Global equity markets enjoyed positive returns in the first quarter. Returns were driven by solid economic data, positive corporate earnings trends, and very strong investor sentiment. The sharp move higher in both consumer and business sentiment since November’s election is noteworthy. As shown in the graphs below, the Consumer Confidence Index and the Small Business Optimism Index have reached levels not seen since before the 2008 financial crisis.
Source: Conference Board. As of Mar. 28, 2017
Source: Natl. Federation of Independent Business. As of Mar. 27, 2017
These types of qualitative, survey-based readings, referred to a “soft data,” often lead quantitative economic measures, or “hard data,” by one to two quarters. Positive sentiment can have a ripple effect throughout the economy. Optimistic consumers tend to spend more, which can positively impact both GDP growth and corporate earnings. Similarly, optimistic business owners and corporate CEOs also tend to spend more, investing in capital equipment and additional workers to grow their businesses.
Much of the recent surge in optimism can be attributed to expectations around legislative changes under the Trump administration and a Republican-controlled Congress. While politics is often ignored by the stock market, the next few months are likely to be an exception. The degree to which tax reform, regulatory reform, and infrastructure spending bills are successfully addressed in the coming months will likely impact both the soft and hard data going forward. Congress’s recent failure to pass the healthcare reform bill has dampened optimism somewhat. We view this as a healthy move off of the elevated levels of sentiment recorded since the election.
Hard economic data has generally been stable and improving. The Conference Board’s index of Leading Economic Indicators (LEI) is a composite of 10 economic data points that can be effective in predicting turning points in the business cycle. The LEI has had 6 consecutive months of overall gains and recently hit its highest level in over a decade, indicating an improving economic outlook for 2017 and very low risk of a recession in the next 12-18 months.
Source: Conference Board, Schwab Institutional as of March 2017
Other positive data include continued strong employment figures and an uptick in inflation measures. These are the two key indicators followed by the Federal Reserve. The Fed raised short term interest rates as expected following its recent meeting, noting solid labor market conditions and inflation closing in on its 2% target. The Fed intends to raise rates slowly, and indicated it would likely increase rates twice more in 2017.
The yield on the benchmark 10-year treasury ended the quarter just below year-end levels. We continue to think that interest rates are likely to remain range bound until there is a more marked change in the fundamental economic outlook. All else being equal, an environment of low but gradually increasing rates should be positive for stocks, and slightly negative for bonds (as bond prices move opposite rates).
Finally, many investors remain concerned over stock prices given the strong performance of equity markets over the past 8 years. The current forward price-to-earnings (PE) multiple for the S&P 500 stands at 17.5, above the historical average of 15.9. When we evaluate PE ratios, we think it’s important to look at periods of similar interest rates and inflation. Low to moderate levels of both factors can justify higher valuation multiples. Over the past 60 years, the average forward PE multiple during periods when inflation and interest rates were similar to today has been 17.6, in-line with the current level. Considering this data, along with the recent positive trajectory of economic and earnings reports, we do not yet view PE multiples as high enough to warrant a reduction in our allocation to stocks.
In summary, we continue to favor an overweight to stocks over bonds, with hedged equity providing the potential for greater returns than bonds with less volatility than stocks. Core bonds remain an important diversifier, however, and help to stabilize the portfolio during the inevitable periods of stock market decline.
Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.