After a strong rally that began when Donald Trump was elected and culminated with a 7.45% rise in January, equity markets sold off in February and March. The S&P 500 declined 10.15% from its all-time closing high on January 26th before finishing the quarter with a three-month decline of 1.22%. The initial selloff was swift, and was followed by a failed rally which led to a retest of the February 8th low. The S&P 500 finished the quarter at 2640.87. The exact cause of the market turbulence is hard to pinpoint. It began with the release of the January Employment report that showed greater than expected wage growth. This raised fears of rising inflation in the months ahead. Other catalysts included higher interest rates, President Trump’s increasing protectionism and anti-trade rhetoric and the news that Facebook’s data was used by political consultants for data-mining purposes. Additionally, the markets were fully valued and overdue for some type of pullback especially in the context of rising bond yields. Information technology and consumer discretionary were the only two sectors that rose in the first quarter. All the other sectors underperformed the S&P with the financial services sector not far behind while basic materials, energy, consumer staple, and telecom services sector significantly underperformed.
Meanwhile, Treasury yields increased across the curve, with short-term rates rising more than long-term rates and credit spreads widening. This led to losses for bond investors. The Bloomberg Barclays Aggregate and Intermediate US Government/Credit Indices fell 1.46% and 0.98%, respectively, during the quarter. Cash, which had been unloved until recently, produced a positive return and outperformed the S&P 500 and bonds. The Federal Reserve increased the Federal Funds rate another 0.25% making the returns on cash attractive in a world where financial markets have suddenly become much more volatile.
In other areas, emerging market equities outperformed the S&P 500 in the first quarter and finished up 1.07%, while developed markets underperformed the S&P 500 falling 2.20%. The dollar continued its decline in the first quarter, contributing to gold and oil's rise of 1.68% and 7.48%, respectively. Despite the rise in oil prices, the energy sector lagged the S&P 500 by more than five percent.
Global Economic Trends
Internet stocks and the technology sector in general have consistently been amongst the market leaders during this bull run beginning in 2009, and with good reason. Their earnings and revenue growth have been strong despite a slow-growing global economy. They possess very good balance sheets, and robust profit margins. Any type of loss in user confidence coupled with the possibility of regulation in the United States and abroad are bound to lead to lower valuations and possible slower growth. The technology sector represents a little under 25% of the market, while consumer discretionary companies Amazon and Netflix represent another 3% or so. If tech stocks falter, at least a couple of sectors will need to grab the baton for equity markets to move higher. For now, above-average growth rates, and mostly reasonable valuation should lend some support. However, if global regulators start to clamp down on the ability of tech companies to gather data and/or threaten to do something about market concentration, this could change the positive investment case for some of the internet and tech darlings.
Amazon’s stock declined 4.38% on the second to last day of the quarter after reports that President Trump would like Amazon’s tax collection policies to change to mirror retail companies with physical locations. It is not clear that the President has the political authority to affect change, but the reports triggered a pullback in one of the market’s best performing and largest stocks. Mr. Trump tweeted on the last trading day of the quarter his dislike that Amazon pays little taxes and takes advantage of the U.S. Postal System. The Internet and technology stocks have billions of dollars in cash, and dominant market share positions. Investors are starting to worry that global regulators may be aiming to reduce their market dominance.
Healthcare stocks also ran into trouble during the quarter. The decline in healthcare stocks was exacerbated by the announcement that Amazon, Berkshire Hathaway, and JP Morgan are creating a business to try to rein in healthcare costs. Details are fuzzy, but the news triggered a pullback in healthcare stocks. Additional talk of regulating healthcare costs in March didn’t help either. The U.S. economy would undoubtedly be helped by a better and cheaper healthcare system. Corporate competitiveness would improve and consumer financial positions would strengthen. Until this happens, any talk of price regulation that doesn’t fix the system is likely to be a market negative.
New Potomac Partners has taken advantage of the rise in short-term rates and added short-term T-Bills to client portfolios to dampen volatility and generate a positive return. Cash outperformed S&P 500 and the Bloomberg Barclays Aggregate Index in the first quarter. While this may not happen for the entire year, cash and cash equivalents now offer a competitive return in addition to providing portfolio diversification. In addition, we expect intermediate and long-term rates to consolidate before moving higher in the second half of the year. There is a reasonable chance that the yield on the ten-year Treasury Note will hit three percent before year-end.
NPP believes equities may recover in April because we expect first quarter earnings to be strong and interest rates to be stable. We also expect global stock markets to stay in a broad trading range over the next quarter rather than resume a strong bull market. Fortunately, equity market volatility will likely provide good buying opportunities in companies with strong earnings growth and reasonable valuations.