by Connor Darrell, Head of Investments
It was “Much Ado About Nothing” last week, as one of the busiest weeks of the year proved to be one of the least memorable in terms of market moves. The Trump Administration once again managed to make things interesting when it announced on Friday its intentions to impose a 25% tariff on up to $50 Billion of imported Chinese goods, prompting a small pullback in U.S. equities. The move wasn’t major, but it was enough to erase the small gains that had been posted over the week’s first four trading days. As is common when equity markets react to negative news, bonds produced small gains despite the Fed’s decision to increase interest rates.

There were no less than four key events last week (three of them were officially scheduled ahead of time) that had the potential to influence markets in a meaningful way. We go through the key details below:

1. The Summit with North Korea
   While historically significant, there were few details emerging from the summit that caught the attention of financial markets. In post-meeting press conferences, President Trump made a case for the North Korean Government to consider opening up to foreign investment, stating that Chairman Kim has a “great opportunity” to improve the livelihood of his people. In the long run, geopolitical uncertainties tend to be overtaken in significance by economic fundamentals, and it is unlikely that (short of a war) the ongoing concerns in North Korea will prove to have a lasting impact on markets.
2. Federal Reserve Policy Meeting
   The Federal Reserve raised the federal funds rate a further 0.25% on Wednesday. The move was highly telegraphed and was already priced into markets, so the net impact was minimal. However, we did gain further insights into how the Fed views the current state of the economy (quite favorably) and learned that two more hikes this year are expected.
3. ECB Policy Meeting
   The European Central Bank also held policy discussions this week, and officially announced its intention to wind down its massive bond-buying program. The European economy is a bit behind the U.S. in its recovery but has undergone the same type of monetary policy “stimulus” as has been experienced here in the U.S. The ECB made clear in its communications that while the aggressive bond purchases will cease, interest rates will remain unchanged until at least September 2019. The monetary policy environment overseas remains more accommodative; a sign that the U.S. economy stands on more solid footing. Markets took the news well, and any fears that the adjustments would lead to market turmoil proved unfounded.
4. Tariff Announcements
   The most influential “event” of the week was the only one not officially listed on the calendar ahead of time, as the Trump Administration offered details on its plans to impose tariffs against Chinese goods. China was quick to respond with its own plans, and fears of an escalating trade war were stirred up yet again. Markets opened Friday sharply lower but managed to claw back a decent portion of early losses. The concerns over tariffs continue to linger, though the market has remained resilient overall.

by Connor Darrell, Head of Investments
The S&P 500 managed to rally last week (posting a 1.66% gain), but markets have had limited time to digest the further escalation in trade rhetoric coming from the G7 summit in Quebec (which ended on Saturday). President Trump’s continued focus on economic protectionism has caused consternation among major trade partners, and the risk remains that significant changes to trade policy could hinder long term global economic growth.

The week of June 11^th is likely to bring multiple events that have the potential to significantly impact financial markets, including monetary policy meetings in the US, Europe, and Japan, in addition to the historic summit between the U.S. and North Korea on Tuesday in Singapore. We will do our best to break down the important takeaways in next week’s update.

We continue to emphasize to clients that in the long run, markets are driven by the underlying economic environment and growth in corporate earnings. That backdrop remains quite favorable at this time. As investors, we need to be aware of how politics and policy impact our portfolios, but barring a major change to the forward outlook, the long-term strategy should remain largely in place.

by Connor Darrell, Head of Investments

It was a busy week for financial markets, with a mixed bag of positive economic news and disruptive political developments.  On the positive side, the US unemployment rate continued to track lower, reaching 3.8% in May.  Unfortunately, that news was offset by two major developments in the global political landscape.

First, markets opened sharply lower on Tuesday as Italian political negotiations sparked fears that Eurosceptics (those who are opposed to European Union membership) were set to take control of the government.  The political situation in Italy remains complex and the long-term outlook uncertain, but those fears were somewhat alleviated later in the week as a more favorable consensus was reached on the re-establishment of the government following March’s inconclusive election results.

Then on Thursday, the topic of tariffs once again dominated financial news headlines when the Trump Administration announced that it would allow the temporary tariff exemptions (Initially granted when the 25% steel and 10% aluminum tariffs first took effect in March) for Canada, Mexico, and the EU to expire.  According to Goldman Sachs Investment Research, those countries accounted for approximately 40% and 48% of 2017 US imports of steel and aluminum respectively.  Canada and Mexico immediately responded with retaliatory measures and stocks slid lower on the news.

