“Diversify and rebalance. They don’t invite me on the television, because my message is, don’t look at television, just diversify and rebalance.” Harry Markowitz, Nobel Laureate and ‘father’ of Modern Portfolio Theory
What a great year for investors. As Harry Markowitz noted in a recent interview, diversified investors across equity regions, styles and credit sectors had a strong year. Of particular note was the banner year enjoyed by international stocks, as improving economic conditions, strengthening currencies and central-bank policies provided support for stocks. The year 2017 was also notable for some things that didn’t happen, most importantly in Europe. Rising nationalist sentiments that threatened the Eurozone market hung over elections last year; we’re happy to report that investors’ worst fears were not realized, and stability prevailed in elections and the markets. The U.S. is also battling those forces, but market optimism supported domestic markets as well. Here’s a snapshot of returns in 2017:
We began 2017 with some trepidation due to the then-upcoming global elections and prospect of the end of ‘easy money’ policies by key central banks, which have promoted a rotation to riskier assets (i.e. stocks). The surprising election of Donald Trump and the ‘Trump rally’ following the 2016 U.S. elections promised good things for U.S. stocks, but the global knock-on effect was less certain. As we can see below, the year began well for most assets; global stocks roared out of the gate and didn’t look back. U.S. large-cap indices, powered by technology stocks, were positive in every month and posted five months with returns greater than 2%. International stocks, represented by the MSCI ACWI ex USA index, were also positive for every month of 2017; six of those months were above 2%. They were in turn powered by emerging markets stocks, positive in 11 of 12 months and over 2% in nine months. Clearly, positive global data trends led to high expectations and some ‘rational exuberance.’
Bonds, particularly high-quality U.S. issues, took a different path. Expectations for higher growth and higher inflation after the 2016 election began pushing yields higher by the end of 2016. The U.S. benchmark 10-year Treasury initially rose. Concerns over slower Fed rate hikes, Trump administration policies and lower growth and inflation expectations pushed rates lower by mid-year. Clarity on the Fed’s end to quantitative easing and its plan to reduce its balance sheet, in conjunction with a continuing expansion and passage of tax legislation, then pushed rates higher by year-end 2017. The yield curve began to flatten and rates are expected to rise after a year of ‘clipping coupons.’
“If you knew the future you wouldn’t need portfolio theory.” Harry Markowitz
We believe the broad economic environment is one of the two key sources of market optimism. What we’re seeing is a global expansion with synchronous growth for the first time in years. This graph below of the Purchasing Managers Index (PMI) is a succinct example. A reading over 50 for this index is considered expansionary; this graph is separated by region, with key economies highlighted. If the adage ‘A rising tide lifts all boats’ holds true, then the tide appears to be coming in.
One important fact to note is the U.S. is considered to be late in its growth cycle, but many other countries listed above are still in early growth stages. This is a good indicator of a longer-term global expansion. Also of note is that the Eurozone is a top trading partner of the U.S., and is beginning to show signs of acceleration. Finally, investors may benefit as non-U.S. stocks rotate into a strong market cycle as the U.S. cycle begins to reach maturity.
These expectations have led to slight increases in expected returns for global GDP in 2018. The dispersion of forecasts (the table below is from November) indicates that the U.S. is expected to continue its late-stage expansion, with other regions still positive but at lower growth than estimated for 2017. Some forecasts were revised to account for the passage of the Tax Cuts and Jobs Act of 2017, which is expected to provide a one-time boost to U.S. GDP to the 3% level. Reviews on sustained longer-term U.S. growth are still being compiled.
In the U.S., we see positive signs for consumers and investors. Consumer confidence is rising, which has positive implications for consumption (the largest component of GDP). Also, median household income had its best two-year growth period in 50 years, and household net worth is rising as well.
Finally, equity-earnings estimates are rising as well. Investors should be particularly pleased that, after years of moribund returns and forecasts, the global expansion is reaching Japan. Emerging markets, which are an area of dynamic growth, are enjoying higher forecasts due to a weakening dollar, growing national wealth and a shift to domestic production and consumption (China).
In sum, the 2018 forecast is good for global stocks and flat for bonds. Growth and earnings are expected to be positive. Earnings will matter most in the U.S., and Fed policy will also have an effect.
