2nd Quarter 2017download commentary
US stocks had their best first half total return performance (price change plus reinvested dividends) since 2013 advancing +9.3% for both the S&P 500 and the Dow Jones Industrial Average. US stocks made new all-time highs as they outperformed most of the other major asset classes during the 2017 first half. In addition, US stocks have been the best performing asset class over the last 5 and 3 year periods ending June 30, 2017. The 5 year gross total return for the S&P 500 increased +97.9% and the 3 year total return rose +31.7% ending June 30, 2017. The other major asset classes had returns for the first half of 2017 as follows: 3 month US Treasury Bills (+0.3%); long term US Treasury Bonds (+5.5%); Investment Grade Corporate Bonds (+3.9%); and gold (+8.4%).
The highest quality stocks (ranked B+ or better by Merrill Lynch ) advanced slightly more for the first half (+6.4% vs. +6.2%) compared to the lower quality stocks (ranked B or worse). We saw a major shift during the latter months of the first half as the higher quality growth companies substantially underperformed the lower quality companies. The A+ rated companies only rose +5.0%, while the C & D rated companies increased +8.3%. This was primarily the result of the higher beta stocks responding to expectations of better global economic growth. The equal-weighted Nifty Fifty (S&P 500 largest companies) recorded a positive return of +6.4%, but modestly underperformed the other 450 stocks in the S&P 500 for the first half +6.9%.
The MSCI AC World Equity Index (Ex. US) rose +9.0% in local currency, outperforming US equities. In US dollars, the MSCI AC World Index rose significantly by 14.5%, reflecting the substantial depreciation of the US dollar during the 2017 second quarter. The MSCI Emerging Markets Index (local currency) increased +15.0% during the first half. Many of the emerging economies are highly dependent upon commodities, which experienced some price rebound during the half. The US consumer price index (CPI) rose +1.4% for 2017 through May.
The 2017 first half was marked by increasing US employment, decent corporate profit growth and optimism regarding legislative changes that would enhance US economic and corporate profit growth. These included: (1) lower corporate and individual income tax rates; (2) a reduced regulatory environment; (3) more US based manufacturing; (4) lower healthcare costs for companies and individuals: and (5) higher governmental spending on infrastructure and defense.
The best performing equity sectors during 2017 first half were primarily focused on industries that were positively impacted by improving economic growth, reduced governmental regulations and generally stocks with the highest betas. The best performing sector (price change only) was Technology (+16.4%), but it began to falter in June. Technology stocks contributed 38% (3.5 percentage points) of the S&P 500 first half gain, but had contributed as much as 50% prior to the June sell-off. The second best performing sector was Health Care (+15.1%). The third best performing sector was Consumer Discretionary (+10.2%). Correspondingly, the two worst performing sectors for the half were Energy (-13.8%) and Telecommunications (-12.8%) The Energy sector suffered from lower crude oil prices and telecommunications reflected increased competition.
While US GDP growth is sub-par as compared to prior economic recoveries, the US economy is still showing signs of moderate growth. However, with the 2017 change in administration, the likelihood of (1) lower income taxes for companies and individuals; (2) less regulatory requirements; and (3) higher spending on infrastructure should provide a more positive environment for economic growth over the next few years. As long as employment grows and real wages can experience some improvement, the US economy should advance in 2017, despite the difficulty in some other world economies. Dearborn Partners envisions 2017 US GDP growth to be in the area of 2.0%- 2.5%, despite a slower growth rate in the first half.
On the positive side, corporate earnings are doing reasonably well even though revenue growth continues to be moderate for many industries. Corporate margins remain near record highs. Productivity improvement and share repurchases by corporations have been an important contributor to the advance in earnings per share growth. Federal Reserve policy is still very accommodative, despite the recent rise in short term interest rates. US employment is rising. The unemployment rate is relatively low at 4.4%. Inflation continues to run below 2%. Modification of bank lending requirements (Dodd/Frank) should help economic growth. Low energy prices should continue to help the level of disposable income for most families. Housing prices continue to show signs of improvement in most regions of the country. The housing affordability index is still attractive due to low mortgage rates.
On the negative side, inflation-adjusted wage growth has been flat or falling for the last few years. In addition, the US employment participation rate (62.6%) remains low. Since consumer spending accounts for about 70% of the US GDP, this places pressure on domestic economic growth. There is a shortage of skilled labor in a number of key industries, especially for computer science and engineering. The energy industry, which has historically been an important sector for employment growth, is still experiencing layoffs due to the sharp decline in energy prices. Finally, income tax rates remain high following the passage of the Affordable Care Act placing additional pressure on disposable income for upper income groups. The top federal income tax rate is 39.6% before the impact of Alternative Minimum Tax.
In general, the higher quality companies that dominate our portfolios continue to generate improving free cash flow with earnings/dividends advancing at a faster pace than inflation. Balance sheets are the best condition that we have seen in years due to higher capital positions, lower cost of carrying debt, as well as reduced overall debt levels. Productivity remains high and profit margins reflect management’s focus on cost containment. We continue to closely watch the trend in revenue and earnings growth for 2017.