Amid the conflicting signals, US equities outperformed, and bonds generated small gains as investors sought refuge from some of the volatility.

by Connor Darrell, Head of Investments
Bonds rallied last week, with the 10-Year Treasury yield dropping back below 3% and the Bloomberg Barclays U.S. Aggregate Bond Index posting gains of 0.74%. Stocks produced mixed results, with the U.S. outperforming its International counterparts.

Another By-Product of “Low for Long” Interest Rates: Corporate Debt
Moody’s, a well-respected provider of credit research, issued a sobering report earlier this month warning of the potential for “a particularly large wave” of defaults on below investment grade corporate bonds when the next economic downturn eventually arrives. The report cites the low interest rate environment as a key contributor to a significant increase in the amount of corporate debt outstanding and a subsequent rise in the number of global non-financial companies carrying below investment grade credit ratings.

Coming out of the financial crisis, with interest rates at their lowest levels in decades, many corporations took advantage of the low rates to go out and borrow additional funds to invest in their businesses. And with investors starved for yield, even many companies that were in poor financial health were able to issue debt at relatively low rates. This has been beneficial to the overall investment climate and a tailwind for the stock market, but may leave many companies exposed in the event of a prolonged economic downturn.

Default rates on corporate bonds remain very low, but the Moody’s report highlights the need to be vigilant, even in strong economic environments. We have discussed in past communications that we find ourselves in uncharted waters with respect to monetary policy, making it even more important to be on the lookout for potential risks in the marketplace. Rising levels of corporate debt is certainly one of those risks to watch.

by Connor Darrell, Head of Investments
Both large cap stocks and bonds ended the week marginally lower, but the heightened volatility observed over the past few months seems to have waned for the time being. Internationally, stocks traded largely in line with those in the U.S., although emerging markets stocks had their worst week in quite some time. Emerging markets stocks have faced headwinds from the increasing strength of the U.S. Dollar, which reached a five-month high last week.

US small cap stocks were a bright spot last week, and have been all year. The Russell 2000, which tracks a broad basket of small cap stocks, is up over 6% so far this year, outperforming the S&P 500 by about 4%.

Oil Prices on the Move
It is easy to forget that there was a solid four-year stretch from December 2010 to November 2014 where the average retail price of a gallon of gasoline in the US was well over $3. But a confluence of factors (including technological advances that increased US oil production, as well as a concerted effort by members of OPEC to put a squeeze on those same U.S. producers) led to a massive decline in the price of oil beginning in late 2014. From peak to trough, the total price decline was over 70%, and consumers reaped the benefits for a number of years. However, that has changed rather dramatically in the last 12 months, as prices have come roaring back.

The surge in oil prices over the past year has been driven by a variety of influences, including increasing demand driven by strong global economic growth, cooperation between Russia and OPEC, economic collapse in Venezuela, and logistical inefficiencies disrupting the distribution of US shale oil. On top of this, the Trump administration’s decision to withdraw from the Iran nuclear deal and re-impose sanctions could lead to a decline in Iranian production, which would further deepen the supply shortfall.

In the near term, the rise in oil prices has the potential to increase inflation and pose as a headwind to economic growth (albeit not nearly large enough to offset the benefits of recent tax reform). We have discussed in the past that the Fed is watching inflation closely, as it is one the key indicators that helps to dictate monetary policy. However, the Fed is unlikely to be coerced into altering its path of normalization by something as fickle (and potentially temporary) as rising oil prices. It is more likely that the worst side-effect of the recent run up in oil prices will be some pain at the pump during the summer travel season.

by Connor Darrell, Head of Investments
Stocks posted their strongest weekly gain in over 2 months last week, with energy stocks leading the way amid further increases in the price of oil.  It certainly won’t be celebrated by those of us traveling for summer vacations over the next couple of months, but oil prices are likely to remain elevated if the Trump Administration is able to reinstate economic sanctions on Iran.  International markets also posted gains on the week.

Bonds had a relatively uneventful week, but remain under the microscope of many investors and media outlets as interest rates creep higher.  We discuss some of our thoughts on what the market might be overlooking in our update below.

The Bigger Unknown in Monetary Policy “Normalization”
Likely due to their direct influence over the interest earned on savings and paid on loans, the Fed’s interest rate decisions seem to get all of the attention when it comes to discussions of monetary policy.  However, faced with the unenviable task back in 2008 of combating the deepest recession in a generation, the Fed pulled out all the stops, using every tool in its arsenal to inject life back into the US economy.  As a result, in addition to the traditional (and oft discussed) avenue of pulling interest rates down near zero, the Fed also implemented multiple rounds of Quantitative Easing, an unprecedented expansion of Reserve Bank Credit (the Fed Balance Sheet).  This was accomplished by purchasing trillions of dollars’ worth of bonds in the open market in order to inject more money into the financial system and increase liquidity in markets.  The ultimate purpose of the policy is largely the same as the reduction in interest rates, but it is widely considered to be a much more extreme approach.

