The return of market volatility was the story in the first quarter. ... If Q1 is setting the tone, it could be ... to bi
A QUARTERLY NEWSLETTER FROM
BREMER ASSET MANAGEMENT
A Bumpy Quarter. Is it Just the Beginning? After a calm start to Q1, volatility appears to be the new norm.
Bonds Struggle as Events Alter Landscape What’s behind the bond market decline?
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2nd
2018
INVESTMENT MANAGEMENT UPDATE
JOEL REIMERS, CFA CHIEF INVESTMENT OFFICER
MICHAEL ADKINS SENIOR PORTFOLIO MANAGER
ANNE SORENSEN SENIOR PORTFOLIO MANAGER
If you or someone you know could benefit from our services, please contact a Wealth Management Advisor at 800-908-BANK (2265). Ask about Wealth Management, or visit the Wealth Management tab on Bremer.com.
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VOLATILITY RETURNS IN THE FIRST QUARTER The return of market volatility was the story in the first quarter. Big gains in stocks in January were quickly erased in early February. Relatively calm market activity in 2017 made the increase in volatility that much more jarring for investors. The quick turnaround occurred after the February employment report showed strong growth in jobs created and wage growth. With the Federal Reserve already on a path to higher interest rates, a tight labor market increased the possibility that interest rates could rise faster than expected. Rising trade tensions between the U.S. and China also threatened synchronized global economic expansion.
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Buckle Up Already this year we’ve seen sharp plunges, powerful rallies and a growing list of investor concerns. Is this the storm that comes after the calm? Michael Adkins reviews Q1 and issues driving the equities market, page 2.
Bond Outlook Tax reform, interest rates and a new Fed chair. If Q1 is setting the tone, it could be a challenging year for fixed income. Anne Sorensen discusses key events and strategies for balancing your portfolio with bonds, page 8.
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A BUMPY QUARTER. IS IT JUST THE BEGINNING? After a calm start to Q1, volatility appears to be the new norm. By Michael Adkins
The first quarter got off to a great start with U.S. stocks rising more than 7% and hitting record highs multiple times in January. All seemed well as the market continued its upward momentum following two years of slow, steady above-average gains in 2016 and 2017. Through January the S&P 500 Index had gone 15 months without a loss on a total return basis, the longest such streak in its history. 2
This state of calm ended rather abruptly in February. A strong jobs report showed employers added 200,000 jobs in January and average hourly earnings increased 2.9%, the healthiest gain since 2009. Stocks dropped sharply on fears that increased labor costs from the tight labor market would threaten profit margins and prompt the Federal Reserve to increase its pace of interest rate hikes. A report that weekly jobless claims had fallen to their lowest level since January 1973 added to the downward pressure on stocks. In addition, the two-year budget deal reached by Congress sharply increased spending on both defense and discretionary items. This extra spending, combined with recent tax cuts, Contact us
will force the government to borrow more than $1 trillion in the coming fiscal year. These headwinds resulted in the S&P 500 and the Dow Jones Industrials each dropping more than 10% from record highs in just nine trading days in February. This was the first correction in two years and with it came a spike in market volatility.
Through January the S&P 500 Index had gone 15 months without a loss on a total return basis, the longest such streak in its history. The return of volatility The stock market was extremely calm in 2017 in terms of volatility, although this may not have been apparent to many investors. The S&P 500 Index closed more than 1% higher or lower only eight times in 2017. The last time markets were that calm in terms of daily volatility was back in the 1960s.
CBOE Market Volatility Index (VIX)
In February and March daily moves of more than 1% in the broad stock indexes became common, occurring on about half of all trading days. While such volatility is not unusual in equity markets, the daily gyrations seemed extreme to many investors unaccustomed to them after a long period of calm.
