The final quarter of 2017 saw an acceleration of gains among most financial asset categories. Domestic equity benchmarks advanced more than 6%, with large-company stocks besting small caps by a healthy margin. Overseas stock gains were also in the mid-single-digits; the emerging-market category outperformed more mature economies. Real-estate securities edged up, led by timber-related issues; commodity prices rose (oil was up more than 16%; gold gained 2%). Benchmark bond yields inched higher: the 10-year U.S. Treasury finished at 2.40%, compared to 2.33% at the end of September; municipal bonds generally produced positive three-month returns while investment-grade corporates were off slightly, on average.
Among large-company U.S. stocks, the strongest groups were Consumer Cyclicals, Financial Services and Technology; weaker performance came from the Capital Goods, Consumer Staples, Energy and Health Care sectors. Growth-oriented stocks beat out their value counterparts.
Benchmark Performance – Equities
|Fourth Quarter 2017||Last Twelve Months|
|S&P 500 Index||+6.6%||+21.8%|
|Large-Cap. Core Mutual Fund Avg. (Morningstar)||+6.4%||+20.5%|
|Small-Cap Stocks (Russell 2000)||+3.3%||+14.6%|
|Non-U.S. Stocks (Developed – MSCI EAFE)||+4.3%||+25.7%|
|Non-U.S. Stocks (Emerging – MSCI EM)||+7.3%||+37.5%|
Benchmark Performance – Fixed Income
|Fourth Quarter 2017||Last Twelve Months|
|Barclays Intermediate Gov’t/Credit Index (taxable)||-0.2%||+2.1%|
|Intermediate Municipal Mutual Fund Avg. (Morningstar)||+0.4%||+4.6%|
Two thousand seventeen marked the eighth full year of the current economic expansion and financial-asset bull market. The year’s news was overwhelmingly market-friendly: global economic activity strengthened, profit growth accelerated, and political risk receded. Global central banks moved tentatively away from the emergency monetary accommodation in place since the Global Financial Crisis of 2008-2009. Financial-market gains were robust and broad-based.
The global economy was on increasingly sound footing – a distinct improvement after a multiyear stint of sub-par growth and worryingly low inflation. The U.S. economy accelerated modestly, expanding at a full-year rate above 2% (compared to 1.6% in 2016). The latest reported quarter (July-September) was stronger – coming in at +3.2% – and more recent data suggested the pick-up was intact: nationwide house prices gained more than 6% year-over-year; job growth remained solid, with unemployment falling to just over 4%; and purchasing-managers surveys, consumer confidence and small-business optimism were all perched near cycle highs (though consumer spending and wage growth remained somewhat lackluster). Overseas, the Eurozone and Japanese economies both grew at rates that exceeded expectations by wide margins. Likewise, despite authorities’ efforts to cool real-estate markets and slash excess industrial capacity, China’s economy advanced faster than the official target (‘around 6.5%’). Other developing economies were firm, benefitting from a healthy China and commodity markets that continued to recover from their 2014-2015 slump. There were widespread signs that the risk of outright deflation was receding.
Improving growth and benign inflation allowed global central banks to move gradually toward more normal monetary policies. In the U.S., the Federal Reserve raised short-term rates three times, bringing their target range to 1.25%-1.50%. Meanwhile, the European Central Bank announced plans to halve the size of its bond-buying program (‘quantitative easing’) during the coming year. Despite some intra-year volatility – the US 10-year Treasury yield traded as high as 2.63% in March and as low as 2.03% in September – longer-term interest rates finished the year slightly lower in the U.S., essentially unchanged in Japan, and modestly higher in Europe and China. Having spiked following the 2016 presidential election, the foreign-exchange value of the U.S. dollar fell by more than 10% through early September before a modest late-year rally.
The past year also saw a salutary ebbing of political risk. Though extreme partisanship and a high degree of dysfunction continued to characterized U.S. politics, the late-year passage of tax-reform legislation was a hopeful step. In Europe, fears that Brexit augured further gains by Euro-skeptical populist movements on the Continent were assuaged by Emmanuel Macron’s stunning victory in the French presidential election and a less clear-cut outcome in German federal elections. Japanese parliamentary elections and China’s five-yearly Communist Party Congress both solidified the status quo in East Asia, following the early-year presidential impeachment in South Korea. The sidelining of trade (and other) disputes between the U.S. and China, as the two superpowers sought to cope with the North Korean nuclear/missile threat, was a further salutary development.
Propelled by improving economic growth, higher commodity prices and a weak dollar, corporate profits grew smartly. Following a modest gain of 6% in 2016, full-year 2017 earnings for S&P 500 Index constituents likely expanded by nearly 18% (the three reported quarters showed gains of +20%, +19% and +9%; the final period – to be reported in coming weeks – is expected to show an improvement of +17%).