Between October of 2008 and December of 2014, the value of the Federal Reserve’s balance sheet swelled from $0.9 trillion to $4.5 trillion (see below chart from Argus Research) as it continued to purchase bonds.  Since then, the balance sheet has remained largely untouched, but the Fed has made clear in its communications that this will soon change.  The consensus among forecasters is that the Fed will begin the process of shrinking its balance sheet later this year by allowing maturing bonds to roll off and ceasing its reinvestment of coupon payments, to the tune of about $50 billion per month.

Like all markets, the bond market is driven primarily by supply and demand, and with the Fed reversing its policies, the underlying balance of supply and demand will undoubtedly be altered.  What would this mean exactly?  The ultimate results are very difficult to predict.  If the Fed is able to effectively telegraph its moves (as it intends), then markets may be able to adjust gradually with no major impacts.  But if the balance shifts more than anticipated, then a major dislocation could take place.  Under such a scenario, the laws of supply and demand would dictate that the oversupply of bonds on the market would drive prices down, and yields up.

Source: Argus Research

That short term rates will increase from here is highly likely and largely assumed by most investors, so in our view, the potential impact of the Fed’s balance sheet unwind, which would occur in addition to the trends already in place, is the bigger “unknown” as we move away from the accommodative monetary policies of the last decade.  Given its current size, it may be appropriate to say that we consider the Fed’s balance sheet to be the “elephant” in the room.

by Connor Darrell, Head of Investments
Both stock and bond markets trended downward last week, until Friday’s jobs report sparked a stock market rally. The Department of Labor reported that employers added 164,000 new jobs in April, and that the unemployment rate currently stands at 3.9%. This was the first unemployment reading below 4% since 2000.

Additionally, there are more than six million unfilled job openings throughout the economy; close to an all-time record. However, despite the continued imbalance in the supply and demand for labor, wage growth has remained slightly below expectations. Wage growth is one of the last pieces of the puzzle, and because of its potential connection to inflation, will be watched closely by the Fed as it steadies its march toward normalization.

A Wacky Earnings Season
Active traders often try to take advantage of earnings calls as an opportunity to buy or sell a stock ahead of its earnings report.  It’s a risky proposition, and one that we do not recommend in the current environment. Per Factset, 81% of S&P 500 companies have reported Q1 earnings in excess of consensus estimates, and overall earnings growth has been over 24%; the highest rate in seven and a half years. Even so, we have witnessed dozens of companies report earnings beats, only to sell off meaningfully during the following trading session. It seems the market has lofty expectations for further growth, and companies that do not raise their forward guidance to meet those expectations are being punished. As we continue to progress deeper into the economic cycle, the heavy emphasis on forward guidance rather than past results is likely to persist.

According to research from Wells Fargo, earnings growth for Q1 would be closer to 7% in the absence of tax reform, and once we reach 2019, year-over-year comparisons will not benefit from the tax reform boost. Add this reality to the confluence of risks that the market has begun to acknowledge rather than ignore, and it becomes a little bit easier to understand why markets aren’t quite ready to break out the champagne to celebrate a successful earnings season.

As the market continues to trend sideways with higher levels of volatility, asset allocation and diversification become even more important. Periods like these are the reason we diversify in the first place.

by Connor Darrell, Head of Investments
Last week brought with it a slew of positive new developments, both economically and geo-politically. Q1 GDP growth exceeded estimates, corporate earnings continued their positive momentum, and small steps were taken toward officially declaring an end to the Korean War (at long last). Despite all of the good news however, both equities (as measured by the S&P 500) and bonds (as measured by the Bloomberg Barclays US Agg) finished flat for the week. Bond markets have faced headwinds all year from increasing interest rates, but we continue to emphasize that rising interest rates do not necessarily mean doom and gloom for bond investors. While shifting interest rates will cause some volatility in bond prices, investors who plan to continue holding bonds until maturity will not be harmed by the interim price movements, and those who hold shorter term bonds in their portfolios will be well positioned to reinvest as rates creep higher. Additionally, rising interest rates will be welcomed by savers and those who are looking to cash as a respite from volatile equity markets.  There are winners and losers under every scenario.

We are presently in the midst of one of the strongest earnings seasons in recent memory, but the stock market has barely budged. The lack of movement suggests that most of what we are seeing was already reflected in stock prices, and that the market is beginning to acknowledge that 2017’s huge gains left us with a much shorter climb for 2018 and beyond. Put simply, the forward outlook is quite a bit different than it was just 6-12 months ago.

