Scientists, astronomers, Star Trek enthusiasts, and alien life believers were inspired by the February news release of NASA’s distant solar system discovery, and potentially habitable planets. Using a method called “transit photometry” (estimates a planet’s size based on the degree of light dimming) at NASA’s Spitzer Space Telescope in Pasadena, Cal., scientists located the “relatively close” system and exoplanets in the constellation Aquarius, about 40 light-years or 235 trillion miles from Earth (in comparison, the Sun is roughly 93 million miles from Earth or .000016 light years). According to experts, getting from one planet to another in this system would take just a few days of travel time, rather than the months it would take us now to get to Venus and Mars, while a person standing on one of the planet’s surfaces could potentially see geological features and clouds of neighboring planets, at a size slightly larger than the moon.
Of most interest to those who are open to the concept of alien life, three of these seven planets sit within the “temperate zone” or “habitable zone”, with the potential to have the right temperature to support life, due to the possible existence of liquid water and oceans. Planets closer to the star-sun, referred to as TRAPPIST-1, would find it more difficult to support life, primarily because of the periodic shooting off of potentially lethal flares and bursts of radiation. More powerful telescopes than what is available today will be needed to further learn about this system, but is only a matter of time. Interestingly, for those who are curious, the NASA budget request for 2017 was $19 billion (a figure that can be debated regarding its relative usefulness).
The first quarter of 2017 reminded investors that, despite the potential for new discoveries and ground breaking transformation, the reality of effecting change is often more complicated than the proposal. Investors began the year with continued enthusiasm along with upward equity market momentum, based on the expectation the change in the White House and majority Republican party make up of congress had the potential to quickly turn into both the adoption and implementation of pro-growth, business-friendly policies. These include the expected repeal of Obamacare, rapid advancement on infrastructure spending initiatives, repeal of Dodd Frank, and the lowering of both corporate and personal tax rates. As such, CEO and small business confidence soared, with the NFIB Small Business Optimism Index reaching levels not seen since 2004. This in turn caused future economic growth estimates to propel higher.
Based on upward stock price momentum and a decent report for fourth quarter 2016 U.S. economic growth, the Federal Reserve, having just raised rates in December, concluded there was enough underlying strength in the economy to convince them to raise the funds rate again by another 0.25%. Signifying the FOMC’s determination to normalize rates and engineer a gradual tightening in monetary policy, the Fed also emphasized the prospect for potentially two more hikes during the year, along with floating the idea of rolling off some of their Quantitative Easing (QE) acquired bond holdings. Concurrent with these messages and eventual rate hike, the Atlanta Fed’s GDPNow forecast for the first quarter was sliding, dropping from 2.5% expected annualized growth in early February, to below 1% at the time of the increase. Although not a “Houston we have a problem” event, this raised concern the timing of liftoff might have been better scheduled.
Politically, still upset from the presidential election defeat, congressional Democrats, who continue to view President Donald Trump as an alien occupying the role of president, dug in their heels to reject health care policy reform initiatives and any others they could delay. The poorly crafted scheme also failed to gain adequate support from Republican constituents, causing the proposal to be pulled before going to a vote. The failed mission took away some of the year’s early enthusiasm, as well as call into question some of the spending reductions which would have more easily allow for the implement of tax cut legislation. This, in turn, caused investors to begin questioning the ability to pass future proposals and some of their “risk on” thesis.
Market reaction to Fed communications and failed legislation was consistent with what one would expect. 10-year Treasury bonds, which had started the year at 2.45%, rocketed up to as high as 2.63% by mid-March in response to the expectation for higher growth, the Fed’s hawkish tone, and rising inflation expectations. However, upon economic results being reported below expectations, the 10-year rates returned to earth, finishing at 2.39% by the quarter’s end. Cyclical sectors of the stock market, where earnings are most leveraged to the strength of the economy, having generated outsized results during the fourth quarter, also retreated as investors tempered their enthusiasm and the timing of broader economic improvement.
