Global equity markets advanced strongly in the first quarter, overcoming geopolitical concerns in the US and abroad. In contrast to last year, foreign markets, especially emerging markets, and technology stocks in the NASDAQ led the way while US small caps saw more modest returns. Top-performing markets included Brazil, India, Mexico and Chile. Although the US Standard and Poors 500 index turned in a strong performance, most emerging markets along with developed markets in Europe and Japan performed even better.
The Federal Reserve raised short term interest rates by 0.25% in March, the second increase since December 2015, and an indication that the Fed believes the US economy is making progress toward its objectives of full employment and price stability. The rate on ten year US Treasury bonds remained virtually unchanged from the beginning of the year at 2.4%. Bonds achieved modest returns with the US Aggregate Bond Index advancing 0.8%.
Equity markets virtually ignored the political and legislative controversies in Washington, the Federal Reserve’s move to raise interest rates, the decision by Great Britain to move forward with their exit from the European Union, and the upcoming elections in Italy and France which could also impact the stability of the European Union. An old Wall Street saying “bull markets climb a wall of worry” rang true this quarter.
Returns for key indexes were:
|Dow Jones Industrials index||16.5%||5.2%|
|S&P 500 index||11.9%||6.1%|
|S&P 400 mid-cap index||18.7%||3.6%|
|Russell 2000 small-cap index||19.5%||2.1%|
|Total International, excluding US||4.8%||8.6%|
|Dow Jones Global Stock index||5.9%||6.4%|
|Barclays US Aggregate Bond index||2.4%||0.8%|
Economic and Market Outlook The US economy is healthy and resilient, although economic growth remains sluggish. Interest rates remain low by historic standards and corporate earnings are expected to post strong growth for the first quarter. Unemployment is a low 4.7%, but this low rate may be partly attributable to a steady erosion of individuals choosing to participate in the work force over the last half-century.
Although the economy is healthy, there is a good deal of political, economic and market uncertainty surrounding the new President and Congress. The Trump administration said they will initiate corporate tax reform and streamline burdensome regulations both of which should prove beneficial to corporate earnings and a likely reason that US equity markets have rallied since the election. As we learned from the recent attempt to pass new healthcare legislation, the legislative process is often difficult to predict and impossible to know what, if any, new tax legislation may result. This creates a good deal of uncertainty in forecasting after-tax corporate earnings and a fair value for stocks.
While some policies proposed in the presidential campaign, such as tax and regulatory reform, if passed, should prove positive for the markets, others, such as tariffs or trade barriers, could undermine the earnings of US and foreign corporations. Some proposals, such as the border adjustment tax (BAT) may sound good on the surface, but are complex and a dramatic change from our existing system that could result in unintended and undesirable consequences.
Adding to that uncertainty, the Federal Reserve is expected to increase interest rates two more times this year and begin reversing Quantitative Easing (QE) by not purchasing new bonds as their current holdings mature. Small and infrequent rate increases would likely have minimal impact on the financial markets however large and more frequent rate hikes would create a serious obstacle to both the stock and bond markets. Since QE has not been tried before, no one knows for certain what the impact of reversing it will be.
The US equity market represents slightly more than half of global equity markets (as measured by market value). Historically, a globally diversified equity portfolio has performed better than a strictly US portfolio more often than not. That was not the case the last six calendar years as the US outshone most foreign markets. As a result of the stronger performance in the US market in recent years, both developed and emerging overseas markets are more attractively valued compared to the US.
Foreign markets also face uncertainty, particularly in the European Union as Great Britain negotiates their exit and Italy, Germany and France face elections which could influence their status within the EU. We have learned that elections are sometimes difficult to predict and these are the three largest economies in the Euro Union that have zone adopted the Euro as their currency, so it is important to keep these risks in mind.
Emerging markets are also significantly undervalued compared to the US, however their corporate earnings could be adversely affected by a strengthening US dollar, rising interest rates, and potential US trade tariffs.
Slowly rising interest rates may present a mild headwind for fixed income investors since they diminish the value of existing bonds. Shorter term bonds will not be subject to as much interest rate risk as longer term bonds. If interest rates rise slowly, as is expected, most bonds and bond funds should continue to produce positive returns.
Because of the many political uncertainties here and abroad, it would appear to be prudent to invest cautiously both in the US and overseas.
To improve the US economy, which has been growing at a sluggish 2% per year we may need to set aside the “easy answers” politicians have proposed. Instead we need to focus on increasing the size of the workforce and making them more productive. To increase the size of the workforce we need to either increase the proportion of our population in the workforce (which has been declining for decades), and / or increase the number of qualified immigrants. Embracing technology such as robotics, while training (or re-training) displaced or under-employed workers (along with those no longer seeking employment) would appear to offer opportunities to ramp up US economic activity while also reducing national strife. While easier said than done, adopting a national focus on this is critical for our economic strength, ability to finance future government spending on defense, social programs and entitlements, as well as our national cohesion.
The growing prominence and cost of Medicaid Medicaid was created without much fanfare in 1965 as a small program to cover poor people’s medical bills. Over the following fifty years its mission has expanded to include people with incomes up to 133% of the poverty level falling into certain categories including low-income parents and children, pregnant women, low-income seniors, and adults without dependent children Originally the federal government shared the costs with the states and each state established their own rules. The Affordable Care Act (“Obamacare”) expanded coverage with the federal government now paying up to the entire costs for certain newly eligible beneficiaries. Critics suggest that this now gives the states less incentive to control costs. According to the NY Times, Medicaid has surpassed Medicare in the number of Americans it covers. Medicaid now insures 20% of the US population, 40% of American children, 50% of all births and 66% of people in nursing homes. (Yet, according to the New England Journal of Medicine there is no significant difference in mortality, blood pressure or diabetes of Medicaid recipients vs the uninsured.) Due to the large number of people receiving Medicaid (and who want to continue to receive it) and high costs associated with it, it has become a very important element in our national discussion on healthcare.