Index level
90
VIX
Financial crisis (S&P 500: -48.8%)
80 70 60 50 40
J.P. Morgan acquires Bear Stearns (S&P 500: -13.1%)
Level
’08 Peak
80.9
Average
19.8
Latest
20.0
Global slowdown, China, Fed uncertainty (S&P 500: -12.4%) Inflation, trade, tech (S&P 500: -10.2%) Global slowdown Oil, Eurozone fears U.S. recession double-dip (S&P 500: -7.4%) fears, China (S&P 500: -9.9%) Taper (S&P 500: -10.5%) Tantrum (S&P 500: -5.8%)
U.S. downgrade, Flash crash, Europe/periphery stress Europe/Greece (S&P 500: -19.4%) (S&P 500: -16.0%)
30 20 10 0
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
'17
Sources: CBOE, FactSet, J.P. Morgan Asset Management. Stock market returns are based on calendar year peak to trough declines experienced during VIX spike, except for J.P. Morgan acquires Bear Stearns, which is based on the calendar year peak to the acquisition date. Average is based on the period shown from 12/31/2006-3/31/2018. Guide to the Markets – U.S. Data are as of March 31, 2018.
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Fortunately the market moves were often offsetting, and the net result of the ups and downs was a quarterly drop of only 0.8% for the S&P 500 Index. This decline broke a streak of nine consecutive positive quarters and was only the second negative quarter in the past five years. The Dow Jones Industrial Average of 30 large U.S. companies declined 2.0%. The NASDAQ Index was up 2.6% due to big gains in technology stocks earlier in the quarter. Small-cap stocks in the Russell 2000 Index were down 0.1%. Growth stocks out-performed value stocks across the board. Growth stocks of large-, mid- and small-sized companies all had low single-digit gains while value stocks in each category dropped between 2% and 3% in the quarter. Outperforming growth sectors
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A Bumpy Quarter. Is it Just the Beginning?
were technology and consumer discretionary, while losses of 7% in the telecom and consumer staples sectors led the declines in the value style. Foreign stocks in developed markets, as measured by the MSCI EAFE Index, were down 1.5%, while foreign emerging market stocks managed to eke out a gain of 1.4%. Improving fundamentals in earnings and economic growth gave emerging markets a boost.
The S&P 500 Index closed more than 1% higher or lower only eight times in 2017. The last time markets were that calm in terms of daily volatility was back in the 1960s.
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Q1 GDP and earnings expected to support equities The U.S. economy is expected to continue expanding in 2018, supported in part by the $1.5 trillion tax reform package passed by Congress. Tax cuts are expected to boost corporate earnings and help prolong the U.S. economic expansion that is now one of the longest on record. Contact us
S&P 500 earnings per share
Analyst expectations are for 17% earnings growth year-over-year on the S&P 500, powered by tax cuts, consumer confidence, and a growing economy.
Index quarterly operating earnings $44
n
$41
S&P consensus analyst estimates
4Q17: $33.86
$38
U.S. fourth quarter GDP growth was revised from 2.5% up to 2.9% at the end of March mainly due to increased consumer spending fueled by the strong jobs market. Other recent signs of strength include existing home sales, orders for durable goods and leading economic indicators. These trends suggest that GDP growth could increase to 3% or more as we move into the summer months. Globally, almost all countries are projected to see positive GDP growth in 2018. Analyst expectations are for 17% earnings growth year-over-year on the S&P 500, powered by tax cuts, consumer confidence, and a growing economy. However, the optimism sparked by Trump’s election seems to be fading a bit and consumer confidence surveys declined in March, although prior levels were at 18-year highs. Contact us
$35 $32 $29 $26 $23 $20 $17 $14 $11 $8 $5 $2 -$1
'02
'05
'08
'11
'14
'17
Sources: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management; EPS levels are based on operating earnings per share. Earnings estimates are Standard & Poor’s consensus analyst expectations. Past performance is not indicative of future returns.
A Bumpy Quarter. Is it Just the Beginning?
The stock market declines in February and March, combined with positive earnings revisions, resulted in more reasonable equity valuations that are now closer to long-term averages.
S&P 500 Index: Forward P/E ratio 26x 24x 22x 20x
6
A number of companies have revised first quarter earnings guidance upward and expectations for the rest of 2018 are even higher, with quarterly gains estimates ranging from 17% to 21%. Continued above-average earnings growth in the technology sector and an earnings rebound in the energy and materials sectors due to rising oil prices should boost first quarter results. The stock market declines in February and March, combined with positive earnings revisions, resulted in more reasonable equity valuations that are now closer to long-term averages. The forward P/E of the S&P 500 Index fell from 18.6x to 16.4x, now just slightly above the 25-year average of 16.1x.
