Eye on the Markets - 2017

First Quarter Evaluation and a Look Back

By Ketu Desai

As most of the first quarter data related to corporate and economic health has now been released, it is a good time to evaluate where we stand. In this article, we will review recent market activity, review recent data, risks to the market, and look forward to upcoming market-related events.

While in recent months the market has hit multiple all-time highs, leadership has been narrow. In other words, the S&P has been largely driven by a few large capitalization tech stocks. The tech-focused Nasdaq has nearly doubled the performance year-to-date of the S&P. Outside of technology, performance has rotated among the various sectors. For instance, more recently, less risky, higher yielding sectors such as utilities and consumer discretionary have outperformed. Earlier in the year, the financial sector and industrials did well. Earlier in the year, interest rates were increasing, and the expectation was that we would get significant fiscal stimulus. More recently, interest rates have been getting lower, due to the lower future growth expectations, as the prospect for simulative fiscal policies have diminished.

In other asset classes, gold has staged an impressive rally, as interest rates or Treasury yields have been coming lower. The lowering of domestic growth expectations and Treasury yields, combined with strong data from non-domestic economies has caused a decline in the US dollar. Accordingly, emerging market and European stock markets have staged impressive rallies. Oil prices have been volatile and range-bound. Despite an extension of OPEC cuts, the supply and demand dynamics remain unfavorable for oil prices to stage a significant rally.

Corporate earnings have been a key driver of the market hitting all-time highs. With 98% of S&P 500 companies reporting earnings, 75% beat earnings expectations, and 64% beat revenue estimates. Earnings grew 13.9% during the quarter, the fastest pace since 2011. One of the key themes has been the improvement of foreign economies. The Commerce department estimates that in the first quarter, rest-of-the-world profits grew 25%. The weaker dollar should provide further support to earnings growth. Full-year 2017 earnings growth is expected to be 10%. Such growth would be positive for markets, as earnings growth is a key determinant of market performance.

One of the other key drivers of market performance is the state of the economy. Early readings of the domestic economy were generally weak. Many suggest the weak first quarter numbers are seasonal. However, revised numbers for the domestic economy weren't as bad as early GDP reports indicated. First quarter (Q1) GDP got revised up to 1.2% from 0.7%. Second quarter GDP is tracking 3.4%, according the Atlanta Federal Reserve GDPNow. Full-year growth is expected to be around 2% or so.

While earnings, global economic growth, and global monetary policy are providing support to this market, there remain risks. The list of risks is long, starting with political, implementation of pro-growth policies, geopolitical, valuation, rising rates, sub-prime auto-loans, Chinese deleveraging, and Canadian housing. Earnings were also not strong across the board.

Retail is a sector that is going through secular change, and this earnings season highlighted that there are clearly some winners and losers. Some of the mall-based retailers appear to be losers, see share performance on names such as Macy's, JC Penny, Sears, Lululemon, Under Armour, and Target. Retail store closings are estimated to be more than four times greater this year versus last. There seems to be change in consumer preferences, in not only how they shop, but also how they spend their money. Travel, experience, gaming, beauty, and online are some of the areas that have been outperforming.

This has an impact beyond just retail to other sectors. Take for instance commercial real estate and banks. Many have warned, including the Federal Reserve, about the evaluated valuation in commercial real estate. This is coming at a point when there is an important amount of maturities in commercial mortgage-backed securities, tightening commercial RE lending standards according to a recent Fed loan officer survey, increasing delinquency rate, and the potential for increasing vacancies from the changing retail landscape. This spreads to banks as well, as banks have $270 billion worth of retail-related commercial real estate loans. We have seen in recent history that a single sector can infect the broader market in sectors such as technology, telecom, housing, and energy. This story will evolve over time, and it remains to be seen if this story will impact the broader market.

For the near-term, the market will focus on the outlook for fiscal policy, second quarter economic data, and if there will be any changes in global central bank policy, including the Federal Reserve meeting held in June. The market will pay close attention to the outlook for policy and change in interest rates.