Quarterly Client Letter – Q1 2018

  • April 13, 2018
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Dear O’Brien Wealth Partners Investor,

The market engaged in a lock step game of tug-of-war between the bulls and the bears in the first quarter as two powerful, diametrically opposed forces competed for supremacy. As these forces traded their advantage back and forth we saw the return of volatility, which was absent from the market in 2017. Individual investors chose their sides based on where they think the market is heading, and pulled for their teams by buying or selling based on that view. The quarter started with the “Bulls” making inroads as the market headed up pricing in the effects of tax reform for individual companies. The Bull Team was overpowered later in the quarter by the “Bear Team” as the market was spooked by inflation concerns, President Trump’s unilateral introduction of tariffs, and an internet privacy scandal. But the largest casualty of the quarter was investors who were complacently short the volatility trade and were violently yanked out of the game. Spiking volatility caused some inverse VIX ETFs, which make money when volatility is low, to close down -90% in the course of a single day on February 5th (with most of the decline coming in the final 15 minutes of the day!)

The cautionary eyes appear to be focused on inflation, as a large jump in inflation could signal the end of this extended bull market. Testing this theory, the volatility this quarter was prompted by a whiff of anticipated inflation, causing bond prices to drop and yields to rise, which led equity investors to become nervous and sell stocks. Current thinking is that when inflation exceeds the Federal Reserve’s 2% target, they will be forced to hike interest rates. These hikes may come faster than the market can bear, which some predict will lead to our next recession. While inflation hasn’t increased significantly, even a glimmer of a pick up in anticipated inflation is causing concern. President Trump’s sudden announcement that he would impose tariffs on steel and aluminum imports caused further concerns. This, coupled with NAFTA troubles, is feared to lead to a potential “trade war” as other countries retaliate with tariffs of their own. Finally, technology stocks, which carried the markets in 2017, saw their prices fall as Facebook came under increased scrutiny for their privacy policies.
In the second half of the quarter Team Bull recovered nicely, led by market fundamentals which remain strong. Growth in the U.S., as measured by GDP, edged up towards 3% year-over-year spurred along by the implicit bottom-line benefits of corporate tax reform stimulus. Most economists see 3% growth continuing through the end of 2018, but slowing in 2019 due to a declining labor force and slowing productivity. Corporate earnings growth continues to steam ahead, with an impressive 25% year-over-year increase in operating earnings projected over the next twelve months for the S&P 500. This increase in earnings, combined with the recent market sell-off, brings U.S. equity valuations closer to fair value as forward Price/Earnings ratios ended the quarter roughly in-line with 25 year averages. The markets experienced a roller-coaster of ups and downs throughout the quarter but ultimately finished not far from where they started. The U.S. equity market ended the quarter down only -0.76% (as measured by the S&P 500 Index) and U.S. small-cap stocks finished the quarter down only -0.08% (as measured by the Russell 2000 Index.)
Outside the U.S. market valuations remain relatively more attractive and we continue to see a favorable outlook on global growth and earnings. Depending on the actions that U.S. politicians adopt to deal with the trade deficit, they may turn to devaluation of the dollar as a better option than widespread tariffs. Tariffs have been calculated to be a very small part of the trade deficit equation. Any drop in the dollar will provide a tailwind to investors invested overseas, enhancing returns in an already attractive asset class. If U.S. equities are fairly valued, international equities are relatively cheap, especially companies in the emerging markets.
(over)

Emerging markets are benefiting from stabilizing oil prices, relatively low debt levels and attractive valuations based on their histories. Under that backdrop equities domiciled in the emerging markets (and particularly the frontier markets) saw the best returns of the quarter as the MSCI EM Index posted a return of 1.42% for the quarter.
Within the fixed income markets, the increased movement in interest rates was driven largely by fears of inflation and the actions of the Federal Reserve. Jerome Powell, the new Chair of the Federal Reserve, provided much of the same substance seen in the past from Janet Yellen, and the March meeting of the Federal Open Market Committee reinforced the message that a slow and steady stream of rate hikes will be needed to keep the economy from overheating. Despite the volatility in the stock market, the Committee raised rates by 25bps during the quarter, while simultaneously boosting their outlook for growth and inflation. Rates are likely to continue to slowly move up over time due to a combination of hikes by the Federal Reserve and supporting supply/demand characteristics. A decrease in demand will come from the Fed as it reduces its balance sheet by $30B/month and an increase in supply will come from the Treasury as it will be forced to issue considerable amounts of new debt to finance our country’s new tax cuts. This combination should push rates slowly higher. From a performance perspective fixed income markets were generally hampered by an increase in interest rates and fell a bit more than the equity markets, down -1.46% (as measured by the BBgBarc US Agg Bond Index.)
What does this mean for you portfolio?
During a quarter in which an increase in interest rates spooked the equity markets, there were only small pockets of positive performance in traditional assets. Our global bond position was one of our best performers as its long dollar and short duration positioning made it an excellent counterweight to our more traditional investments. Despite U.S. large cap stocks in aggregate finishing in negative territory, those with a growth tilt were positive, capitalizing on their strong start to the year. We also saw a resurgence of active management outperformance coinciding with this increase in volatility as almost all of our active managers outperformed their respective benchmarks over the quarter. Internationally, our growth-oriented emerging markets manager finished in positive territory, capitalizing on the strong performance in Brazil. Our low duration positioning within fixed income provided protection over the quarter as each manager was able to outperform the more interest rate sensitive benchmark.
During market volatility we like to remind our clients that we have planned carefully for these times. Our focus on long-term goals and diversification are our best defenses to weather these markets, while remaining invested and without losing discipline. As our portfolios were stress-tested over the last quarter in several ways, each component acted as anticipated leading to a stronger sum of the parts.
If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.

Your O’Brien Wealth Partners LLC Investment Team