Q1 2017 Market Review And Commentary

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Includes: BXUB, BXUC, CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, MDY, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SLY, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, XLE, XLK, XLP, XLV, XLY, ZLRG
by: Dave Dierking, CFA

Summary

The Federal Reserve may be ready to lift rates again in 2017, but will it be too far, too fast?

The Treasury yield curve flattened in Q1. I'm lowering my year-end target on the 10-year note to 2.75%.

Despite the production cut agreement, I think oil will have some trouble consistently staying above $50.

Gold still looks attractive here and could top $1300 in short order.

The market continued rolling right along in the 1st quarter as corporate earnings growth and the prospect of tax and regulation reform kept investors in a good mood. For the quarter, the Dow Jones Industrial Average (NYSEARCA:DIA) was up 4.6%, the S&P 500 (NYSEARCA:SPY) added 5.5% and the Nasdaq Composite gained a remarkable 9.8%. Smaller companies, which had outperformed large caps by a significant margin in 2016, became laggards in 2017. The S&P 400 MidCap Index (NYSEARCA:MDY) was up 3.6% while the S&P 600 SmallCap Index (NYSEARCA:SLY) added just 0.6%.

^DJI Chart

^DJI data by YCharts

The economy continues to do well. Earnings and revenue growth have returned in a big way. After an earnings recession that resulted in five consecutive quarters of negative year-over-year earnings growth, things are again looking positive for corporate earnings. Analysts are forecasting 6.4% earnings growth in Q1 on roughly 6% growth in revenues. Consumer confidence readings are at levels we haven't seen in some 15 years. Unemployment rates are still hovering just below 5% while the core inflation rate has remained steady at around 2.2%.

Things on the political front haven't been quite so rosy. President Trump's primary campaign platforms - immigration and healthcare reform - have hit major roadblocks. The travel ban has been blocked in the courts twice while the American Health Care Act never even made it to the House floor for a vote due to a lack of support. The Trump administration has said it's moving on to tax reform but even that is looking uncertain.

The president's ability to push through tax reform may have been weakened in light of the healthcare reform failure. Even House Speaker Paul Ryan went on record Wednesday saying that tax reform could take longer than healthcare reform. The bottom line: Washington may be the catalyst that moves the markets for the remainder of 2017.

Technology Leads; Energy Lags

The technology sector was the big winner in the 1st quarter as the Technology ETF (NYSEARCA:XLK) posted a gain of more than 10%.

SPY Total Return Price Chart

SPY Total Return Price data by YCharts

The sector has a valuation roughly on par with the S&P 500 right now is expected to grow at a faster clip. Tech is currently the only sector forecast to grow earnings by double digits in Q1. After lagging in 2016, healthcare (NYSEARCA:XLV) returned to outperform again in Q1 as healthcare reform and a push to lower drug prices are being pushed to the back burner for now. Consumer staples (NYSEARCA:XLP) and discretionary stocks (NYSEARCA:XLY) also did well amidst the economy's recovery.

Energy was the clear loser in Q1 as it was the only one of the major sectors to post a loss. The Energy ETF (NYSEARCA:XLE) lost nearly 7% as OPEC production cuts have largely failed to move energy prices higher. The sector did, however, spike on recent news that the production cut agreement may be extended.

Will The Fed Raise Rates Too Far?

The Fed moved rates higher by a quarter point in March as was widely expected and job growth remained strong and unemployment low. The wording and forecast in Janet Yellen's statement following the move was remarkably similar to comments made in the previous quarter suggesting the Fed has seen little evidence to change their current way of thinking. The Dot Plot indicated the Fed could still be compelled to lift rates again in 2017, maybe more than once.

Not everyone, however, is convinced it's the right path. Skeptics point to wage growth, which is still low (and in real terms may actually be declining). In a low unemployment rate environment, workers typically have more leverage in demanding higher wages, but thus far, we haven't seen much evidence that this is happening. If rising rates make loans and mortgages more expensive while working families don't see a corresponding rise in earnings, it could threaten a return to recession. I'm on record as saying we'll see at least one more rate hike in 2017. Not sure about a second though.

The Treasury Yield Curve Flattens

The treasury market had a curious reaction to the Fed rate hike announcement in March. As the Fed raised rates, treasuries actually rallied and saw yields drop anywhere from 5-10 basis points. Perhaps the market didn't like the Fed's current projected path of rate hikes?

1 Year Treasury Rate Chart

1 Year Treasury Rate data by YCharts

Overall, the curve flattened in Q1. Rates on the long end of the curve (10 years and longer) remained relatively little changed while the 1- and 2-year notes increased by several basis points. At the beginning of the year, I called for a 3% yield on the 10-year note by the end of 2017. Based on wage growth data and the market's reaction to the last rate hike, it looks like 3% may be a little high. 2.75% seems more in the ballpark. Still, I see little reason to invest in the long end of the curve.

Can Oil Stay Above $50?

As mentioned up at the top, the production cuts agreed upon by OPEC don't seem to be having their desired effect as existing crude inventories seem to be having some trouble clearing out. The price of oil dropped some 10% in early March but rebounded when OPEC expressed interest in continuing on with production cuts.

WTI Crude Oil Spot Price Chart

WTI Crude Oil Spot Price data by YCharts

This has always struck me as a bit of a tenuous agreement. If cuts initially accomplish the goal of raising oil prices, aren't some of these companies going to be tempted to ramp up production again to take advantage of the new, more profitable oil?

In last quarter's update, I said…

"While a short term drift back into the mid-$40s wouldn't surprise me, I think we finish 2017 closer to $60."

I'm sticking with the $60 year-end target, but it seems like this might be a best-case scenario.

Gold Shining Brighter

Gold took advantage of political uncertainty and a weaker dollar in Q1 to add nearly 9% to its value and close just short of $1250 an ounce.

Gold Price in US Dollars Chart

Gold Price in US Dollars data by YCharts

Despite its rise in Q1, I still think gold is attractive and has some room to run. Historically, gold has performed well in rising rate cycles, which it looks like we might have in 2017. The prospect of any number of political events - elections in France, Germany and Iran, the start of Brexit, North Korea - could result in a flight to quality that causes Treasury and gold prices to move even higher. I wouldn't be surprised if gold is above $1,300 in relatively short order.

Conclusion

The market seems to want to keep moving higher and the Fed has little interest in rocking the boat, but I think investors should consider taking a bit of a defensive posture. I think the trend is still up and Q1 earnings should help fuel some of that rise but the markets might be underestimating some of the potential risks at play currently.

I don't think it's time to necessarily make radical adjustments to asset allocations but it's also important to consider that valuations are still high, the Fed could ultimately take too heavy a hand in trying to control the growth/inflation balance and political uncertainties from a number of corners of the globe could change conditions at a moment's notice.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.