Q2 2017 Market Review And Commentary

by: Dave Dierking, CFA


The Fed may or may not lift rates again in 2017. Would a rate hike be the wrong move?

The Treasury curve flattened again in the 2nd quarter. Should that be a reason to worry?

My original year-end target of $60 for oil seems way too high. $45 by the end of 2017 seems more reasonable.

Gold has catalysts that could move it either up or down. I think it hits $1200 before it hits $1300.

Bitcoin is not in bubble territory but I'm searching for a better entry point.

An economy that remains solid, if not strong, coupled with record low volatility spelled another good quarter for the markets. Equities tacked on another several percentage points pushing year-to-date gains into the double digits in several sections of the market. In the second quarter, the Dow (DIA) added 3.3%, the S&P 500 (SPY) gained 2.6% and the Nasdaq was up 3.9%. Smaller stocks continued to lag their large cap counterparts. The S&P 400 MidCap Index (MDY) was up 1.6% while the S&P 600 SmallCap Index (SLY) added just 1.4%.

Through the first half of 2017, equities continue to deliver solid and steady gains with very little in the way of interruptions. The Dow, S&P 500 and Nasdaq have been no more than about 3% off their 2017 highs at any point during the year.

Chart ^DJI data by YCharts

The first quarter earnings season was a huge success. According to FactSet, the S&P 500 delivered nearly 14% year-over-year earnings growth, the highest growth rate since 2011, finally supporting some of those outsized valuations with 75% of companies exceeding their earnings expectations. Analysts are again forecasting double digit growth in the second quarter.

The jobs situation looks solid. Total non-farm payrolls increased by 581,000 jobs in the quarter while the official unemployment rate closed the quarter at 4.4%. Wage growth, however, remains a disappointment as a flood of new and available jobs hasn't translated into higher incomes yet. With inflation slipping back below the Fed's 2% target, it puts the path of future interest rate hikes into some question. The odds of another Fed rate hike before the end of the year, according to the Fed futures market, currently sits at around 60%.

Events in Washington continue to throw a wrench into the global geopolitical environment but that hasn't translated into much volatility in the financial markets. President Trump is still attempting to push through his first piece of major legislation without any clear picture of when that might be. Healthcare reform is front and center but the Senate's version of "repeal and replace" doesn't look like it has the necessary votes to pass unless several revisions are made. We hear rumblings about tax reform but no concrete agenda yet. North Korea's ongoing threat of missile attacks remind us that we're still just one event away from things turning upside down!

Healthcare and Technology Lead; Energy Remains a Loser

Fueled by gains in the FANG stocks (or FAANG or FAAMG or whatever the current acronym du jour is), tech continue its market leadership in Q2. The Technology Sector ETF (XLK) is up 14% for the first half, but healthcare emerged as the biggest winner so far. Both healthcare service providers and medical device makers delivered solid gains, fueled by the possibility of advantageous healthcare reform coming out of Washington, pushing the Healthcare ETF (XLV) to a 16% gain. Drug price reform appears nowhere in sight also helping the situation. Four different major sectors delivered double digit gains.

Chart XLV Total Return Price data by YCharts

It's a theme that has been ongoing for some time now but supply and demand imbalance in the crude oil market continues to pressure prices and, in turn, energy company revenues. The Energy ETF is down nearly 13% in the first six months as oil prices struggle to remain above $50 a barrel. In last quarter's update, I put a $60 price target on WTI crude by the end of 2017. Barring an unforeseen event, it looks like oil prices are going to remain well below that level. Somewhere around $50-55 seems more reasonable now.

Another rate hike this year or not?

The Fed has followed through on their expected rate hike plan but now things might start to get a little murkier. While only Neel Kashkari of the Minneapolis Fed has been a consistent dissenter on recent hikes, there's a growing sense that the Fed may be moving a little too fast. Interest rates and inflation are a delicate balancing act and, with inflation below target, some feel that another hike this year could do more harm than good.

In his statement talking about why he dissented, Kashkari makes the following statement.

A tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs onto their customers, which should lead to higher inflation. That makes intuitive sense.

The problem is that while we've got job growth and a low employment rate, we don't have wage growth or inflation. A rate hike in an already low inflation environment could put recessionary pressure on the economy and disrupt what's been a pretty nice economic recovery. If I were to guess right now, I'd say we'll see one more hike in December. In June's Dot Plot, 12 of the 16 Fed governors who offered up a forecast saw another rate hike before the end of the year. I think the majority will win but keep an eye on how the Fed's plan to begin running off its $4.5 trillion balance sheet may factor into this.

The Treasury Yield Curve Gets Flatter

The flattening of the Treasury yield curve has been a consistent theme for 2017. The spread between the 10-year note and the 30-year bond started the year at around 125 basis points but has dropped to as low as 80 recently. The spread between the 10-year and the 2-year is similarly at its lowest levels of the year.

Chart 1 Year Treasury Rate data by YCharts

What does it mean? Generally, a flattening yield curve could be a signal that the market is expecting lower inflation rates or is concerned with the macroeconomic environment. That makes sense given some of the economic indicators mentioned earlier. I dropped my year-end forecast on the 10-year Treasury yield to 2.75% in last quarter's update. I'm sticking with that forecast for now but I think that might be as high as it gets.

Are We Stuck With Oil In The $40s?

It sure seems like it. Since its prolific plunge from over $100 in 2014 to below $30 in 2016, oil has broken the $50 mark a number of times and failed to hold it every time.

Chart WTI Crude Oil Spot Price data by YCharts

The OPEC production cut agreement was supposed to serve as a buoy for oil prices, but thus far has done very little to prop them up. The likely reason? The United States itself. Domestic rig counts have increased in 24 of the past weeks pointing to further production increases. The trendline has been decidedly down since the beginning of March. While that's good news to consumers at the pump, it's not for energy producers. My original year-end target of $60 oil seems quite unlikely now. I'd put the over/under at around $45.

Gold In a Tug of War

Gold has done a lot of bouncing around within the $1200 to $1300 range and finishes the first half right in the middle of that range.

Chart Gold Price in US Dollars data by YCharts

Gold has catalysts pulling it in either direction right now. Despite its rise in Q1, I still think gold is attractive and has some room to run. A healthy economy, strong job growth and solid corporate earnings have many investors adding to their risky asset positions. That would tend to push gold prices downward, but the political uncertainty both here and abroad could lead to a flight to quality. The market has reacted very little to political events so I'd expect the price of gold to hit $1200 before it hits $1300 again.

Is Bitcoin Overcooked?

I haven't covered bitcoin in any of my previous quarterly updates. Given its prominence, it seems like it's time to correct that oversight.

Despite all of the volatility of the last several weeks, bitcoin has still gained well over 100% in 2017. The question now is are we in bubble territory and the cryptocurrency is ready to pull back below $2000 or is this just the beginning of something bigger.

There's no doubt that cryptocurrencies are growing by the day and long-term investors might still want to buy but I'm just not finding this a compelling entry point just yet. Ethereum, another crypto with arguably more practical applications than bitcoin, has had even a wilder ride and that's not even considering the flash crash that dropped it down to $0.10 a few weeks ago. Such significant rises almost always require some period of consolidation. Granted, bitcoin is down some 20% from its all-time highs, but I think it needs to pull back closer to $2000 before resuming an upward trend again.

Now that I said that, it'll probably be above $5000 in the next few weeks.


Economically, things seem to be moving along swimmingly. If I'm being a contrarian, I could probably make the argument that when things seem to be going great, that's the point when you should start worrying. I'm not at that point yet but I don't think it's worth being mindful of. The Q2 earnings season is expected to be another good one and I think that will put something of a floor under equities but another Fed rate hike without a corresponding rise in inflation would cause me some concern.

The bulls still remain in control and the trend is still flat to up. Outside of a major political event, there doesn't appear to be much impetus for increased volatility which should also help the bull case in the third quarter.


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