Against this supportive backdrop, stock markets surged. The strongest results came from U.S. large caps, Japanese and emerging-market stocks – all advancing more than 20%; local-currency gains were more subdued in Europe, though dollar weakness boosted returns to U.S. investors. The S&P 500 posted positive returns in all twelve calendar months – a first-ever occurrence (though 12-month winning streaks not corresponding to the calendar year have happened several times). Volatility continued to be extremely low: the S&P 500 rose or fell by more than 1% on just eight trading days – the fewest since 1965 – and no cumulative market pull-back reached even the puny 3% level. The advance was characterized by remarkably strong breadth, with every S&P industry group finishing the year above its 200-day moving average. Investment flows into stock-related mutual funds totaled nearly $300 billion (compared to net outflows in recent years), suggesting the long-lived bull market had finally shed its reputation as ‘the most hated in history.’
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to give us the +6.6% S&P 500 total return?
|Fourth Quarter (October-December) 2017|
|+ Change in Earnings||+3.1%|
|+ Change in Valuation||+3.0%|
|= Total Return||+6.6%|
Our read: Price gains again outstripped (healthy) profit growth; further earnings expansion will be essential to validate elevated valuation.
Both the current economic expansion and bull market are getting long in the tooth, and it seems prudent to wonder how much longer either is likely to last. While economic and earnings growth seem intact, these fundamental pluses are set against lofty expectations, ebullient sentiment and frothy valuation. How investors react to the accelerating removal of extraordinarily accommodative monetary policies will be a huge wild card.
Benign economic conditions seem set to persist in the New Year. In the U.S., cyclical indicators like auto sales, housing starts and the ratio of leading to coincident economic indicators are all near multiyear highs – suggesting a downturn is at least several quarters away. And tax cuts seem likely to provide an extra near-term boost. Abroad, 2018 began with robust readings from Europe (where the manufacturing purchasing-managers’ index hit an all-time high) and Japan (where leading economic indicators were at multiyear highs). The outlook for China is murkier. Though recent purchasing-managers data hint at acceleration, the broader economy is set to confront mounting headwinds in the form of tightening credit conditions, enhanced regulatory scrutiny of the financial system, and intensifying efforts to shed excess industrial capacity and cut pollution. Any signs of weakness could quickly rekindle ‘hard landing’ fears (notably absent in 2017), with repercussions registering in the prices of industrial commodities and non-Chinese emerging-market financial assets.
Corporate profits should continue to benefit from the recovery in commodity markets and firm global growth. The corporate rate cut at the center of the tax-reform act will contribute a one-time boost to many sectors – variously estimated to add between 6% and 10% to 2018 aggregate profits. A reversal of the dollar’s 2017 weakness – a possible unintended consequence of tax reform – would dim prospects for U.S. multinationals and exporters later in the year. The perennially optimistic Wall Street consensus currently sees full-year profits advancing a robust 16%.
The withdrawal of extraordinary monetary accommodation surely poses the greatest risk to investors in the period ahead. This process will gain considerable momentum this year if solid economic performance allows the European Central Bank and perhaps even the Bank of Japan to join the Federal Reserve on the path toward what the Bank Credit Analyst has called a looming collision between markets and monetary policy. If bankers’ plans are clearly communicated, and economic developments allow the process to proceed as expected, investors may take it in stride – as they did the Fed’s moves in 2017. A potentially worrisome scenario could arise, however, if politically motivated fiscal stimulus in the U.S. (tax cuts boosted by an infrastructure-spending bill?) added superfluous ‘rocket fuel’ to an economy already running near capacity. A spike in bond yields, especially if accompanied by signs of rising inflation, could easily set off an unpleasant chain reaction in other markets, even if it didn’t prompt the Fed to slam on the monetary brakes.
The fundamental underpinnings of financial market performance – economic growth, corporate profits and (perhaps to a lesser extent) bond yields – all seem set to remain supportive. What’s not to like? you may ask. We see three obstacles. First, a rosy outlook is widely held among investors, in contrast to a year ago, when many expected 2016’s sluggish growth and heightened uncertainty to persist. Accordingly, whereas most of 2017’s surprises were positive, more may be negative this year. A related phenomenon is a marked change in investor sentiment. After spending much of the bull market in neutral territory, surveys of individual investors, investment newsletter writers, institutional money managers and consumers at large have all reached bullish extremes, suggesting many would-be buyers are already heavily committed to stocks. And finally, valuation is challenging. Happily, last year’s price gains were roughly matched by robust earnings growth, meaning U.S. stocks didn’t get more expensive. Unhappily, they were already pricey a year ago – within the top 10% of all historical readings.
None of the above means a market downturn is near at hand; that would likely require a notable deterioration in economic data, ballooning bond yields and/or a suddenly hawkish Fed, or an unforeseen ‘bolt from the blue’ (or a foreseen one from Pyongyang?). Present market conditions limit longer-term prospective returns and increase the likely magnitude of any correction. But just about anything could happen in the short run; a ‘melt up’ is probably at least as likely as a collapse. Accordingly, we will maintain constructive positioning with regard to stocks and other ‘risk assets,’ while carefully monitoring economic, earnings and bond-market signals for early signs of a negative turning point.
At the outset of the New Year we want to thank you for your continued support and encourage you to let us know what is on your mind. Please call or email any time.