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February 2017 Market Commentary

Wednesday, Mar 1, 2017

U.S. and global equity markets continued the rally that began in November 2016, driven by positive economic surprises and improving expectations for corporate earnings, to end the month substantially higher. The following table contains a summary of February’s market performance:

Index February YTD Index February YTD
S&P 500 (Total Return) +3.97% +5.94% All Country World Index (Net) +2.81% +5.62%
MSCI EAFE (Net) +1.43% +4.37% Barclays Aggregate +0.67% +0.87%
MSCI Emerging Markets (Net) + 3.06% +8.70% 60/40 Blend* +1.95% +3.70%
* 60% All Country World Index/40% Barclays Aggregate

Much of the explanation for the market’s performance has been given to the “Trump rally.” Markets have been driven higher by improving investor optimism that lower corporate and personal tax cuts will raise earnings and spending, despite the lack of policy specifics from the Trump Administration. Overlooked, however, has been economic data that has surpassed expectations. The Citi Economic Surprise Index, a measure of whether economic data was weaker or stronger than forecast, climbed to its highest level in nearly three years following stronger-than-expected reports on retail sales, consumer prices and business activity.

U.S. manufacturing production expanded at the fastest pace since 2011. The ISM index, a measure of orders, advanced for the sixth straight month to levels last seen three years ago. At the industry level, 17 of 18 industries posted growth in February, pointing to the breadth of the recovery. Improving economic fundamentals have not been limited to the U.S. The Eurozone Composite Purchasing Managers Index suggests that the Eurozone economy is growing at its fastest pace in almost six years. The Eurozone produced 3 million new jobs over the last year, raising total employment to the all-time high seen in 2008. Other forward-looking signs of growth are an improvement in the European Index of Leading Economic Indicators, and loans-to-business climbing at their fastest pace in seven years.

Despite positive economic fundamentals, forecasts of 2017 U.S. GDP growth have risen to only 2.5%. The impact of improving growth is finally finding its way to inflation, however, and in expectations for monetary policy tightening. The Fed’s preferred measure of U.S. inflation registered 1.9%. European inflation, stuck at 1% for much of 2016, has also accelerated toward to 2%, driven in part by the rise in energy prices over the last 12 months. Leading indicators of expected inflation, wage and energy costs remain subdued, however. The Fed reported that wages continue to respond only “modestly or moderately” to job market tightening. And despite the OPEC agreement limiting supply, U.S. crude stockpiles reached a record level, limiting the likelihood that oil prices will climb higher.

With U.S. unemployment below 5% for the last nine months, and inflation approaching its policy target of 2%, the Fed has met its policy targets, increasing the probability that it will resume the process of interest rate normalization by raising the Federal funds rate. Following the release of its most recent FOMC meeting minutes as well as comments by San Francisco Fed President John Williams that he saw "no need to delay" raising rates, the market-implied probability of a March hike climbed from 40% to 82%. Bond markets have taken the news in stride, with one-year, two-year and ten-year Treasury bonds essentially flat for the month, reflecting the market’s view of a stronger economy. The yield on the U.S. ten-year Treasury bond started the month at 2.47% and finished the month at 2.39%.

Historically, higher U.S. interest rates have hurt emerging market currencies and equity values. Instead, emerging market equities have rallied on the idea that a stronger U.S. economy will drive growth in the emerging markets, supporting higher commodity prices and corporate profits. Growth across the emerging markets is expected to be 4.2% in 2017, up from 3.4% in 2016. Commodity prices have climbed 20% since bottoming in 2016.

The strong start to the year enjoyed by equities has surprised “strategists” and raises questions about how markets will perform the rest of the year. Bloomberg observed that the S&P 500 index has already surpassed the average estimate of Wall Street strategists (low of 2275; high of 2500). Investors are divided on whether to raise estimates. While some analysts are raising their year-end targets, others point out that the Shiller P/E ratio suggests investors are paying more today for a dollar of earnings than at any point leading up to the financial crisis.

What’s an investor to do? Those who believe in the promise of regulatory and tax reform have stepped into U.S. equities, driving prices higher, believing they will be rewarded with higher earnings. Value-focused global funds, according to strategists at HSBC, are rotating into European equities based on attractive valuations relative to U.S. stocks, improving European growth and earnings, and a weaker euro. But to do so, they are discounting the potential impacts of upcoming elections across Europe that concern CAPROCK.

CAPROCK remains constructive on equities over the longer term believing that accelerating economic and earnings growth will support higher equity prices. However, we are concerned that in the near term the market is “approaching a point of maximum optimism” regarding the benefits of prospective Trump administration policy initiatives. This leads us to believe that if tax or other reforms were to disappoint the market’s expectations we could see a sell-off in equities. We believe such an event would provide an entry point for those wanting to increase their allocation to public market equities.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but CAPROCK makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.

Copyright 2016 The CAPROCK Group, all rights reserved. The CAPROCK Group is an SEC Registered Investment Adviser. This communication is not a solicitation or offer to sell investment advisory services except in states where we are registered or where an exemption or exclusion from such registration exists. All written content is for informational purposes only and may not constitute a complete description of available investment services. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns. Cappadocia Hot Air Balloon