March 31, 2017
For the first quarter the Montag & Caldwell Mid Cap Growth Composite gained 6.42%, beating the 3.94% return for the S&P MidCap 400 Index and slightly lagging the Russell Midcap Growth Index return of 6.89%.
The post-election stock market rally continued in the first quarter with the S&P 500 tacking on 6% on top of the 5% fourth quarter post-election advance. All told, as of the end of the first quarter, the S&P was up 11% since November 8. However, there was a notable shift in leadership during the quarter. The so-called “Trump stocks” (cyclical reflation beneficiaries like financials, energy, materials and industrials) that led the initial advance took a breather and gave way to some of the secular growers within health care, technology and consumer discretionary. The lagging performance of the “Trump stocks” seemed to coincide with a pullback in the dollar and bond yields, a sign that investors’ enthusiasm for the timing, if not the substance, of the Trump administration’s pro-growth agenda, and in particular tax reform, started to wane a bit.
In our last quarterly letter we had warned that investors seemed to be placing a lot of faith in the successful passage and timely implementation of the new administration’s agenda. However, following the failure of Congressional Republicans to unify to pass their own health care reform legislation, investors are left to question their ability to push through similarly complicated tax reform. Considering the down payment that health care reform was expected to make on the federal budget deficit, it now becomes monumentally more difficult to pass meaningful tax reform that is revenue neutral (a key requirement of passage under budget reconciliation) without including controversial proposals such as the border-adjusted tax (BAT). The BAT was expected to produce roughly one trillion dollars in new tax revenue but seems to lack the necessary support in the Senate given its potential adverse effects on import prices, consumption, and profits for certain companies such as retailers that are heavily dependent upon foreign goods. Thus, it seems more likely that President Trump and Congressional Republicans may be forced to settle for a scaled back package of tax cuts that come with an expiration date. While still positive, this outcome is certainly not as desirable as more comprehensive tax reform that would truly affect behavior and drive new investment.
At the same time that doubts are emerging about policy makers’ ability to fulfill investors’ hopes for improving growth to justify the post-election rally in share prices, we see a growing discrepancy between sentiment-based indicators of economic growth, which continue to show strength, and data reflecting actual economic activity, which have remained soft. This dichotomy between the so-called hard data and soft data presents a risk for investors that near-term profit growth may prove disappointing. We currently expect first quarter real Gross Domestic Product to show growth of just 1%, a step down from last quarter’s 2.1% and the post-recession average of about 2.0%. While it is possible we could see an inventory-fueled bounce in the second quarter, we expect full year 2017 real GDP growth to once again be about 2.0%.
Looking forward, easy comparisons, rising energy and bank profits, and a return to synchronized global expansion all suggest corporate earnings should show further year-to-year improvement after bottoming in the second quarter of 2016. Global central bank policy remains accommodative and risk of a recession remains remote. And following the health care setback, President Trump and Republicans in Congress are highly motivated to show progress on fulfilling campaign promises for pro-growth policies.
That said, we believe the market is vulnerable to a mild setback in the near term. The stock market remains fully valued on a variety of measures and investor sentiment surveys reflect a high level of complacency. The CBOE VIX index, commonly referred to as the “Fear Gauge”, just recorded its second lowest average level on record in the first quarter, and the market recently went an unusually long 109-days without a 1% decline, its longest stretch in nearly 22 years. Thus, the market is overdue for a bout of increased volatility.
Meanwhile, the Federal Reserve is in tightening mode, having already raised short rates three times and seemingly on track to lift rates at least twice more this year. Historically, investors have paid heed to the “three hikes and a stumble” rule of thumb that says stocks tend to fall after the Fed has increased rates three times. Additionally, the March FOMC minutes indicate a desire by Fed governors to begin shrinking its balance sheet, which is the next step towards policy normalization, but an unprecedented one with unpredictable outcomes. It is clear that the Fed is eager to make the hand-off to fiscal policy makers for supporting the economy. The question is whether the Trump administration and Congress are prepared to take that baton just yet. With soft economic data pointing to the possibility of disappointing near-term profit growth, Congressional Republicans challenged to deliver on investors’ high hopes for meaningful stimulus, and the potential for some sort of geopolitical crisis to test the new Trump administration, increased market choppiness seems likely.
We remain confident that the Montag & Caldwell Mid Cap Growth holdings should perform better during challenging markets and offer the prospect of superior long-term risk-adjusted returns.