President Trump campaigned on the idea that he wanted to shakeup the political establishment in Washington D.C. From an investment perspective, we were concerned at the beginning of 2017 that any shakeup would knock the bull market, already in its late stages, off course. While the shakeup of “traditional politics” continues, the only shakeup in the markets seems to have been a reawakening of the “animal spirits”, exemplified by a soaring stock market, rising consumer confidence and business investment.
Global stocks, as measured by the MSCI ACWI Index, outperformed the S&P 500 for the year, posting returns of 23.97% and 21.83%, respectively. Over the fourth quarter though, the S&P closed the gap with its global counterpart, advancing 6.64% vs. 5.73%. Equity markets were in the spotlight this past year, and deservedly so, but both US and global fixed income markets posted positive returns despite the tremendous continued flows into stocks. The Bloomberg Barclays US Aggregate Bond Index returned 3.54% for the year while the Bloomberg Barclays Global Aggregate Bond Index returned 7.39%. Performance for fixed income markets mirrored the equity markets in the fourth quarter, as the US index made up some ground on the Global index posting a return of 2.24% compared to 2.02%.
By taking a closer look at the performance of the S&P 500, it is quite clear why equity investors have enjoyed the last decade. It is also apparent why concerns continue to mount about how richly valued stocks have become. The S&P’s 5-year annualized return of 15.8% is 48% higher than the index’s average annual return of 10.68% since 1971. What’s been fueling this bull market? For starters, inflation has not posed the challenge many pundits warned of following the Fed’s quantitative easing program. Given this low inflationary backdrop, the fact that a large part of the market’s return has been driven by “multiple expansion” is not a surprise. “Multiple expansion” refers to the increase in the price-to-earnings ratio of of the S&P 500. The P/E ratio over five years has increased 51.75%. In other words, at the end of 2012 investors were paying $14.82 for every $1 in earnings and at the end of 2017 the same earnings were being valued at $22.50. If inflation accelerates, or earnings growth does not live up to expectations, stock valuations will increase further.
The Federal Reserve continued to normalize rates in 2017, raising the Federal Funds rate three times over the course of the year—including once in the fourth quarter. The Fed’s tightening was not the only major development on the US monetary policy front: President Trump nominated Jay Powell to succeed Janet Yellen as Chair of the Fed. Powell will now head up an institution that has seen significant turnover in the Board of Governors over the last year. President Trump will have substantial influence over additional changes to the Board’s composition, which will ultimately determine the future direction of monetary policy.
As we look ahead at 2018, we pose three questions that we believe encapsulate some of the most important factors for investment opportunities and challenges in the near term.
Will equity markets ascend higher even as the unprecedented monetary accommodation of the last decade recedes?
Empirical studies of what the unprecedented quantitative easing program did (and did not do) to financial markets will persist for years, if not decades. Equity markets though, can likely write their conclusion now on the era of accommodative policy, which saw countless new records as corporate profits soared. In the US, normalization of monetary policy continued, yet the S&P 500, Dow Jones and Nasdaq posted double-digit returns in 2017. Keys to watch for in 2018 are how markets react to a more broad-based pullback in monetary stimulus and the effects of the Fed’s balance sheet reduction. If yields continue to rise in the US, investors who piled into stocks in search of higher yields may return to traditional fixed income investments which could lead to a cooling off in equity markets. However, if central banks take a more cautious approach than markets currently expect in 2018, a continuation of the equity market melt-up is certainly possible.
Will corporate tax cuts in the US supercharge growth and further spur a synchronized global recovery?
The GOP-led Congress got a big win in the last weeks of 2017 by passing tax reform legislation, the first major overhaul of the tax code in decades. A legislative victory is one thing—the real focus should be on whether it will be enough to jumpstart GDP growth and propel the world’s largest economy to new heights. Our belief is that the tax overhaul will provide a short-term boost to the economy, but its effects will peter out by 2019 and 2020. Since equity markets are forward-looking, strong jobs and GDP numbers to start 2018 could drive stock markets higher, at least for part of the year. However, if the effects of the economic stimulus from the tax bill seem like they will be short-lived, the second half of 2018 may see a true retreat in equity markets—something that was absent last year.
Geopolitical tensions filled the headlines in 2017 but were largely ignored by financial markets. Can that defiance continue in 2018?
Politics were hard to ignore in 2017. After an intense US Presidential election in 2016, followed by high-profile elections in Europe this past year, every event, both global and domestic, appeared to strike a political chord. Overall, markets embraced the good news emanating from the political sphere (business friendly policies, tax cuts, etc.) and frankly ignored or downplayed the bad (North Korea, rising debt in China, anti-globalization rhetoric, etc.). Will this persist? Booming corporate profits and the overall synchronized global recovery of 2017 outweighed many of the geopolitical tensions that popped up throughout the year. If this recovery falters due to renewed weakness in Europe, the debt bubble in China bursting, or increased trade frictions, it will become increasingly challenging for markets to climb higher.
Last year was certainly one to remember, but a single calendar year will not change our investment approach. With equity markets off to a hot start in 2018, we will continue to pursue opportunistic equity exposure where we see pockets of value. On the fixed income side, we will continue to favor shorter duration over longer duration securities as rates rise. And finally, we will continue to keep some dry powder in our portfolios to take advantage of any pullbacks or compelling buying opportunities that present themselves.
Carl Hall, CFA
Chief Investment Officer