2017 was an outstanding year for equities. Global growth was in sync for the first time since the 2008 recession with the world’s 45 largest economies all in expansion mode. This previously occurred from 2004 to 2007, a period also very good for stocks. Broad appreciation of global equities was supported by accelerated earnings growth in most markets and, importantly, led by the largest four: US, Europe, Japan, and China. Continued money creation from global central banks through quantitative easing (QE) also buoyed stock prices. While the US has begun a gradual QE winddown, central banks in Europe and Japan added another $2 trillion in liquidity in 2017. Despite the age of the expansion in the US, pro-growth policy changes in 2017, including deregulation and tax reform, indicate continued growth in 2018. We judge the likelihood of a recession in 2018 to be very low.
The S&P 500 notched its 9th consecutive quarterly advance (+6.6%) with continued low volatility. The worst drawdown of the year was a benign -2.8% from early-March to mid-April, making 2017 one of the least volatile years in history. Historically, years of extremely low volatility have been followed by some type of a correction, particularly when inflation re-emerges, which typically lags economic strength by about two years. Following the mid-cycle slowdown in 2015, our economy picked up momentum in early 2016 and accelerated in 2017. So, we reason that higher inflation this year would not be a surprise. This also supports the Fed’s planned rate hikes in their quest to get back to “normal”. Market volatility tends to be low in periods of Fed accommodation, but increases as monetary policy becomes more restrictive. Our outlook for 2018 generally includes increased market volatility propelled by higher inflation, higher short and long-term interest rates, and a meaningful reduction in the Fed’s balance sheet.
Interest rates have been in a long-term secular decline for 35 years. The yield on the 10-year US Treasury peaked in 1981 at 15.84% and declined to an all-time low of 1.36% in 2016. Today’s 2.50% yield is almost double the low, yet is far below the 50-year average of 6.45%. To make matters worse for bond investors, the real rate of return (adjusted for inflation) over the past 5 years has only been 0.35% per year compared to the 50-year average real return of 2.37% per year. Why are real rates so low? The Fed and other global central banks have taken extreme and unprecedented measures to suppress interest rates. Where would rates be without intervention? It’s impossible to know exactly, but, with the Fed removing stimulus and inflation moving above 2% this year, the likelihood that the 10-year US Treasury yield reaches 3.00% is high. While this increase will hurt bonds with longer maturities, it will allow investors to buy bonds at more attractive rates. Eventually higher interest rates could negatively impact other asset prices (stocks, real estate, etc.) as discount rates and higher financing costs are digested.
We do not believe a recession or bear market is likely in 2018. First, recessions rarely occur in a year that starts out with leading economic indicators as strong as they are today. GDP growth is likely to be stronger in the first half of 2018 than it was in 2017, the best growth year in this nine-year expansion. Next, bear markets have historically been a function of three sources: protectionism, bubbles, or inflation. While there was great concern that President Trump would make a dramatic leap toward protectionism, the harsh rhetoric of the campaign has toned down and the likelihood of real disruption has faded. Asset bubbles result from market euphoria pushing prices to unseen heights and then crashing back to reality. While we believe all types of assets are highly valued in today’s market, the likelihood of a bubble causing a bear market in 2018 seems remote. Though we expect inflation to pick up significantly this year, we don’t expect it to do significant damage to markets. Historically, rising commodity prices (oil, copper, steel, etc.) have squelched growth at the end of an economic cycle. Today, commodity prices are far from prior peaks, and in some cases, just now bottoming after the last recession. Wage inflation is likely to pick up with tighter labor markets, however, we don’t believe labor costs will rise enough to severely impact earnings and push us into a bear market.
- Stocks globally were up (↑24.3%). Outperforming were International Emerging (↑32.1%), International Small Cap (↑30.0%) and International Developed (↑25.3%). US Large Cap (↑21.6%), US Mid Cap (↑18.3%), and US Small Cap (↑14.5%) lagged the global benchmark. Value stocks significantly underperformed growth stocks in 2017.
- Looking ahead, global earnings reports continue to be strong, particularly in the US due to tax cuts, which should support stocks through year-end. However, with valuations and investor complacency high, risks are elevated. We continue to invest with caution despite the near-term outlook which has improved markedly over the past few months.
- Broad market bonds (↑3.6%) returned above-coupon returns as spreads continued to narrow despite higher interest rates in short maturities. Investment Grade (↑6.5%) and High Yield (↑7.5%) corporate bonds performed well as credit spreads tightened back to 2014 levels. Municipals (↑5.4%) performed well as non-traditional buyers entered the market and pushed down yields. Bank Loans (↑4.3%) earned their coupon but were not helped by their zero duration in a market where spreads were flat. Emerging markets sovereign bonds (↑10.1%) performed best, earning high coupons and benefiting from additional spread tightening.
- Looking forward, bond returns are likely to face continued headwinds in the form of higher interest rates, which will keep total return at or below coupon return.
- On a risk-adjusted basis, our Alternatives portfolio (↑7.0%) performed well in 2017 with all three components up: Hedged Equity (↑10.3%), Managed Futures (↑6.4%) and Multi Alternatives (↑4.5%). This return was achieved with less than half the risk of the stock market.
- We believe the biggest contributors to performance over the next few months will be those with the most exposure to equity markets, yet continue to believe it is important to diversify into strategies with low or no correlation to stocks over the longer term. Alternatives will continue to serve an important role in the portfolio by reducing exposure to the negative effects of stock price volatility, interest rate increases and downside participation.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer