Despite some minor bumps along the way, equity markets continued their upward climb during the second quarter. All three major U.S. stock indexes ended higher, with the S&P 500® up 2.57%, the Dow Jones up 3.32% and NASDAQ up 3.87%. Over the first half of the year, both the S&P 500 and the Dow Jones rose approximately 8% and NASDAQ about 14%. In addition, investment grade bonds, high yield bonds and foreign stocks all rallied during the past three months, demonstrating a desire by investors to own a variety of investments. The stock market — and other risky assets — have proven to be remarkably resilient as tightening monetary policy and President Trump’s political difficulties continue to take center stage.
After much debate and multiple delays, the U.S. House of Representatives passed a health care reform bill with slim support (217 yes votes, 213 no votes) in early May. While certain compromises were made in order to secure enough votes for passage, several Republicans and all Democrats voted against the measure. After receiving the House bill, Senate Republicans decided to draft their own version and are now encountering many of the same headwinds that stalled the legislation in the House. The Senate has an even narrower margin of error, as a bill cannot pass if more than two Republicans vote against it (unless Democrat support is received, which is highly unlikely). To date, nine Republican senators have publicly opposed the Senate version of the bill. As a result, it appears improbable that either of the current bills will become law at this time.
The difficulty Republicans have had with health care has put President Trump’s priority of comprehensive tax reform in serious jeopardy — at least in 2017. While the president has called for a complete overhaul of the federal tax code, any bill that makes it out of Congress will likely be watered down from what was originally promised on the campaign trail. If Congress cannot come to consensus on tax reform, a somewhat easier approach the president may consider is to introduce temporary tax cuts. While not as sweeping as reform, tax cuts could provide financial relief for many Americans and serve as a jumping-off point for future tax reform discussions. In any event, it is very possible that investors may lose some hope if Republicans cannot pass one of the two signature promises of the Trump campaign. Such an event would likely lead to increased stock market volatility in the second half of the year.
At its June meeting, the Federal Reserve raised the Federal Funds rate for the second time this year, increasing it by 0.25% to a new target of 1.00% to 1.25%. This increase was widely expected and, as such, caused little reaction in financial markets. In addition to raising rates, the Fed also announced preliminary plans to begin reducing its $4.5 trillion balance sheet. Specifically, the Fed expects later this year to stop reinvesting in maturing mortgage-backed securities and Treasuries totaling approximately $10 billion per month, gradually increasing the amount until the monthly total reaches $50 billion. As mentioned in our first quarter review, no country has ever undertaken this type of monetary stimulus reduction, so it’s uncertain how markets will react upon commencement of such a massive unwinding. However, we would expect the pulling back of financial stimulus to create at least some degree of volatility for risk assets.
Despite few legislative successes in the first six months of the Trump administration and an increasingly polarized political climate (across parties as well as intra-party), consumer sentiment remained high through the second quarter, while market volatility, as measured by the VIX, stayed near all-time lows. However, U.S. economic growth continues to be slow — especially during a period of time when the Fed is raising rates — and consumer spending is weaker than what we typically see during periods of economic expansion (despite a very low unemployment rate of 4.3%). We do not think that current “hard data” indicators support the highs we are continuing to see in “soft data” confidence measures. We will be watching this closely over the second half of the year.
With the current U.S. bull market in its later stages, valuations are stretched in both equity and fixed income markets. We believe we are entering a lower-return market environment defined by higher levels of risk and unpredictability. While it’s impossible to know exactly when a market downturn will occur and for how long it will last, we think that, absent a significant catalyst for growth, lower-than-historical returns could persist for several years going forward. In addition, with the Fed tightening monetary policy and the Trump administration struggling to gain approval for growth-inducing policies, there is a good chance the current low volatility environment will end fairly soon — resulting in a less favorable equity market. In times of higher expected volatility and lower expected returns, it is important for investors to be appropriately diversified and remain committed to their long-term investment strategy. As always, we do not recommend trying to time the market.
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