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+1 Std. dev.: 19.3x
18x 16x
25-year average: 16.1x Current: 16.4x
14x 12x
-1 Std. dev.: 12.9x
10x 8x '90
'92
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
'14
'16
'18
Sources: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since December 1989, and FactSet for March 31, 2018. Average P/E and standard deviations are calculated using 25 years of FactSet history.
Tech wreck? Not yet, but stay tuned. Much of the downward pressure on stocks in March has been in the technology sector, which led all sectors with a gain of 29% in 2017. Tech was still the top-performing sector in the first quarter with a gain of 3.5%, one of only two positive sectors. The other was consumer discretionary, up 3.1%. However, Facebook is under pressure from investors and Congress regarding its data privacy practices. President Trump has been critical of some of Amazon’s business practices. These companies and the tech sector overall may have trouble leading the market higher in the months ahead. Tighter regulation on use of data could pressure the high margins and profit growth of tech companies like Facebook, Google and Apple. Political strains with Russia and rising trade tensions with China, combined with the daily uncertainty swirling around the Trump administration, make it unlikely that we will return to the calm waters of 2017 anytime soon.
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7
BONDS STRUGGLE AS EVENTS ALTER LANDSCAPE What’s behind the bond market decline? By Anne Sorensen
Bonds struggled throughout the quarter as the Federal Reserve continued to raise rates. All categories of bonds including government, corporate, high-yield and municipal bonds posted negative returns. Bonds with maturities longer than 20 years, investment-grade corporate bonds and high-yield bonds declined the most. 8
Many issues affected bonds’ decline in the first quarter. Rising inflation, uncertainty about the new Fed chair, a flattening yield curve and the unknown effects of tax law changes contributed to bond market moves in the first quarter of 2018.
Structural factors such as an aging population and improving technology are keeping inflation low. The economy may also be growing more slowly than expected.
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Inflation more muted than expected Interest rates rose, and bond prices fell, early in the quarter as investors feared that lower corporate taxes would lead to higher business costs, including wages. The fear was that these factors would lead to higher inflation, which undermines the value of bonds by eroding the purchasing power of their fixed interest payments and principal. Bond prices improved toward the end of the quarter after data was released suggesting that inflation is losing momentum. The most recent reading showed the Consumer Price Index (CPI) was lower than expected with the “core” (excluding food and energy) rising 1.8%, which is below the Fed’s target inflation rate of 2%. Structural factors such as an aging population and improving technology are keeping inflation low. The economy may also be growing more slowly than expected.
CPI and core CPI
Jerome Powell chairs his first Fed meeting Investors anxiously awaited Jerome Powell’s debut as Chairman of the Federal Reserve at the March FOMC (Federal Open Market Committee) meeting. In March, the Fed raised the Federal Funds rate by 25 basis points to a target of 1.75%, but Powell’s outlook was more dovish than expected. While some economists expect the Fed to hike rates four times in 2018, the ‘dot plot’ rate projections for the year remain unchanged at three rate hikes. The “dots” on the dot plot represent guidance for future rate hikes.
% change vs. prior year, seasonally adjusted 15% 50-yr. avg. Feb. 2018
12%
9%
Headline CPI
4.1%
2.3%
Core CPI
4.0%
1.9%
Food CPI
4.0%
1.4%
Energy CPI
4.5%
8.0%
Headline PCE deflator 3.5%
1.8%
Core PCE deflator
1.6%
3.5%
6%
3%
0%
-3%
'70
'75
'80
'85
'90
'95
'00
'05
'10
'15
Sources: BLS, FactSet, J.P. Morgan Asset Management. CPI used is CPI-U and values shown are % change vs. one year ago. Core CPI is defined as CPI excluding food and energy prices. The Personal Consumption Expenditure (PCE) deflator employs an evolving chain-weighted basket of consumer expenditures instead of the fixed-weighted basket used in CPI calculations. Past performance is not a reliable indicator of current and future results. Guide to the Markets – U.S. Data are as of March 31, 2018. Contact us
Following the meeting, the Fed changed the language on current economic activity from “solid” to “moderate” and added that “job gains have been strong.” Chair Powell downplayed inflation concerns, saying “there is no sense in the data that we are on the cusp of an acceleration of inflation.” Finally, Chair Powell downplayed the importance of the dot plot. Investors like the dot plot because it gives an indication about the future direction of the Fed Funds rate. Fed Chair Powell said
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Bonds Struggle as Events Alter Landscape
that he is reducing his reliance on the dot plot to focus more on economic data. Chair Powell’s statement introduces uncertainty into the bond market because investors will no longer be able to rely on the dot plot to predict the future direction of interest rates.
