Q4 2017 Market Perspective
On behalf of the Altium Investment Committee;
Global equity markets were in rally mode all year long and the bull market has continued into 2018. Synchronized global economic growth, accommodative central bank policy and low market volatility are a few of the key drivers supporting this market rally.
It seemed as though all year long we had to convince ourselves that it was OK for this rally to continue. As students of investor behavior, we understand that staying the course can sometimes be an uneasy feeling. As your advisor it is our responsibility to remove emotional biases that can derail a sound long-term investment strategy. In this communication, we will discuss many of the key factors that we will be watching in 2018.
We know that recessions occur naturally as part of a normal economic cycle and we do anticipate market volatility to pick up when the economy contracts, however, it is unknown as to when the next recession will occur. That being said, we firmly believe that time in the market is more important than timing the market. Importantly, our confidence stems from the work put in by our investment committee to construct portfolios that utilize proprietary models, which incorporate our perspective and forward-looking capital market projections. Ultimately, we want to focus on the factors we can control, specifically: asset class diversification, tax efficiency as well as risk and cost mitigation. Further, we strive to protect your portfolios from the factors outside of our control.
We look forward to continuing this conversation throughout the year and working on your behalf in 2018.
KEY HEADLINES DURING 2017
Stocks rally globally & bonds are stable
Equity markets rose in 2017 with international stocks leading the rally. Large cap U.S. stocks, international developed market stocks and emerging market stocks were up 21.9%, 25% and 37.3%, respectively, in 2017*.
Bonds continue to provide income and stability to portfolios. The 10yr U.S. Treasury yield was relatively unchanged for the year (ending at 2.4%), while the Barclays Aggregate Bond Index was up 3.5% for the year.
Yield curve flattened but remains positively sloped
The U.S. Fed raised short-term rates three times in 2017 and has indicated its plans for three additional hikes in 2018. This is in line with consensus market expectations.
Short term U.S. Treasuries increased in tandem with the Fed rate hikes, however, yields on the 30 year Treasury decreased roughly 10% (or 0.3%) during the year.
The spread between the 10yr and 2yr U.S. Treasury, while continuing to trend lower, ended the year positive by 0.50% (An inversion would occur when this spread becomes negative).**
Rising short term interest rates and potential inversion of the yield curve
We expect to see increasing short-term rates driven, in large part, by the U.S. Fed, which will be under the leadership of its new Chairman Jerome Powell. Assuming three potential rate hikes of 0.25% it could mean short-term rates increase by 0.75% during the year.
As we have said throughout 2017, we will keep a close eye on the yield curve. With only a 0.50% positive spread between the 2yr and 10yr Treasury, it is possible that we get closer to inverted territory towards the end of the year. For example, this would occur if the 10 year yield remained flat (as it did in 2017) and the 2 year yield increased by more than 0.5% (it increased 0.67% in 2017).*** An inverted yield curve has historically indicated that the economy is nearing a recession.
Inflation & the U.S. Dollar
Inflation has been contained despite the Fed’s aggressive accommodative policy. In November, Core CPI was up just 1.7% and it has averaged just 1.76% since this latest economic recovery started in 2009****. Inflation tends to be an indicator of a late cycle economy, so a material pick-up in inflation could bring volatility back into the equity market.
During this recent period of low inflation, the U.S. Dollar has remained strong until recently. A strengthening dollar tends to keep inflationary pressures at bay, such as commodity prices. Should weakening of the Dollar coincide with rising Inflation we could expect additional strain on the economy, which has been creeping closer towards a contraction.
Beneficiaries of a declining Dollar and rising inflation would continue to be commodities (and those industries tied to commodity prices) as well as emerging markets, which are highly correlated to commodity prices.
Details emerge on benefits of tax reform
Who will be the primary beneficiary, if any, to the recently passed tax bill? The expectation is that lower corporate tax rates will improve corporate profitability and drive business in and to the U.S. (theoretically positive for stimulating economic growth).
The bigger unknown is how the tax bill will impact the end consumer. Ultimately, we believe it is the consumer who will determine economic growth as personal consumption is the largest component of GDP (GDP is one of the primary indicators used to gauge the health of the economy).
Global growth and maintaining global equity diversification
Economic growth was persistent across the major global economies in 2017. As result, global stocks (as measured by the MSCI ACWI Index) experienced gains every month in 2017. With central Banks expected to continue their accommodative policies across the globe, expectations call for continued economic growth.
While we traditionally maintain a home country bias in our portfolios, or overweight to U.S. stocks vs. international stocks, we continue to recommend having both international developed and emerging market allocations. Allocations to these asset classes improve the benefits of diversification to portfolios.
The market generally attempts to discount what it knows or at least can anticipate which unfortunately includes things such as a potential conflict with North Korea and random acts of terrorists. However, the unknown can shock the market, which is why we continue to stress the important role that more stable assets (such as certain fixed income assets) play in portfolios.
We believe using backward looking earnings multiples to predict future results is unreliable at best. When looking at forward-looking earnings multiples, we believe it is clear that economic growth and increasing corporate profits should keep multiples from becoming “over-valued”. The debate over whether the market is fairly valued or over-valued should continue all year.
Stocks and indexes are often valued using a Price to Earnings (P/E) ratio which looks at the price of a stock or index relative to its actual (historical) or estimated (forward-looking) earnings per share. It is important to understand that when using a P/E multiple the perceived value of an investment is directly related to its price movement and its earnings expectations. Therefore, if prices move up considerably (as they have in this bull market) and earnings do not grow at a similar pace, an investment may reach historically high multiples. We continue to monitor market valuation, however, we have seen a steady increase in consensus S&P 500 earnings estimates for 2018 and therefore we do not expect concerns over valuation to be a drag on the markets in 2018.
AN UPDATE ON ALTIUM
2017 was a significant year of growth for Altium and we expect to surpass many milestones as a firm in 2018. Construction is currently underway to double our office space and we anticipate our team growing towards 50 employees by the end of the year. In addition to the growing team, we have made significant investments in new technology and resources that will enhance the capabilities of the various departments within the firm. In particular, material enhancements have been made to our portfolio management platform and reporting solution.
We would like to take this opportunity to thank all of you who continue to support Altium and our mission of empowering the pursuit of fulfillment for our clients, our industry and our community.
We hope that you all had a wonderful Holiday Season and are as excited as we are about the upcoming year.
Gregory Slater, CFA®, CFP®
Chief Investment Officer
Chart A) 2017 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2017 total return, International, emerging market, S&P 500, Barclays Agg indexes
* LC US stocks = S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
** Yield curve; spread between the rate on 2yr. Treasuries and the rate on 10yr. Treasuries
**** Core CPI. https://tradingeconomics.com/united-states/core-inflation-rate
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