January - February 2017
Bullish Bias
U.S. stocks in strong advance
Manufacturing activity robust
Fed keeps rates unchanged as inflation rises
We're back to publishing our monthly Journal after a very busy year end. February continued the strong start to the year for U.S. stock investors, with the S&P 500 up almost 4% for the month. Bonds returned a "normal" .6%, while commodities slipped marginally. Gold has gotten off to a strong start this year, leading all categories with an 8.8% year to date return, with emerging markets a close second at 8.5%:
Longer term, it's getting to sound like a broken record: U.S. stocks have PASTED the competition.  No other category is even close:


Investors who understand the power of "mean reversion" have been frustrated by the multi-year underperformance of international stocks and bonds, but we note that many long term asset allocators (especially endowment funds) have been upping their foreign allocations recently.

In U.S. economic news, in late January the Commerce Department reported that the U.S. economy's expansion slowed in the fourth quarter as the nation's Gross Domestic Product (GDP) expanded at a 1.9% annual rate in the final quarter of 2016.  That's a significant drop from the 3.5% growth rate in the  third  quarter and well below the consensus of 2.2%.  For the entire year, the U.S. grew just 1.6%, compared with the 2.6% increase in 2015. Newly-elected President Trump has vowed to make economic growth a key part of his administration, promising to cut taxes, reduce regulations, and spend more on public works.  In the details of the report, a wider trade deficit was the biggest negative factor on the GDP calculation.  Had the trade gap been unchanged, the economy would have grown over 3%.  Trade has been a drag on the U.S. due to a softer global economy and a stronger dollar that makes American exports more expensive.
Manufacturers in the United States reported the strongest growth in more than two years according to the Institute for Supply Management's (ISM) manufacturing index. ISM said its manufacturing index climbed to 56% in January, marking its fifth straight gain and easily surpassing economists' forecasts.  In addition, it's at its highest level since the end of 2014.

Similarly, manufacturing in the U.S. ended the year on a solid note according to the Institute of Supply Management's Purchasing Manager's index (PMI): January's PMI rose to 55.1 in January up from December's 54.3.  The solid improvement in business conditions was driven by sharp increases in output and new orders.  In addition, companies raised their purchasing activity to highest rate since early 2015 and increased payrolls to meet the greater production requirements.  Chris Williamson, Chief Business Economist at IHS Markit commented, " US manufacturers are seeing a bumper start to 2017, with production surging higher in January on the back of rising inflows of new orders.  New work is growing at the fastest rate in over two years, thanks mainly to rising demand from customers in the home market. " In short, it has been a long time since manufacturing has looked this good, and investors are anticipating more of the same.
The latest monthly employment report showed the U.S. created 227,000 new jobs in January, which was the largest gain in four months.  Retailers, financial companies, restaurants, and construction firms led the industries seeing the most job gains. The unemployment rate rose slightly in large part because more people began looking for work again. Jim Baird, chief investment officer at Plante Moran Financial Advisors summed it up simply stating, " The jobs market just keeps on rolling. " President Trump has vowed to make jobs the central focus of his White House with a three prong strategy of tax cuts, reduced regulations, and infrastructure spending.

On February 1st, the Federal Reserve kept interest rates unchanged and said the economy was still on just a moderate growth path despite the surge in confidence among consumers and businesses following the election.  As was widely expected, the Fed voted to leave the federal funds rate at the 0.5-0.75% rate. The Fed's policy committee vote was unanimous.  In its statement, the Fed noted "measures of consumer and business sentiment have improved of late" but said business investment remains "soft."
In December, the Fed indicated it anticipated three interest rate increases this year, but analysts had not expected any movement this early in the new administration's presidency.  By the next meeting in mid-March, more details should be known about Republican plans for taxation and infrastructure spending, and whether the new administration will be able to deliver the level of growth currently expected. Meanwhile, investors are finally starting to get the benefit of persistently higher short term yields as money market funds and CD's have lifted off the zero floor and are now paying roughly .25% - .50%.