Federal funds rate expectations FOMC and market expectations for the fed funds rate 7%
Federal funds rate FOMC year-end estimates Market expectations on 3/21/18
6%
FOMC long-run projection
5%
10
Floating rate securities funds are attractive because their rates will rise along with increasing short-term rates, while the net asset values are managed to remain close to par.
4% 3.38% 2.88%
3%
2.13%
2%
1.63%
2.57%
2.88% 2.69%
2.11%
1%
Flattest yield curve in a decade The gap between yields on two-year bonds and yields on ten-year bonds is the lowest in a decade. Investors pick up only 47 basis points (less than one half of one percent) by extending maturities from a two-year treasury to a ten-year treasury. Many investors are nervous about the yield curve “flattening,” which historically points to slower growth ahead. Contact us
0% '99
'01
'03
'05
'07
'09
'11
'13
'15
'17
'19
Sources: FactSet, Federal Reserve, Bloomberg, J.P. Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the March 2018 FOMC meeting. Guide to the Markets – U.S. Data are as of March 31, 2018.
Long run
The yield curve flattened last quarter because short-term rates rose while long-term rates barely budged. Short-term treasury rates move in tandem with Fed rate hikes, while long-term rates reflect investors’ views on future growth and inflation. Today’s low long-term rates mean that investors expect future growth and inflation to be muted despite short-term concerns. What does this mean for bond investors? Unless investors believe that interest rates are going to fall soon and want to lock in current rates, it does not pay to buy long-term bonds with interest rates that are not much higher than short-term rates. We recommend purchasing bonds in the short to intermediate area of the curve when purchasing individual bonds. Floating rate securities funds are attractive because their rates will rise along with increasing short-term rates, while the net asset values are managed to remain close to par. We recently added a floating rate security fund to our strategic portfolios to capture these benefits.
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Yield Curve U.S. Treasury yield curve 4.5% 4.0%
4.0% Dec. 31, 2013
3.5% 3.0%
3.0% 2.5%
2.3% 2.1%
2.4%
2.6%
2.7% 2.7%
Mar. 31, 2018
3.0%
2.5%
2.0%
11
1.8%
1.5% 1.0% 0.8%
0.5% 0.1%
0.4%
0.0% 3m 1y 2y 3y
5y
7y
10y
Sources: FactSet, Federal Reserve, J.P. Morgan Asset Management. Guide to the Markets – U.S. Data are as of March 31, 2018.
30y
Bonds Struggle as Events Alter Landscape
12
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How are tax-exempt bonds affected by the new tax law? The new tax law is altering the landscape for both buyers and sellers of tax-exempt bonds. The bottom line is that state-tax-exempt income is now more valuable to individuals because the deductibility of state income tax is limited under the new law. However, the lower corporate tax rate reduces the attractiveness of municipal bonds to corporations. As a result, municipal bonds underperformed taxable bonds during the quarter because heavy selling by banks and insurance companies caused prices to drop. The law also disrupted the supply of new bonds. In the first quarter, new issue supply was down 30% from the fourth quarter of 2017. Many municipalities issued bonds in late 2017 instead of 2018 because of uncertainties about the law. In the future, tax-exempt bonds could become scarce if it becomes difficult for governments to raise revenue when state taxes are not deductible. Lower supply relative to demand would in turn make bonds more expensive.
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In the future, tax-exempt bonds could become scarce if it becomes difficult for governments to raise revenue when state taxes are not deductible. Summary Bonds produced negative returns last quarter, as the yield curve continued its flattening trend. While the long-term effects of tax law changes are unknown, we continue to recommend tax-exempt bonds in portfolios for income and diversification. We also recommend holding bonds in portfolios as a hedge against volatile equity markets. Floating rate bond funds should provide a stream of income while protecting against rising rates.
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