An escalating war of words between two nuclear-armed countries….the Federal Reserve’s plans to continue tightening monetary policy……the unpredictable actions of a novice U.S. president…..diminished expectations for the new administration’s pro-growth economic policies.
One might think that these headlines would cause a degree of anxiety among investors, but financial markets digested these and other negative headlines with hardly a blip in the third quarter, continuing its yearlong streak of complacency. The S&P 500 has yet to post a single down day of more than 2% this year, the first time since 2005. In the turbulent days of 2008, that number exceeded 70. In fact, 2017 has so far registered the smallest drawdown (a decline from peak to trough) in any calendar year going back to 1914. The S&P 500 finished the quarter at another all-time high.
And investors’ slumber was not confined to just the United States. The broad global stock market index (MSCI All Country World or ACWI) has now gone 328 days without a correction of 5% or more. If the streak is extended through October, it will be the longest run in 30 years. It has been 6 years since a true “correction” of 20% or more, triple the median time.
The S&P 500 gained another 4.5% in Q3, raising its total return to 14.2% in 2017. Continuing a trend that began earlier in the year, overseas developed markets outpaced the U.S., while emerging market stocks were even bigger winners. The MSCI EAFE Index of developed market equities has gained 20.0% through September 30, while emerging market equities have surged 27.8%.
Interest rates remained subdued, despite the Fed’s continued efforts to “normalize” monetary policy. As a result, fixed income securities delivered solid returns. A broad measure of U.S. fixed income (Barclays U.S. Intermediate Gov’t./Credit Index) is up 2.3% on a YTD basis. Municipal bonds outperformed taxable, gaining 3.9% so far this year.
Outlook and Strategy
Underpinning the rally in asset prices has been a sustained decline in the value of the US dollar. A weaker dollar helps US multinationals compete in overseas markets, and boosts reported earnings when overseas profits are translated back to greenbacks. The dollar’s weakness has been driven by: 1) concern about a widening federal budget deficit resulting from proposed tax reform legislation; and 2) accelerating growth in Europe which has made the steady growth rate in the US look relatively weak. Despite the Fed’s intention to continue to raise rates (which is normally bullish for the currency), the dollar has fallen about 9% this year.
Having just navigated the most turbulent month of the year in historical terms (September), past history would indicate a relatively smooth ride for the remainder of 2017. According to a study published by the Leuthold Group, since 1928 there have been 29 Septembers in which the S&P 500 made a 12-month high (including this year). Following those prior 28 instances, the market rose over 80% of the time in the fourth quarter, averaging a 3.7% increase.
Nevertheless, the old market adage that “investors climb a wall of worry” has perhaps never been more apt than today. Despite the steady rise of stock prices, investor sentiment is neutral at best, absent the euphoria that typically accompanies extended market rallies. Having reduced our recommended global equity allocation to neutral earlier this year, we remain cautiously optimistic about the outlook for the foreseeable future. Our optimism is supported by a continued recovery in corporate earnings that is expected to continue into 2018 (albeit at a slower rate of improvement) and improving growth trends outside of the US. Even after seven years of economic expansion, an imminent recession in the US looks unlikely.
In our view, one important key to the future direction of stock prices will be the level of interest rates, both here and abroad. If rates remain around current levels, we could see further upside in stock prices as tax reform unleashes a source of cash that could be used to boost capital expenditures. On the other hand, higher interest rates caused by an explosion in federal borrowing could slow down corporate investment and encourage a reversal of fund flows out of equities and back into fixed income.
In any case, this is not the time to be lulled into complacency. With equity valuations stretched, a single event could dramatically change the investment landscape. Complacency will one day give way to anxiety, and investors need to be mentally prepared. Long-term investors may actually welcome a modest pullback, as it will likely create tax-loss harvesting opportunities and reset the bar for higher returns in the future.
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