Many investors are trying to handicap when the Fed will raise rates again. Federal Reserve Chairwoman Janet Yellen gave testimony to the Senate Banking Committee in mid-February that left open the possibility of an interest-rate increase as early as March.  Yellen stated, " At our upcoming meetings, the Fed will evaluate whether employment and inflation are continuing to evolve in line with...expectations, in which case a further adjustment of the federal funds rate would likely be appropriate."  At future meetings, she stated the Fed would rely heavily on economic data to determine the strength of the labor market and whether inflation is moving to the central bank's 2% target.

Inflation is measured by the CPI and the PPI, and both were up big in January. The Producer Price Index (PPI) rose +0.6%, its largest advance since late 2012.  Over the past 12 months, wholesale costs are up +1.6%. The Bureau of Labor Statistics also reported the prices Americans pay for goods and services surged by the largest amount in four years.  As with the wholesale PPI, the surge in the price of gasoline was the culprit.  The Consumer Price Index (CPI), rose a seasonally-adjusted +0.6% in January. Over the past year, the CPI has risen +2.5%, its sharpest year-over-year increase in 5 years:
Late in February, Minutes from the Federal Reserve's last interest-rate meeting revealed "many" Fed officials expressed support for raising interest rates "soon", but were wary given that the fiscal policy of the new Trump administration and Republican Congress remain largely unknown.  According to the minutes, officials used the phrase "considerable uncertainty" when characterizing the new administration's fiscal plans. Only a "couple" of the 17 Fed officials argued that uncertainty over fiscal policy should not delay a near-term rate hike, while most officials said it would take "some time" for the outlook on fiscal policy to become clearer.  As for when to expect the next rate hike, Ian Shepherdson, chief economist at Pantheon Macroeconomics, said " May is more likely than March, but a blockbuster payroll report for February could easily change that. "
Perhaps the more important development is the one no one is talking about but which is about to explode into the news on March 15: the hardening of the debt ceiling. As a reminder, in October 2015 Speaker John Boehner and President Obama made a cynical deal to increase the debt ceiling to $20 trillion, but made sure that the limit would become permanent on March 15, 2017 (the next President's "watch"), thus "kicking the can" and avoiding being blamed for the next "debt crisis" (you can be sure that Trump will be blamed instead.) So markets are about to be tested, with threats of government shut-downs, lots of finger-pointing, and no one with enough guts to speak the truth: only reducing spending, especially entitlements, will enable fiscal recovery.
The story for 2017 so far is the relentless rise in stock prices . While many attribute this to the "Trump Effect", it is more likely that investors are embracing a recovery in earnings from the trough of the last 2 years. Our friends at Eaton Vance put together a terrific monthly report, and this graph is one of our favorites, clearly showing that "next twelve months", or NTM, earnings are picking up globally from a very tough last twelve months (LTM). (Notice the Russell 2000 - small cap stocks - whose consensus earnings have reversed from -23.3% to +25.3%. No wonder small cap stocks were up 21% in 2016!):

Source: Eaton Vance Monthly Market Monitor February 2017
Nothing goes up forever, so investors should expect a respite at some point, but market bulls have been encouraged by the stock market's break-out. Interestingly, a bullish signal recently flashed that has never been wrong.  Sam Stovall, Chief Investment Strategist at CFRA, notes that, since 1945, there have been 27 years when the S&P has achieved gains in both January and February.  The stock index then finished up for the year (on a total-return basis) in every single one of those years.  According to Stovall, that's going 27 for 27, or batting a thousand.  The average rise in those years was a way-above-average +24% according to Stovall's research. While a heck of a precedent, remember that past performance is no guarantee of future results!

So, as we head into 2017, we're reminded that bearing risk has its rewards. It's also important not to let opinions drive investment strategy (we prefer to let the data do the talking!). Since now is the time the media scours the planet looking for pundits to give forecasts for this new year, it might be useful to inoculate ourselves against them by keeping in mind these wise observations:
"We've long felt that the only value of stock forecasters is to make fortune tellers look good."
 Warren Buffet
"We have two classes of forecasters: Those who don't know - and those who don't know they don't know."   John Kenneth Galbraith
"Forecasts create the mirage that the future is knowable."  Peter Bernstein
"It ain't what you don't know that gets you into trouble.  It's what you know for sure that just ain't so." Mark Twain
Have a great month, and we'll be back to you in early April!

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