It all came together for financial markets in 2017: accelerating earnings growth, marked improvement in sluggish overseas economies, benign interest rates, improving consumer confidence, and a big tax cut for US businesses heading into 2018. These trends propelled equity markets to strong gains in all geographies, leading to a gain in the MSCI All Country World Index (ACWI) of 24% in US dollars.
Importantly, these gains were achieved with little of the normal anxiety that come with owning stocks. Much has been written about the absence of volatility in stock prices in recent years, and 2017 continued that trend. Indeed, last year was the first year ever in which the S&P 500 recorded a positive total return in each calendar month.
There was very little not to like for US investors in 2017. The dollar index fell almost 10% in 2017, boosting the returns of foreign markets for dollar-based investors. Equity markets were led by a 37.8% comeback in emerging markets after years of disappointing results. Japan, long the whipping boy for global investors, jumped 24.0%. Fueled by an aggressive ECB, European economies started to show signs of life and equity investors were rewarded with a gain of 25.4%. The S&P 500 rose a healthy 21.8%, but failed to keep pace with overseas markets for the first time in years.
Bond markets performed better than expected, as investors absorbed three rate hikes in 2017 and inflation remained tame. The bellwether 10 year US Treasury bond finished the year almost exactly where it started, at a yield of approximately 2.43%. High yield fixed income again delivered better returns than their investment-grade counterparts. Domestic real estate posted modest gains, but were outshone by strong returns in international real estate, whose performance was also helped by a weak US dollar.
About the only place to suffer losses was in energy Master Limited Partnerships (MLPs), which suffered from declining distribution levels and souring investor sentiment. With oil prices stabilizing in the high $50’s, MLPs rallied sharply in December, but still finished with high single-digit losses for the full year.
Outlook and Strategy
First, the good news: despite the strong gains posted by stocks around the world, corporate earnings growth was also robust, helping to keep price-earnings ratios from rising further into overvalued territory. As an example, Asian companies recorded an aggregate 23% growth in earnings in 2017. So despite the MSCI Emerging Markets Index rise of 37.8% last year, emerging market stocks remain reasonably valued at 13.5 times 2018 expected earnings. In the US, earnings grew an estimated 9.6% last year and are expected to rise another 11.8% in 2018. Strong earnings growth, aided by the new lower corporate tax rate, should continue to support relatively high valuations levels among US stocks.
Many investors are wondering how long the party can last. After all, since the US market’s nadir on March 9, 2009, the S&P has risen at a compounded annual rate of 19%, about double its long-term average. Despite investor nervousness, strong gains in US stocks are usually followed by another up year. The S&P 500 has risen 20% or more in 26 calendar years since 1943, and followed that up with gains in 20 of the subsequent years. The average gain following those big up years was 12%.
From a fundamental perspective, things remain on a solid upward trajectory. Deregulation and tax reform in the US has instilled a new level of optimism in corporate America which should translate into a bump in capital expenditures. Consumer spending during the critical holiday period appears to have been strong. Internationally, economies are growing at rates not seen since the Great Recession in the last decade. In short, we see few of the traditional warnings signs that would lead to an economic downturn.
Outside of an unexpected geopolitical crisis, it seems that the greatest risk to asset prices is a burst of higher inflation accompanied by a spike in interest rates. The bull market in stocks has feasted on an environment of very low interest rates, helped by the Fed’s desire to maintain a very easy money policy as the US crawled out of the worst recession since 1929-32. We expect to see 3 or 4 more rate hikes in 2018 as the Fed restores a more “normal” policy environment and attempts to restrain the prospect of higher inflation. How they manage this transition will be critical to the performance of financial markets in 2018.
Our view remains largely positive for equities in the coming year. We continue to believe that emerging markets are the most attractive geographic region for equity investors, with particular emphasis on Asian equities. Our base case is that interest rates move higher as the Fed lifts the short end of the yield curve, but not enough to seriously threaten the outlook for US stocks. We look for continued modest improvement in European and Japanese stocks. Bonds should continue to deliver steady income, with the possibility of some price erosion as rates rise. With oil prices recently breaching the $60 level, we expect a strong year for energy infrastructure.
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