A Return to “Normal”
2018 is likely to become the year of mean reversion. The Federal Reserve has made it abundantly clear that it intends to begin increasing interest rates at a steadier pace. The term that bankers use is “normalize,” and it really is a fitting term for what is going on in the economy and in the markets. Volatility in the stock market, CDs paying more than 0.5%, and a central bank balance sheet that doesn’t contain trillions of dollars of bonds are all “normal.”

After a decade of abnormal, a return to normal is going to take some getting used to.

by Connor Darrell, Head of Investments
Earnings season is now in full gear and the initial data has been quite strong. According to Factset, a little less than 20% of S&P 500 companies have reported earnings thus far, and the blended earnings growth rate for these companies has been 18.3%. The healthy earnings growth pushed equity markets higher for the second straight week, while bonds finished down as the ten year Treasury note pushed close to 3%.  The 3% threshold will be an important milestone in the normalization of interest rates.  Rising interest rates have been discussed ad nauseam in financial news outlets, but are a natural part of the economic cycle and should be expected to continue as the economy strengthens. The Bureau of Economic Analysis will release its first estimate of Q1 2018 GDP growth this week, and investors will likely be focusing on the year over year numbers as they look for further evidence of an improving economy.

What Happened To the Infrastructure Bill?
Following the passage of tax reform at the end of last year, it was widely expected that lawmakers would quickly shift their attention to infrastructure. For the time being, scandals, international tensions, and unrest within the Trump Administration seem to have slowed the legislative momentum established following the tax victory, and it now looks unlikely that an infrastructure spending bill will be introduced in Congress until after the mid-term elections in November. From a market perspective, the delay is unlikely to have major implications, but from an economic growth standpoint, an infrastructure bill could be an interesting wild card.

In terms of economic impact, infrastructure spending has similar effects to tax cuts. The increased spending on projects should have a positive impact on labor markets and create new jobs. In theory, those workers then have more money in their pockets to spend on goods and services, which should be a tailwind for economic growth. Many observers have been quick to point out that some aspects of the tax bill are “front loaded”, in that their effects phase out over time. An infrastructure bill passed during 2019 could potentially pick up some of the slack and help to carry growth momentum a little bit further, essentially allowing us to squeeze even more juice out of this long expansion. Given that outlook, it is entirely possible that this becomes the longest economic expansion in history, exceeding the period from 1991 to 2001 when the US experienced 120 straight months of economic growth. Given that the current expansion is already over 105 months old, there isn’t a lot further to go.

Of course all of this is incredibly difficult to project with any real degree of confidence, especially when considering the myriad of external factors and the possibility of significant changes to the composition of congress following the mid-term elections. But even without further stimulus in the form of infrastructure spending, the economy remains on firm footing and the risks of recession remain relatively low in the immediate future.

by Connor Darrell, Head of Investments
Despite a busy week in Washington headlined by Speaker of the House Paul Ryan stepping down from his post, stocks managed to climb 2% higher last week. The market’s gains were bolstered by a rebound in technology and energy stocks.  Facebook CEO Mark Zuckerberg endured two difficult days of Congressional testimony surrounding data security and privacy on the web. The testimony was well-received by the markets. Bonds were down slightly after the minutes from the most recent Federal Reserve meeting were released and suggested further rate hikes remain likely.

Now that the first quarter of 2018 is in the books, investors can shift their attention to the first earnings season under the new tax laws. Throughout Q1, the stock market was hampered by shifting inflation expectations, a selloff in technology stocks, and fears of an all-out trade war, but the steady flow of new corporate earnings data that is set to commence this week should provide investors with a (much needed) new area of focus. According to Factset, the market is expecting 17.1% growth in corporate earnings, which would be the highest growth rate since 2011. The strong estimates are a product of the reduced corporate tax rates under the new law, as well as increasing consumer confidence and economic growth.

Time to Follow Through

The optimism for earnings growth is in stark contrast to some of the nervousness that markets have exhibited over the past few months, where intra-day selloffs of more than 1% have been commonplace.  That divergence is in many ways a microcosm of the increasingly conflicting signals that investors must grapple with moving forward. Shifting economic policies in the US and the potential for rising inflation and interest rates are offset by improving economic growth and consumer confidence around the world.  But if Q1 taught us anything, it’s that expectations can only get us so far. At some point we need to see real tangible progress, and Q1 earnings season is the market’s first opportunity to prove to us that all the optimism surrounding tax reform’s impact on corporate profits was justified. If earnings live up to all the hype, stocks could find more stable footing and finally put some of these trade fears in the rear view mirror. If it doesn’t, we could all be left a little disappointed.