Q2 2017 RECAP

July 6, 2017

2^nd-qtr. 2017: Equity divergence in Developed Markets. WTI, USD decline. The 2nd quarter opened on a cautious note. Stocks stumbled after a strong start to 2017. Meanwhile, bond yields, already well-off peak levels, declined further as geopolitical tension on the Korean Peninsula intensified. In the forefront, oil prices made a 2nd attempt to break higher, but ultimately failed as the rhetoric cooled and the hint of possible confrontation subsided. At least for now.

A rebound ensued, but markets stayed within well-worn ranges. US equities saw a sharp move back to previous highs, but no more. It would take until June to see a break-out to a new trading range, with the S&P passing 2400. Treasuries refused to end the rally as yields marched lower still, erasing a good portion of the market’s initial ‘Trump play.’ It was in Q2 that a sense of uncertainty about the president’s agenda surfaced. Q1 closed with a House vote on the pending health bill. Three-months later, the same is true in the upper chamber of Congress. A vote in the Senate (one was postponed) after the July 4^th recess may have enormous consequences for the administration’s agenda in the remainder of 2017.

Yields ratcheted down through a combination of mixed economic data, with many important data points below forecast. None more so than the monthly inflation numbers. Three times in-a-row, both the monthly and the annualized number declined. So while the Fed boosted rates in the 1st-half, inflation targets have been pushed-out to the medium-term vs. the short-term. The Fed’s mandate is half-complete in the short-term, and chair Yellen is confident inflation will rise to the 2% mark next year. For the Fed, the better side of the debate has been the employment rate, near 96%, it’s the highest in more than 10 years.

The storyline on stocks had been the Nasdaq’s sizzling run. Indeed, the index led the way once again, until the first week in June. Then a one-day reversal led to further questions on whether this year’s increase was sustainable. Talk of sector rotation dominated the rest of the month, and though the tech-heavy composite rebounded from its low, it did not fully recover, before falling back a 2nd time at the end of Q2. Nasdaq closed the month of June at its low point with more questions to be answered beyond mid-year. In summary, the slip has not been severe, but whether selling momentum continues may depend on the upcoming earnings season. The 1st-half saw the index post its best returns since the spring of 2009.

The oil market was a display of contrasts. The signature moment was to be OPEC’s extension of its original agreement…this was met with disappointment. A part of the ongoing narrative was built on diminishing supply – over time. A series of weekly inventory declines failed to stem the tide. Rig counts kept rising. A stand-off was not considered enough, and even that possibility was not attained. The 5-year average supply, the market’s barometer, did not decline, but stayed elevated. Demand was not the focus. The backdrop ahead of OPEC’s well-publicized May meeting was not promising based on supply and demand. Yet, rumors of an increase over and above the initial round of production cuts made the rounds. In the end, OPEC played their cards conservatively, stating balance will return to the market this year. Speculators and investors thought otherwise and pushed prices lower, to and through this year’s low (down to $42), a relentless 5-weeks of declines. Before month-end, domestic oil (WTI) had fallen into a bear market, a drop of more than 20% from its previous high. A mini-rebound in the final days dulled some of the quarter’s losses, but the price remained well-below where it opened 2017.

The Federal Reserve marked mid-year with accomplishments. Twice the funds rate was raised absent international turmoil. That had not been the case the previous two years. On paper, the Fed has options as the 2nd-half gets underway. Will economic growth affirm the central bank’s centerpiece of a third rate increase in 2017? Will inflation weigh on the odds or become a secondary factor? The balance sheet has been discussed in greater detail than markets anticipated, earlier on the calendar and in a far more granular manner. Of course, the third piece of this year’s puzzle is the chair’s position. A review by the administration is underway. Always a delicate subject, and this year more than one can recall in previous appointments. In all, as many as five board members are to be nominated (each needs Senate confirmation). With so many unknowns on a 12 or 18 month horizon, markets will likely keep the focus on the next 6 months.

Finally, the US dollar. The currency weakened in Q2 and, for a 2nd time in 2017, was sold in the days right after the Federal Reserve lifted short-term rates. At face value, it may mean investors do not see real rates rising, but rather remaining negative in the medium-term. That would encompass the next 6 months. Worth noting that currencies are relative value plays. A currency may be on a steady track, but if a new catalyst promotes a contender then new capital moves in a new direction. In the case of the euro-dollar exchange rate, less political uncertainty and renewed economic optimism is palpable in the euro-zone. That has shifted the terrain in the past 6 months. Worthy of observation: stock purchases this year, and especially in the 2nd quarter, were not hedged away from the euro. So unlike last year, and the year before, a greater degree of confidence is included in the equation.