As we close the door on 2017, we look back a bit surprised at the magnitude of the rise in global markets. Riskier assets appreciated almost across the board - perhaps no greater example of 2017 “animal spirits” is the headline grabbing emergence of cryptocurrency trading. For stocks, favorable earnings and low interest rates drove valuations higher and led to record highs for most indices. Bond markets struggled to find equilibrium while grappling with Fed rate increases and the magnitude/direction of inflation. As we head into 2018 it appears the economy is picking up steam as we will see in the paragraphs below.
There was a lot of optimism in 2017 from an economic standpoint. Most economic indicators continue to show positive trends, which drove the better than expected performance of stock markets:
• The unemployment rate dropped to 4.1%
• The pace of new home sales reached a 10-year high
• The ISM Manufacturing Index saw its highest reading in December since 2004
• Real GDP growth exceeded 3.0% in the second and third quarters despite the impact of destructive hurricanes in Texas, Florida, Puerto Rico, and the Virgin Islands
• Comprehensive tax reform legislation passed for the first time in over 30 years, designed to make U.S. businesses more competitive globally and putting more money in the hands of the consumer
• Financial conditions eased, in the face of a tightening monetary policy on behalf of the Fed
• Consumer confidence hit a 17-year high
The last three points, in our opinion, are the most important factors for markets moving into 2018 and beyond.
The chart below shows that the index used to measure financial conditions (the Chicago Fed National Financial Conditions Index) is showing the easiest financial conditions in many years:
This seems counterintuitive since the Federal Reserve has increased the overnight borrowing rate five times since the fourth quarter of 2015. The purpose of the Fed raising the overnight rate is to “tighten” financial conditions in an effort to keep inflation from heating up beyond their 2% target. Therefore, our interpretation is that banking and business confidence has improved due to strong deregulatory efforts coupled with the business-friendly tax reform bill. Banks are lending more freely with less restrained capital, many businesses are investing in future growth, hiring, paying bonuses, and consumer confidence is soaring as a result.
The next chart shows the quintile ranking of Consumer Confidence going back to the 1980s. A ranking of “1” represents a top 20% reading of consumer confidence. As you can see, we are in (and have been in for nearly 12 months) the top quintile of confidence readings. In fact, we are at the highest levels since before the 9/11 terror attack in 2001. With approximately 70% of the U.S. economy based on the consumer, you can see why the markets have been so jubilant, and may continue to be if this trend holds.
As of year-end, the GDPNow model forecast (from the Atlanta Fed) was projecting 3.2% real GDP growth in the fourth quarter of 2017, further reinforcing the strength of the economy.
U.S. Equity markets continued to rally in the final quarter of the year. For the fourth quarter of 2017, the S&P 500 posted a positive 6.6% return. For the full year, the S&P 500 returned 21.8%. The S&P 500 has now risen for nine consecutive quarters. As we indicated earlier, 2017 also logged the lowest year on record for market volatility (VIX Index) since tracking began in 1986.
For the fourth quarter, all eleven economic sectors in the S&P 500 posted positive results. The Consumer Discretionary sector was the best performing sector during Q4 (up 9.9%), with the Technology sector finishing in a close second (up 9.0%). Tech was by far the best performing sector of 2017 (up 38.8%). The outperformance in the Tech sector also led to a wide dispersion in performance between Growth and Value indexes. For the full year, the Russell 1000 Growth index (up 30.2%) outperformed the Russell 1000 Value index (up 13.7%) by nearly 17.0%, the widest variance since 1999 (chart above). Technology makes up 37.8% of the Growth index while only representing 8.4% of the Value index.
Though every sector posted a positive return in Q4, two sectors remained in negative territory for the full year. The Telecommunications (down 1.3%) & Energy (down 1.0%) sectors were the only two to finish in the red, but both performed positively in the quarter (up 3.6% & 6.0% respectively). Energy pared significant mid-year losses as oil rallied, though natural gas prices remained range bound. Telecom stocks were held back most of the year on continued price competition in the wireless industry.
