The S&P 500® Index gained 6.07%* (in Canadian dollar terms, the return for the quarter was 5.25%) for the first quarter of 2017. The equity market posted positive returns each month of the quarter with the S&P 500® Index returning 1.90%*, 3.97%* and 0.12%* for January, February and March, respectively. The equity market’s advance was steady over the first two months and reached a year-to-date closing high on March 1st. The S&P 500® Index declined 2.16%* from March 1st through March 27th before advancing at month-end. Realized volatility and implied volatility were persistently low throughout the quarter.
The equity market’s advance in January and February was fueled by strong corporate earnings, positive economic data and optimism that the Trump administration would quickly enact its agenda of reducing regulations and reforming the tax code. The January release of the Purchasing Managers Manufacturing Index was the strongest since March 2015, and the January employment and retail sales reports exceeded expectations. Measures of business and consumer confidence reached multi-year highs. Though the Federal Reserve (Fed) raised its rate by 25 basis points (bps) as expected in March, rhetoric about future rate increases was relatively dovish – as noted during Chairman Yellen’s press conference after the rate hike and during her semi-annual testimony to Congress in February. Nearly 78% of S&P 500® Index companies reported fourth quarter earnings that met or exceeded analyst estimates and aggregate operating earnings grew 4.77%, the fastest rate since the fourth quarter of 2013. Market weakness in March was driven in part by the failure of Congress to pass a healthcare bill that repealed or modified the Affordable Care Act, calling into question the ability of the Trump Administration to enact other portions of its policy agenda. At the end of March, the final estimate of fourth quarter GDP growth came in at 2.1%, an upward revision that beat consensus estimates.
Implied volatility, as measured by the Chicago Board Options Exchange Volatility Index (the VIX)1, averaged 11.69 for the quarter, exceeding S&P 500® Index realized volatility (as measured by its annualized standard deviation of daily returns) of 6.84%*. The VIX oscillated in a narrow range throughout the quarter with a low of 10.58 and a high of 13.12.
Fixed Income Markets
The Bloomberg Barclays U.S. Aggregate Bond Index (the Aggregate) returned 0.82%* for the first quarter. The yield on the 10-year U.S. Treasury Note ended 2016 at 2.44%* and ended the first quarter at 2.39%*. The bellwether interest rate reached a low of 2.31%* on February 24th before climbing to a high of 2.63%* on March 13th, its highest level since mid-2014.
Gateway Low Volatility U.S. Equity Fund Performance
Series A units of the Gateway Low Volatility U.S. Equity Fund (the Fund) returned 0.79% for the first quarter, underperforming the S&P 500® Index ($CAD) by 446 bps.
Gateway’s index call option activity during the quarter focused on increasing the weighted-average strike price of the portfolio as the market advanced, while keeping weighted-average time to expiration relatively extended. Certain longer-dated contracts offered more attractive protection than shorter-term contracts due to their higher dollar premiums and lower market sensitivity in the event of a market reversal.
Gateway’s investment team took advantage of low volatility throughout the quarter by trading select index put options well in advance of their expiration dates, and keeping weighted-average time to expiration extended in an effort to maintain downside protection at attractive prices.
As of March 31st, the Fund’s diversified equity portfolio was over 95% hedged with index call options with average strike prices between 1.5% in-the-money and 1.5% out-of-the-money, average time to expiration of 29 days and annualized premium to earn of 5% to 7.5%. The Fund ended the quarter hedged with index put options on over 95% of the notional value of its portfolio with average strike prices between 7.5% and 10% out-of-the-money, average time to expiration of 57 days and annualized cost of less than 2.5%. Relative to the beginning of the quarter, this positioning represented increased market exposure and lower net cash flow potential.
Despite high equity market valuations, cautious long-term investors should consider the possibility that equity investments may still outperform fixed income investments over their investment horizons. Although elevated equity valuations have persisted in the market landscape over the last 20 years, the current combination of very low bond yields and very high equity market valuations is historically rare. The last time interest rates were similarly low and equity market valuations were similarly high was the early 1960s. On January 1st, 1961, the yield on the 10-year U.S. Treasury Note stood at 3.84%*, while the trailing 12-month price-to-earnings ratio (P/E) on the S&P 500® Index was 18.60, and climbed to a high of 22.64 by November of that year. Those figures compare to a yield of 2.35%* and P/E of 26.48 at the end of the first quarter of 2017.
