Second Quarter 2017
If the second quarter of this year followed the sharp increase in large cap values that we saw in the first quarter, that would have been unusual. However, the second quarter did rather well, with large U.S. stocks continuing to gain along with mid-cap and small-cap stocks. The quarter began with the S&P 500 at 2362.72 and ending at 2423.41, resulting in an increase of 60.69 points or 2.57%. Mid-cap stocks were up 1.6% and small-cap stocks were up 1.4%.
For the year to date, the S&P 500 began at 2239 and has increased by 8.2% to 2423. Mid-cap stocks are up 5.2% and small-cap stocks are up 2.1%. Large stocks have outpaced the rest of the market, which has been the case for the past several years. While the U.S. stock market has done well, the global market has outshined it. The DJ Global ex-U.S. index is up 12.7% for the year, having added an additional 5.3% in the second quarter.
Some negatives were weighing on the stock market. The Federal Reserve raised the discount rate by 0.25% in June, giving a new range of 1.00% – 1.25% for this benchmark rate. Crude Oil continues to be a drag, with prices down 14% for the year. The largest high-tech companies, making up a large portion of the weighting of the S&P 500 index, have been under pressure and have had some days with major drops in price. In many cases, expectations for this year have not been met. Inflation remains persistently low, interest rates on the 10-Year Treasury have gone down instead of up, market volatility has been very low and financial stocks haven’t met expectations.
Interest Rates and Inflation
In February, the inflation rate reached 2.1%. The Federal Reserve has been targeting an inflation rate of about 2% for some time but has been unable to reach the goal. In February, the economy appeared to be adjusting to greater growth, with pressure building on inflation. The inflation rate then began to slip. The inflation rate is now at about 1.4%. Growth in the U.S. continues, but at a rather low sustained rate. While prices have gone up in some areas of the economy, others have fallen sharply. For example, the pricing of wireless technology and services has dropped this year as the industry has reached maturity and is fighting for increased market share through price discounting.
The expectation of higher inflation should have resulted in bond prices dropping and bond yields rising. This is because when bond interest increases, the value of bonds decreases, resulting in a loss to investors who sell their bonds. Instead, because inflation has not been a factor, we have seen bond prices grow and interest rates fall. For example, in March, when it appeared inflation was rising, the 10-Year Treasury Note rose to 2.609%, and closed the second quarter at 2.298%. The result of lower inflation is that bonds gained in value more than expected during the quarter.
Using the Dow Jones, DJ Corporate Index, the index was at 3.198% at the end of the first quarter and ended the second quarter at 3.010%. This means that the interest rate dropped and the value of the bonds rose. The increase for the quarter was 1.168%. Interest rates are now so low that the chance of interest rates rising is greater than the chance that they will decrease. For bond owners, the important thing to watch is the actual interest being paid vs. the loss in principal on the bond. If this net number stays positive, longer-term, higher income from bonds should result.
The Fed appears to be quite open in signaling what they are planning. Going into their June meeting, they gave strong indications that they were going to raise rates. Currently, they are signaling that they will likely raise rates again when they meet in September. If they make that change, the discount rate will be targeted at 1.25% to 1.50, the third increase in 2017 and the fifth increase since December 2015.
In addition to raising short-term interest rates, the Fed is likely to begin a program of selling portions of the billions of dollars in bonds they have purchased since 2008. The indication of such an action has had a negative impact on interest rates since the end of the second quarter. Worldwide bond interest rates have risen as the Fed and other world central banks are decreasing the borrowing liquidity in their countries.
The Fed’s changes will likely mean that all interest rates will rise. Mortgage interest rates and borrowing costs for companies are already climbing. At the same time, bond values are falling, resulting in losses. These changes could mean reductions in home purchases and in falling home prices. Higher borrowing rates can lead businesses to become unwilling to borrow to expand. A lack of buyers for longer term bonds, which are the most sensitive to interest changes, is occurring.
Even against this backdrop, we witnessed a growth in hiring of 222,000 workers in June. With the increase in hiring, the unemployment level still rose to 4.4%, as more people decided to look for work. Unexpectedly, salaries remain flat for the year. Consumer confidence remains high as most people are not worried about getting a job or transitioning to a new job.
The new administration had promised major tax cuts for businesses. Given the gridlock in Washington, the markets are no longer expecting much in the way of tax relief. The Federal Government promises to spend on infrastructure appear to be greatly diminished. The economy continues to chug along, growing at a tepid rate without government help, but still growing. Perhaps slow and steady is not so bad.
In looking at the coming quarter, I wonder if, in the short run, we might see corrections to both the stock and bond markets. Looking at the longer term, this economy, which continues growing ever so slowly, will continue to grow well into the future. Businesses continue to absorb new workers, and unemployment remains below 5%. Hopefully the Fed will not do anything to stall the economy, and perhaps, just perhaps, the government can get it together and do some things that will boost the rate of growth. Low cost oil and gas is a big benefit to manufacturers and to overseas shipments of U.S. energy. These oil and gas shipments, especially to China, have helped the U.S. balance of payments. I think we have a great deal to be thankful for.
Posted July 14, 2017