For 2017, earnings growth for the S&P 500 will likely come in around 11.0%, so the remainder of the market’s performance has been from P/E or “multiple” expansion. According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is now 18.4x, which is above the 5-year average (of 15.8x). Given the current low level of interest rates and low inflation, it is not abnormal for stocks to trade above average historical valuations (chart to the left). However, if inflation were to pick up, stock market gains could be tempered as valuation multiples contract (P/E ratio declines), even while earnings continue to grow.
The stock market has enjoyed a lengthy period of positive gains with low volatility. If the low inflationary environment continues, coupled with corporate tax reform providing a boost to 2018 earnings growth, then stock market valuations seem very reasonable. However, we are keeping a mindful eye on factors that could disrupt the current environment. As always, our primary focus remains on seeking out high quality companies selling at a discount to our estimates of fair value.
U.S. Bond markets were off in the fourth quarter, falling 0.37% as measured by the Barclays Intermediate Government/Credit index (GVI). For the year, this index returned 1.83%. The 10-year Treasury yielded 2.4%, with 10-year municipals yielding 2.0%. As we often discuss, bond markets are primarily affected by changes in Federal Reserve monetary policy via the Fed Funds rate and inflation expectations. Three factors are being widely discussed in fixed income markets: how far will the Fed raise the overnight rate, how quickly will they unwind the $4.5 trillion balance sheet and the ensuing market reaction, and how both of these factors impact inflation expectations.
Regarding the path of the Fed Funds rate, the Federal Reserve maintains that market and economic conditions will determine how far they will go; i.e. they are “data dependent.” As of now, there is a virtual certainty, based on implied Fed Funds Futures probability, of an additional rate hike in March of this year. After that, investors are split on the timing, but at least one additional hike is priced in. If the Fed moves three or even four times this year, potentially taking the rate to 1.75-2%, we find it difficult to believe that bonds will rally. The Fed is basing its move on inflation and the chart below is the Fed’s Five-year Forward Breakeven Inflation Rate (where the Fed believes inflation will be in five years).
You can see inflation pressures building, and a somewhat dramatic increase in this reading in the last month of the year. Is this due to the fiscal stimulus expected from the Tax Reform bill? While difficult to be sure, it seems reasonable to believe investors anticipate growth will continue, labor markets could tighten, and inflation, at long last, may be on the horizon. If these readings stay at these levels the Fed has ample justification for further tightening policy.
We discussed the unwind of the Fed balance sheet in our last letter. We expect over the course of the next several years the Fed will allow up to $2.5 trillion to mature/roll off from its vast bond portfolio built up over years of quantitative easing during the recovery. So far this process has been absorbed by the market in an orderly fashion. In fact, somewhat surprisingly, the yield curve has flattened even with expectations of increased supply of issuance. The additional yield investors pick up from extending from a 2-year Treasury to a 10-year Treasury has shrunk to just 52 basis points, or 0.52%. This seems to us an asymmetric trade-off, as you increase your interest rate risk by more than a factor of 3 by moving out that far on the curve. Historically when the yield curve flattens in this manner, or even inverts, a recession is just around the corner. The chart below shows how the spread between 2s and 10s gets narrow or turns negative just before the economy rolls over (shaded area indicates a recession):
Notwithstanding an unforeseeable shock, we do not expect recessionary forces to materialize. Assuming this is the case, the yield curve should steepen allowing for reinvestment opportunities further down the road. If inflation expectations continue on its upward path, and Fed policy delivers as they have indicated, then the long-end of the curve should expect increased downside price volatility. We are positioning portfolios with an intermediate duration in this environment.
Several years ago, we wrote “the real economy will determine how the stock and bond markets perform in the long-term.” While simple, that truth is profound. Today again we recognize the political drama and its effect on short-term sentiment. Yet again, we acknowledge that economic and corporate fundamentals determine the overall trajectory of asset prices. Fundamentals, stronger than we’ve seen in years, certainly drove a portion of last year’s bounty while at least an equal portion came from strong sentiment. As we all know, sentiment can change suddenly.
We would be remiss if we did not take this opportunity to express our appreciation for another great year of
working together. The confidence you place in SS&A to manage your wealth is a unique honor and we
individually and collectively express our most sincere gratitude.