The Russell 1000 Value Index, having more exposure to cyclical sectors, gave up roughly half of its early quarter gains to finish the period up 3.3%. In particular, the decline in energy prices, the fall in both bond yields and interest rate spreads, and competitive landscape hurt the energy, financial, and telecommunications sectors, respectively, each having larger weightings in the value indices. On the other hand, the Russell Large Cap Growth Index benefitted from both strong returns and larger weightings in the technology, health care and consumer discretionary sectors, causing the index to generate an 8.9% return in the quarter. This was a reversal of the strong outperformance from the value style in the fourth quarter of 2016 when investors preferred more cyclical exposure. In a slowing economic environment, investors tend to prefer the more organic growth characteristics of the growth style of investing, as well as those companies with more consistent sales and earnings, not those most leveraged to the economic cycle. Similarly, small cap stocks underperformed, due to their being more sensitive to the pace of economic growth, while taking a breath from their strong fourth quarter move. The Russell 2000 Small Cap Index was up 2.5% versus 6% for the Large Cap Russell 1000 Index benchmark.
As discussed in past commentaries, currency movement influences international market net returns. In the most recent quarter, the U.S. dollar gave back some of its recent gains, with the broad trade weighted dollar index falling by over 1.8%, as investors recognized the strength of the domestic economy was not as robust as had originally been predicted. Similarly, the dollar fell 4.8% versus the yen and roughly 1.3% against the Euro. Despite the uncertainty of the French elections, the European economy is gaining traction, along with the possibility of their also reducing monetary policy stimulus. Although time will tell, and economic growth could certainly be reported above expectations in the second half of the year, the Fed’s rate hike in March may have been simply moving forward the expected increase in June. As of the time of this writing, given the uncertain economic environment and timing in the implementation of U.S. tax and fiscal policy, the odds the Fed does not raise rates at all in 2017 have more than doubled from 10% to roughly 22%, and the probability that the Fed raises rates only once between now and the end of the year has increased from 34% to 41%.
Dollar weakness combined with moderating concern for implementation of proposed trade policies, as some of Trump’s initiatives have been delayed, was of greatest benefit to emerging market (EM) securities. Many EM governments and EM-based corporations have issued dollar denominated debt to fund their growth, and a rising dollar and falling commodity prices has placed an increased burden on these issuers, as currency weakness has made debt interest and principal repayments more expensive. However, growth estimates for emerging market countries has improved, and valuation multiples are more attractive than the U.S. markets. After declining significantly since 2011, the outlook for EM markets remains attractive relative to the more moderate growth estimates from the U.S. and international developed markets.
Developed international markets also benefitted from improving economic and currency trends. After several years of underperformance, investors appear to be returning to these asset classes, represented by strong inflows into international and EM-focused mutual funds and ETFs. For the quarter, the EM benchmark returned a robust 11.5%, while the developed international EAFE index returned 7.4% for U.S. based investors. When removing the currency influence, the EAFE Index returned 5.9% for those using the Euro as their home currency and 2.5% in yen based terms.
Astronomers believe finding a second Earth is not just a matter of if, but when. Mere Earthly mortals will need to discount Trump’s periodic shooting off potential lethal flares and outbursts, and while the timing and implementation of Trump’s policies may be delayed (and likely will be watered down in an effort to move towards broader acceptance), it appears to be just a matter of when, not if.
We expect interest rates to drift higher over the course of the year, providing more limited future return, but also value their place in a diversified portfolio, especially in a “risk off” environment, perhaps the result of rising geopolitical tensions. Our outlook for the equity markets remains favorable, based on the expectation for improving business conditions and earnings, although potentially more second half of the year loaded. The markets remain in the “habitable zone” and able to support life, with acceptable organic economic growth, low inflation and interest rates, and limited risk of a recession in the foreseeable future. The growth style is likely to perform well during this interim, choppy period, while value offers attractive characteristics when ideas turn to reality. When this occurs, price levels would be expected to “boldly go where no one has gone before.” If the stars are truly aligned, we might just transit there sooner than later.