“Sometimes we need to lose the small battles in order to win the war.” – Sun Tzu, The Art of War
What a difference a year makes. This time last year, we were trying to make sense of the rollercoaster ride that markets took in the first three months of 2016. As you may recall, in the first six weeks of 2016, U.S. markets sold off dramatically. Major U.S. equity markets dropped over 10%, oil prices reached 13-year lows, and interest rates fell as bond prices strengthened in a flight to safety. Fed chair Janet Yellen calmed the markets by acknowledging negative economic indicators and backed off the promise of imminent rate hikes. Equity markets rebounded dramatically, ending the quarter with slightly positive returns despite the intra-quarter volatility.
The first quarter of 2017 started off in a similar fashion, with daily drama emanating from our nation’s capital. Despite all the noise and rhetoric, financial markets experienced one of the least volatile quarters in history. Increased consumer and business confidence played a key role in the performance of U.S. stock markets. At a sector level, U.S. equity markets were led by growth-oriented stocks in the first quarter, and large-cap stocks outperformed their small-cap brethren. The S&P 500 was up 6.07% for the quarter versus a more modest return of 2.47% for the Russell 2000 Index of small-cap stocks. The quarter also saw international stocks outperform U.S. stocks. Emerging markets’ stocks, up 11.44% for the quarter, posted the best performance of all.
The first quarter was one of quiescence in fixed income markets. Maybe the most important change in fixed income markets, during the quarter, was a continued flattening of the yield curve. The one-year U.S. Treasury opened the year at 0.89% and rose to 1.03% by quarter’s end. The long end of the curve, however, moved in the opposite direction. The 30-year U.S. Treasury fell, albeit only slightly, from 3.04% to 3.02% at the end of March.
Economists and investors are paying particular attention to inflation. The Bureau of Economic Analysis’ most recent release of the Personal Consumption Expenditure (“PCE”) showed inflation at +2.12% over the year ending February 28th. This data point that should be carefully monitored, going forward, as a trend of increasing inflation would most certainly have a negative impact on financial markets.
All of this brings us to our quote above from Sun Tzu. For investors, this quote seems directly relevant to how we view the various parts of a well-diversified portfolio. In a perfect world, our portfolios would be comprised of assets whose return streams were completely uncorrelated. In practice, this ideal is impossible; still, we still strive to come as close as possible to the goal. There will always be some part(s) of the portfolio exhibiting weak recent performance. But we must remember that we are in this for the long haul; to win the war, not just the battle. And we must constantly focus our energy and attention toward that end.