stocks 9.3% Emerging Market Stocks 18.4%
U.S. Small Cap Stocks 5.0% Commodities -5.3%
U.S. Real Estate 2.7% U.S. Aggregate Bonds 2.3%
Overseas Stocks 13.8% International Bonds 5.8%

U.S. stock investors seem a bit complacent now. The VIX index, an indicator of the S&P 500’s expected 30-day volatility, fell to a 23-year low in early May and remained low throughout the quarter. The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty in the U.S. and geopolitical tumult around the world. The extremely low market volatility and high stock market valuations implicitly discount a very rosy economic scenario but economic growth has been noticeably meager so far this year. Interestingly, a U.S. stock market correction (a decline of 10% or more) hasn’t occurred since February 2016 when, on average, they typically occur about once per year.

However, there is room for hope in the most recent economic data. The Atlanta Federal Reserve recently forecasted that the U.S. economy will grow at a 2.9% rate for the year’s third quarter. The unemployment rate is at a near-record low of 4.7% and wages grew at a 2.9% rate in December, the best increase since 2009.

How will the Fed respond to the contradictory data? In past years, the Fed’s actions have repeatedly converged to meet market expectations with a less aggressive rate hiking path than it originally forecasted for itself. The Fed is likely more hawkish at this point in the economic cycle with unemployment down to 4.3% coupled with its expectation that wage, and ultimately, inflationary pressures will emerge. This creates uncertainty and the risk that the Fed will tighten more than the economy and markets can handle. In fact, economist David Rosenberg writes, “If the Fed does what it says it’s going to do, the yield curve will invert sometime next year, with a recession all but an inevitability.”

An inverted Treasury yield curve has preceded the last seven U.S. recessions dating back to the 1960’s. But with global central bank bond purchases still depressing longer-maturity bond yields, this cycle may be different from prior ones. The Bank Credit Analyst sees the risk of a U.S. recession sometime in 2019, after a final burst of growth over the next year. And this being macroeconomics, there are intelligent counter arguments that the Fed is more likely to fall behind the curve (or already has) in tightening monetary policy, meaning a period of higher-than-expected inflation and interest rates will ensue but a Fed-induced recession may be delayed. Whatever the response, it is reasonable to expect additional volatility in the not-too-distant future.