Investors looking for lessons from the early 1960s will find a mix of good and bad news. Economic growth was above average. Corporate earnings were above average and outpaced the market’s return, which was below average. The S&P 500® Index had a cumulative total return of 38.24%* (5.54%* annualized) from December 31st, 1960 to December 31st, 1966, while the cumulative growth of S&P 500® Index earnings was 53.72%* (7.43%* annualized). The high market valuation at the beginning of the period was a signal that significant earnings growth was already priced into the market. But the below average market return wasn’t the only evidence that earnings growth did not meet expectations—there were also two bear markets in the six-year span.2 Remarkably, despite below average returns and two bear markets, investors who remained in the equity market from 1961 through 1966 fared better than intermediate government bond investors who earned an annualized return of just 3.12%*, as the yield on the 10-year U.S. Treasury Note climbed from 3.84%* in January 1961 to a high of 5.16%* in November 1966.
Historically, bear markets materialized in 1946, 1961 and 19873 – soon after the trailing 12-month P/E ratio on the S&P 500® Index climbed above 20. At other times high equity valuations were normalized through earnings growth rather than deep market declines. The early 1990s was one such time, when earnings growth was sufficient to catch up to the market price and significant downside volatility was avoided.
Specifically, from December 31st, 1991 through December 31st, 1994, S&P 500® Index earnings grew more than 20% annualized. The trailing 12-month P/E began the period at 15.35, climbed above 20 by mid-1991 and stayed above that threshold until the first quarter of 1994. Due in part to the market’s high starting valuation, the annualized total return of the S&P 500® Index was only 6.25%* over that three-year period. Despite the below average return, robust earnings growth appeared to have contributed to keeping significant downside volatility out of the market. The worst peak-to-trough decline in the S&P 500® Index over this period was a drawdown of 8.47%* from February 2nd to April 4th, 1994.
Interestingly, earnings growth forecasts for 2017 are similar to the earnings growth rate of the early 1990s. Consensus bottom-up estimates as of March 23rd for S&P 500® Index operating profits are currently about $130, an increase of more than 20% over S&P 500® Index operating earnings as of December 31st, 2016. Earnings growth and market action of the early 1990s suggest S&P 500® Index companies may need to sustain that level of earnings growth for more than one year, if equity investors are to avoid a significant downside event. Optimistic equity investors may want to temper their outlook with the possibility that robust earnings growth going forward may only serve to keep downside volatility out of the market, rather than drive average to above-average equity market returns.
It is also worth noting that, despite higher yields on investment grade bonds relative to today and the 1960’s, the stock market still performed better than the bond market from 1991 through 1994. The Bloomberg Barclays U.S. Aggregate Bond Index (the Aggregate) returned just 4.60%* annualized over the three-year period, underperforming stocks by more than 1.5%* per year on average.4 This happened despite the 10-year U.S. Treasury Note yielding over 8%* at the beginning of 1991 and total-return boosting rate declines over the next two years. Rising rates during 1994 drove losses in the bond market that erased a portion of the gains generated in the first two years of the period.
Analyzing equity and bond market returns in these high valuation periods illustrates that while high market valuations don’t always presage bear markets, neither does above-average earnings growth always result in above- average equity market returns. This is especially true when high valuations are an indicator of priced-in future earnings growth. Moreover, bear markets can occur even during a period of expanding earnings. The early to mid-1960s period shows that equities can outperform bonds over multi-year periods even when equity market returns are below-average and the period includes a bear market. Low and/or rising bond yields can be a key contributor to such outcomes.
Long-term investors face an asset allocation conundrum over high equity market valuations and the possibility that interest rates may soon rise. Namely, exposure to equity market risk may not be rewarded with typical equity market returns, and an overweight position in bonds could mean sacrificing long-term equity returns. Realizing this conundrum is only a small step toward solving it.
Long-term investors may benefit from seeking approaches beyond just blending traditional asset classes to achieve the optimal middle ground between stocks and bonds. Adding equity correlated investments that combine reliable downside protection and greater long-term return potential than bonds may be particularly beneficial.
For more information about Gateway Low Volatility U.S. Equity Fund, please contact your financial advisor.
All data is as of March 31, 2016. Performance for the Gateway Low Volatility U.S. Equity Fund is for Series A — 1 month: 0.2%; 3 months: 0.8%; 6 months: 4.2%; 1 year: 7.8%; and Since Inception*: 3.5%. *Inception Date: September 17, 2015.
1. VIX is an index designed to track market volatility as an independent entity. The Market Volatility Index is calculated based on option activity and is used as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism.
2. From December 12th, 1961 to June 26th, 1962 the S&P 500® Index (USD) lost 27.97% and from February 9th to October 7th, 1966 the S&P 500® Index (USD) lost 22.18%.
3. S&P 500® Index (USD) bear market returns and dates: May 29th, 1946 to June 13th, 1949: -29.61%, August 25th, 1987 to December 4th, 1987: -33.51%, See Note 2 for bear market returns in 1961 and 1966.
4. The S&P 500® Index (USD) returned 6.25% annualized over the three-year period.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values c past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.