September 2017 Market Commentary

“News” drove markets in September. The announcement of a tax reform package, statements by the Fed about the need to continue normalizing monetary policy, instability in global energy markets, unexpectedly strong manufacturing statistics, and a continuation of positive economic news and earnings growth all contributed to large movements in asset prices during the month. U.S. equities, particularly small cap stocks finished higher, U.S. Treasury yields rose sharply, and the dollar appreciated. The latter contributed to the first decline in emerging market stocks this year. Finally, oil prices climbed to two-year highs. The following table contains a summary of September’s market performance:

Index September YTD Index September YTD
S&P 500 (Total Return) +2.06% +14.24% All Country World Index (Net) +1.93% +17.25%
MSCI EAFE (Net) +2.49% +19.96% Barclays Aggregate -0.48% +3.14%
MSCI Emerging Markets (Net) -0.40% +27.78% 60/40 Blend* +0.99% +11.91%

* 60% All Country World Index/40% Barclays Aggregate

The release of a tax reform proposal that calls for a reduction in the corporate tax rate to 20%, the immediate expensing of capital investments, and a reduction in the top tax-rate for pass-through entities to 25% from the current 39% led markets to reassess higher potential corporate earnings. While the S&P 500 index rose nearly 2% during the month, reaching a record high, small cap stocks were the big winners finishing up 6.94%. Small cap companies are viewed as the bigger beneficiary of tax reform given their higher share of domestically-sourced profits. Financial sector stocks outperformed, driven by the implications to earnings of expected higher interest margins. S&P 500 earnings estimates slipped in September, in large part over the impact to earnings from Hurricanes Harvey and Irma, but are still expected to grow by 5% over the third quarter.

Equity markets also benefited from stronger than expected news regarding economic output. Indexes tracking durable goods orders, manufacturing activity, and the output of services all surprised to the upside. Manufacturing activity reached levels not seen since 2004. There were declines in housing construction and home sales, as well as flat consumer spending, but these declines are attributed to the impact of the hurricanes, and are not expected to have lasting effects.

The Fed made news and surprised markets with Janet Yellen’s statement that “low inflation was a reflection of factors that would fade over time, and despite uncertainties, it would be imprudent to keep monetary policy on hold until inflation is back to 2%.” The market, having observed month after month of disappointing inflation results had previously forecast a 33% probability of a rate hike to end the year. Following Yellen’s comments, the market’s forecast of one more 2017 Fed tightening rose to 83%. With the market now anticipating stronger and continued growth, inflation and steady Fed tightening, Treasury yields moved higher. After beginning the month at a post-2016 election low of 2.1%, the 10-year Treasury yield climbed to 2.3%.

The dollar’s nine-month decline against the euro came to an end, as it gained nearly 1%. The dollar rallied on expectations of higher interest rates following the positive U.S. economic news and Fed policy statement. The dollar’s rally was also driven in part by political uncertainty in Europe following Catalonia’s vote for independence from Spain. Many analysts are suggesting that the dollar’s rally could go on for some time based on “strength in the economy and prospects for more interest-rate increases.”

Oil prices capped their biggest monthly gain of the year in September, reaching highs last achieved 26 months ago. The rally was driven in part by threats from Turkey to cut crude exports from Iraq’s Kurdistan region by 600,000 barrels per day (bpd). This, combined with an expected 1.8 million bpd reduction in output by OPEC and non-OPEC producers, raised concerns of tighter supply. The price of Brent climbed to nearly $59 a barrel, but is not expected to go much higher due to increased refining and higher crude output from the U.S. Refinery utilization in the U.S. approached 86% during September while U.S. oil production reached 9.5 million bpd, within 100,000 bpd of the all-time high. Energy stocks were the best performing sector for the month.

Beyond the U.S., the global economy is experiencing synchronized growth. The developed and emerging economies PMI indexes (Purchasing Managers’ Index) are well above 60, signaling broad-based growth. Valuations of non-U.S. developed country stocks and emerging market stocks remain relatively attractive despite their strong year-to-date performance. Japanese stocks are priced well below their 25-year average, and emerging market stocks are at the bottom of their 25-year average. While non-U.S. developed market and emerging market economies continue to produce improving economic and earnings growth, equity prices do face a potential headwind from an appreciating dollar. Nearly a third of the emerging market’s 27.8% return year-to-date (when measured in dollars) can be attributed to the dollar’s depreciation. As the dollar rallied in September, emerging market equities produced their first negative return when measured in dollars this year.

Caprock Investment Committee continues to recommend maintaining target allocations to U.S. equities due to expectations of positive economic and earnings growth through 2018. However, we also recognize that there are risks to the market’s continued strong performance including (1) the negative impact of a stronger dollar on foreign earnings; (2) rising interest rates that could lower the multiple investors are willing to pay for stocks; and (3) that the Fed makes a policy mistake that leads to recession. As a result, portfolios that are overweight U.S. equities should continue rebalancing to their strategic allocation.

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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.