4Q 2017 Commentary: Year in Review
2017 was a very strong year for capital markets worldwide. From the get-go, both equity and fixed income markets advanced upward in a deliberate manner, with historically low volatility. Years like 2017 should be considered the reward for those who invest for the duration and who sometimes must suffer through uncertainty and volatility in order to reap the rewards of long-term investing. Throughout the year, there was undeniable uncertainty by way of the political landscape, the trend of nationalism and protectionism in Europe, and of course threats of terrorism and rogue regimes. That said, the market shrugged it all off and instead focused on fundamentals: a strong rebound in global economic and corporate earnings growth. 2017 was so impressive for capital markets, that all four quarters delivered positive returns for both U.S. stocks and bonds.
Aside from strong market returns for the year, here are some of the highlights from 2017 that deserve consideration:
- It was the worst year for the dollar since 2003.
- The Fed raised interest rates three times in 2017 referencing an improving economy and labor market.
- GDP accelerated throughout the year along with falling unemployment rates.
- The Trump administration attempted and failed to repeal and replace the Affordable Care Act.
- The administration was able to pass tax reform for both corporations and individuals.
Looking forward into 2018, the following factors will be worth paying attention to:
- New Fed President Jerome Powell takes over Janet Yellen’s post in February.
- The effect of the new tax reform package.
- What happens with the Russian probe and its effect on the administration.
- Mid-term elections at the end of 2018 could greatly effect policy going forward.
- Escalation or de-escalation of our conflicts with North Korea and others in the Middle East.
The big story for the stock market in 2017 was that volatility was almost nonexistent. From peak to trough, the worst drawdown for the S&P 500 Index throughout the entire year was -3%. On average, the S&P 500 Index has experienced an intra-year decline of 13.8%* since 1980. Obviously, years like 2002 (-23%) and 2008 (-38%) skew things, but the take-away here is that we do not expect the lack of volatility to continue. In fact, as money managers, we need volatility to create opportunities. An example of this would be deploying cash on market dips or taking a new position in an asset class after it drops significantly.
During the year, certain asset classes and sectors turned in spectacular returns while others struggled. Foreign markets on the whole outperformed the U.S. market. This has been a long time coming, and was primarily driven by lower valuations and a weak dollar. We maintain that foreign equities are more attractive than their domestic counterparts at this time based on several factors including monetary policy, valuation metrics, and accelerating economic and earnings growth statistics. Our client stock holdings are currently allocated approximately 70% U.S. stock/30% foreign stock.
As we look ahead into 2018, we expect increased volatility and most likely a normal market correction. Additionally, U.S. market valuations are slightly above historical norms. Therefore, market returns could still be solid but certainly not as easy to come by as they were in 2017. With tax reform, improved economic data, accelerating corporate earnings growth, low inflation, low unemployment, and strong business and consumer confidence it is hard to make a case that the best of things are behind us.
Fixed Income Overview:
Bond investments turned in solid returns during 2017 as interest rates were relatively subdued. There were minor bouts of volatility during the year primarily driven by inflation data and Fedspeak, but the feared spike in interest rates and the selloff in bond prices was evaded. The year began with the benchmark 10-year Treasury yield at 2.45% and finished the year almost unchanged at 2.40%. Lower quality issues delivered strong returns in this “risk on” environment, while bonds denominated in foreign currencies outperformed dollar denominated bonds.
One of the big stories in 2017 was a flattening yield curve, the phenomenon that occurs when short term yields (2-year Treasuries) catch up to intermediate term yields (10-year Treasuries). The chart below illustrates the 2-year Treasury yield’s significant rise compared to the 10-year yield in the last few months of the year. The recent tightening spread is due to the Fed’s monetary policy of gradually raising interest rates, while inflation has been a non-factor. If the yield curve inverts (2-year yield is higher than the 10-year yield), this is frequently a sign that there will be a recession on the horizon as economic prospects deteriorate. In fact, this indicator has accurately predicted the last 7 recessions. Over the past several decades, it took 17 months on average for the equity markets to turn down once the yield curve inverted and the average market gain over that 17 months was +15%. Not to say that history will dictate the future, but we are watching these market dynamics very closely.
2017 was indeed a great year for investors. Above average returns with ultra-low volatility is a rarity. It will be interesting to see if the new tax bill and the recent acceleration in global economic data will deliver another stellar year. Regardless, we will be focusing on fundamentals, not getting caught up in the headlines or noise. What seemed to be the most hated bull market ever is finally turning into broad based “optimism.” It is not until we see the dreaded “euphoria” phase that we will give serious consideration to de-risking client portfolios. In the meantime, ARQ Wealth’s investment strategies are built on risk/return optimization and stability of principal as our core beliefs.