June 30, 2017
For the second quarter the Montag & Caldwell Mid Cap Growth Composite gained 3.42%, gross of fees, beating the 1.97% return for the S&P MidCap 400 Index and lagging the Russell Midcap Growth Index return of 4.22%. Year-to-date, the Composite is up 10.07% compared to a 5.99% gain for the S&P 400 and a 11.40% return for the Russell Midcap Growth.
Merely looking at the results since the end of the first quarter one might presume it was a rather placid three months, and in some respects that was the case. During the second quarter markets were generally buoyant with all major indices notching respectable gains. News flow and events during the quarter, however, were anything but quiet. The French held an important election which was seen as a potential litmus test for the strength of the European Union. President Trump fired FBI Director James Comey. This prompted widespread criticism and the appointment of Bob Mueller as Special Counsel to investigate whether or not the President attempted to influence Director Comey to shut down an investigation into former National Security Director Michael Flynn. Meanwhile, Congress continued to work on a new healthcare bill following an initial setback with “repeal and replace” earlier in the year. The desire to address Obamacare first pushed other legislative priorities to the back of the line. On the monetary policy front, the Federal Reserve kept its promise to gradually raise interest rates, hiking the Fed Funds rate by a quarter-point in mid-June while also detailing its plans to begin shrinking its massively inflated balance sheet. Lastly, London endured several horrific terrorist attacks.
The markets barely shuddered in response, however, and market volatility as measured by the VIX remained mostly near decades-long lows. Perhaps investors simply shut out the political noise and took their cue from improving economic and earnings fundamentals. U.S. real GDP growth, while hardly blistering, did show some improvement from tepid first quarter readings. Growth in the rest of the world also seemed to pick up a little bit of steam. Meanwhile, we expect that Q2 S&P 500 profits showed further improvement, continuing the recovery from the 2015-16 profits recession. While unlikely to match the double-digit year-over-year gains posted in Q1, which were aided by comparison against unusually depressed energy and materials earnings when commodity prices bottomed in the first quarter of 2016, we expect Q2 profit gains to be broadly distributed across most sectors.
Notwithstanding solid share price gains during the quarter, there was a major underlying shift in market leadership with Growth style benchmarks, led by large cap technology, accounting for the majority of the market’s gains the last few months. In effect, the market unwound the powerful post election “Trump trade” which was led by mostly cyclical areas of the market at the expense of growth stocks. The post-election rally was underpinned by the hope that Trump’s legislative agenda of tax reform, lighter regulatory burdens, and increased infrastructure spending would jolt the U.S. economy from its enduring, yet uninspiring, growth rate of approximately 2% in recent years. This, in turn, would benefit economically sensitive sectors like energy, materials, financials, and industrials. Now, seven months since the election, the agenda has stalled. First half U.S. real GDP growth looks to average the same 2% we’ve experienced over the entire post-recession recovery. Inflation remains tame while Treasury yields and the U.S. dollar have given back most of their post-election moves. Oil prices, too, are toward the bottom of their year-long range. Lastly, the yield curve has flattened following a swift steepening last December. This all served to put a damper on the enthusiasm for those cyclical “Trump stocks”. As a result, investors rotated back to those sectors perceived as least dependent upon a raft of new fiscal stimulus, notably healthcare and technology.
So, is the “Trump trade” dead and gone? That’s difficult to say with any certainty, but it is definitely on hiatus for the time being. Absent major policy initiatives like corporate tax reform or an infrastructure bill we don’t see anything on the horizon that would lead to faster economic growth needed to justify the share price gains by many stocks after the election. While many may argue that technology is a “crowded trade”, the fact remains that many of the recent winners are showing strong sales and profit growth while trading at modest premiums to the overall market. Until we get some visibility that the Trump agenda is getting back on track, we think any major rotations from growth back toward value will prove short-lived.
Looking ahead, while we continue to be concerned with elevated valuations, investor complacency, and suppressed market volatility, those are merely pre-conditions to a market decline, not catalysts themselves. Rather, the market could continue to be supported in the near-term by a low risk of recession, improving corporate profits, a better global economy, accommodative policies by Central Banks throughout the developed world, a gradual and predictable increase in interest rates by our Federal Reserve, and the possibility of fiscal stimulus coming out of Congress. Changes to any of those factors, however, could be a cause for the market to sell-off.