A year to remember.
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It was a most extraordinary year. It started fearful and ended exhausted but exuberant. In January, stocks were in a “show me” mode. The brief post-election rally fizzled, bonds tracked sideways and only the dollar was showing any sign of weakness. But markets then took a calmer look. The givens were that the Fed was going to move slowly and announce clearly. No surprises and no drama. It was the opposite in Washington but markets seemed to distinguish bluster from threat. And anyway, one consistent motif was that government was going to go light on business regulation, cut taxes and spend on infrastructure. In the end they delivered on two out of three, although we’d be the first to agree, it was a messy process.
Overall, we’d point to three main themes:
1. Supportive Monetary Policy: From March on, we had only minimal and short-lived corrections. For the year, the S&P 500 was up 22%, international markets +25%, long and short-term Treasuries +7% and 1% respectively and Emerging Markets +38%. From mid-year on markets never looked back. It was also a year when there was a noted absence of volatility. We were not surprised. Volatility in the past was often the result of the Fed playing its cards close and keeping markets in suspense. This time, the major central banks led by the Fed but closely followed by the European Central Bank and Bank of Japan, flagged their intentions loud and clear. Meanwhile, we saw steady and synchronized growth across the world.
2. Corporate Profits recovery: But perhaps the most important feature of 2017 was that companies delivered on growth. For some years, we’ve seen U.S. companies produce decent earnings growth through a combination of share buy backs and financial and tax management. This was fine as far as it went but the fashion for big buy backs was on the wane going into 2017. Investors wanted real growth and they got it in 2017. We saw corporate earnings for the S&P 500 grow around 10%. All sectors participated including energy and commodity stocks, both of which had a tough couple of years. Only one industry sector had a negative return: telecomm, which found itself in the middle of a price war.
3. Global Growth: Europe finally started to perform as the monetary easing fed through to the real economy. Two major elections in Germany and France returned centrist, pro-growth governments. Japanese stocks had a very strong year, up 19% (but up 23% to a U.S. investor). Why? A successful reelection by a popular Prime Minister, pro-inflation policies and a pick up in world trade.
So what’s ahead for 2018? As we write this in the first week of trading in the New Year, we’ve seen all major markets run ahead. Some of that is a reaction to the tax changes rushed through in the last days of 2017. Although the plan runs to 400 pages, its central tenet is lower corporate taxes. For many companies, especially if they are more domestic than multinational, the 15% tax decrease falls straight to the bottom line. Companies will start to talk more about the effects of a lower tax in the upcoming earnings season. But for most, there will be very little downside to the changes.
Elsewhere, this is what we see running in 2018.
1. World Economy upswing. Global growth is moving along at 4% or so, up from 3.5% in 2017. The sheer size of the U.S. economy, some 25% of the world economy, looks like it will break through the 2% growth pattern we've seen for years and could grow at 2.5%. In the last three quarters of 2017, growth exceeded 3% but that may be unsustainable given recent trade numbers.
Emerging Market economies should have a strong year. China will grow at around 6% but more important, Russia and Brazil will recover from years of low energy prices and consumption. Japan will remain a huge beneficiary of global growth and we expect higher inflation and wage growth to support the domestic side of the economy. The EU is still early in its growth cycle. Many European multi-nationals will benefit from U.S. tax reform and corporate margins and profitability remain well below their 2007 peak. Plenty of room for upside.
2. Interest Rates. The Fed will raise rates. The unemployment rate will remain around 4% and most of the Fed believes that a tight labor market means higher wages and prices. Of course, neither of the last two has happened and we don't expect them to. But the FOMC is more hawkish in 2018 than 2017 and several seats remain unfilled. So expect two to three rate increases this year. But, two important points:
1. When interest rates rise, equity declines are rare. In other words, higher rates mean a better economy, which is good for stocks.
2. If rates increase gradually, which is what we think will happen, bond markets and prices adjust. And total returns will remain positive.
We also believe rates will remain low globally. Other major central banks are three years behind the Fed in tightening. We expect German and Japanese long bonds to remain well under 1%.
3. Equities will outperform bonds. This may not sound like a high hurdle but equities here and overseas remain attractive compared to bonds. International markets are cheaper than the U.S. (even after adjusting for different industry weightings) and companies are still generating strong cash flow and paying and increasing dividends. We would look for an 8% improvement in U.S. stocks and stronger numbers overseas.
Some portfolio changes. We reduced our allocation to Treasury Inflation Protected Securities or TIPS and reinvested into longer-term U.S. Treasuries. We also will continue to take some profits on U.S. REITs, and allocate money to Asia-Pacific markets and international small cap.
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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.