“Capitalism has a fatal flaw — it gets sick and recovers, gets sick and recovers.” Harry Markowitz
Of course, no assessment of a growing global economy and expected stock returns is complete without some cautionary data. As the old saying goes, “Bull markets don’t die of old age, they die of fright.” Here are some of the data we see that suggest keeping expectations in check:
- Stocks aren’t cheap: The long U.S. expansion and market recovery, supported by low interest rates, has driven stock prices higher. The top data in this table (with lower numbers being better than higher ones) indicates that U.S. stocks are in the top quartile of expensive valuations over the past 20 years. Other regions, particularly Japan and Europe, are more favorably priced.The bottom data indicates that, relative to the other three regions listed, U.S. stocks are also expensive. As with the top of the table, this implies that investors may find better valuations in other regions’ developed and emerging markets.
- U.S. rate hikes: Another area of concern is the dislocation between market and Fed expectations for rate hikes. As this graph shows, the market is pricing in a more benign hike cycle than the Fed is forecasting. This may be due to lower inflation and growth expectations on the part of the market. History warns that expectations and surprises determine returns, and if the Fed raises more aggressively than the market anticipates, then stock and bond markets may react negatively.We will also note that, if the Fed raises rates in an orderly fashion (i.e. no ‘surprise’ unannounced hikes or moves greater than 0.25%), bond investors may do well by the end of the cycle. This graph demonstrates some historical rate-increase periods (based on changes in the federal funds rate) and the returns on the high-quality U.S. Aggregate Bond index:
The 1994-95 period, the orange bar in the middle of the graph, was notable due to an unannounced hike of high magnitude. Predictably, the market reacted swiftly and unfavorably. The two periods on the far right of the graph reflect results when well-communicated, gradual hikes occur. We think this is a more likely scenario than the mid-1990s.
- Inflation: As we have noted previously, some inflation is good for growth and wages. Keeping inflation at a level of 2% is one of the Fed’s dual mandates. For the past few years, inflation has been stubbornly low, both for goods and wages. At this point in the growth cycle, that may change. As this graph shows, we are in one of the longest expansions on record, and wage inflation (the orange line) has begun ticking up.Further improvements in the unemployment rate, another statistic closely watched by the Fed, are expected to be limited. A number of reasons are offered, including a skills gap (i.e. applicants don’t have the skills required for the position), an increasing use of technology in manufacturing and higher resulting productivity per worker. Employers may have to offer higher wages to attract skilled workers. If price inflation remains low but wage inflation begins to heat up, this could prompt the Fed to accelerate its hiking cycle and upset markets.
“There are two kinds of people — ill-advised and well-advised. The ill-advised watch Jim Cramer yell at them on CNBC. I may be enthusiastic but I don’t yell advice.” Harry Markowitz [With our apologies to Jim Cramer]
Our advice is consistent and delivered in normal tones: plan for the future, and adjust your plan when necessary; control the things you can; keep investment fees low; diversify and periodically rebalance portfolios. Trying to guess about market moves and ‘hot’ investments will derail any financial plan and impair investors’ probabilities of reaching their long-term goals.
Based on the data we see, we expect the global recovery to continue. Our long-term optimism is unshaken, and 2018 looks like it will be another good year for investors, but perhaps not as robust as 2017. We expect a continuing expansion in the U.S. and abroad based on these views:
- Structural changes in Europe and Japan are supporting higher growth and earnings, and markets are reacting favorably.
- Emerging markets, which make up a growing share of global GDP, are also benefitting from the growth environment. China in particular is transitioning to a domestic-consumption economy, which has major implications for their internal consumer-goods production and countries that export there.
- Stocks in the U.S. and abroad, despite current valuations, have some room to run.
- We think U.S. interest rates will be range-bound this year and that the Fed will hike three times; balance-sheet reduction concerns and surprise inflation are possible headwinds. Tight credit spreads resulting from easy monetary policy and the global search for yield are also a concern. Foreign yields will also remain low due to central-bank policies.
Our concerns are that the U.S. midterm elections are shaping up to be contentious, and portend a possible policy shift and more aggressive opposition to President Trump’s agenda. We’re also becoming concerned about the collapse of trade negotiations, especially with respect to NAFTA. Finally, geopolitical issues, particularly in Asia, are very difficult to predict and are always a threat.
We remain globally diversified in our portfolios, and our efforts will be focused on reviewing credit and equity risks based on our forecast for an eventual slowdown. We expect a good but more volatile environment for global equities, and will maintain exposure in our diversified core and index holdings. Bonds will benefit from credit diversification. Finally, we think now is a good time for investors to review their risk profiles and cash needs, and be prepared to make portfolio or plan changes as necessary.
As always, we welcome your comments, questions and feedback. We wish you and your families a healthy, happy and prosperous new year.
—Your Wealth Management Team at JJ Burns & CompanyDownload Market Commentary
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