by Brad M. Weafer, CFA, Director of Research
As the calendar turns, we find it instructive to take stock of the year behind us and look forward to what might be in store for the rest of 2018.
2017 in Review
It was a good year for equity investors. The S&P 500’s total return was over 20%. Equity markets outside the U.S., which have been laggards prior to 2017, were also in on the act. The MSCI All World Index, excluding the U.S., returned almost 25%. Not only were returns strong, there was a complete absence of volatility. Typically when equity markets are this strong, strategies focusing on profitable, conservatively financed, and shareholder friendly companies have difficulty keeping pace with broad market indices. This year was no exception. Most passive indices tracking high quality or high dividend yield trailed the S&P 500. Fortunately, our active approach of selectively choosing individual companies and diversifying geographically led to attractive rates of return for our clients this year. To paraphrase Bill Murray’s character in Caddyshack, “We’ve got that going for us, which is nice.”
Above 20% returns were certainly not the consensus expectation to start 2017. It was much more common to hear clients or other investors take a much more cynical and pessimistic view to start the year. The sustainability of the post-election rally was questioned by many. There was a palpable fear of what the new President might mean for markets. Along the way, cynics had plenty of events to be nervous about. In the end, equity markets continually shrugged off the news and focused on corporate and economic fundamentals. Almost as if choreographed, the global economy experienced a synchronized increase in growth. Real GDP growth in the U.S. accelerated from 1.5% in 2016 to an estimated 2.2% in 2017. Similar accelerations happened in Europe, Japan, and to a less extent, in China. Global GDP growth is now forecasted to have grown 3.6% in 2017¹. Attractive credit conditions and tame levels of inflation also created an ideal recipe for earnings growth. With three quarters already reported, earnings for full calendar year 2017 are forecast to increase over 10%. What’s more, 2018 forecasts call for another 10% increase, even before factoring in any expected improvements from a lower corporate tax rate.
Another consensus view was expectations of rising bond yields, with many forecasting higher inflation and interest rate hikes from the central bank. The Federal Reserve made three 0.25% increases to their benchmark rate, helping spur the 2-year government bond rate up to a recent 2.0%. Inflation remained subdued with CPI under 2.0%, helping keep down longer rates. The 10-year U.S. government treasury rate was flat over the full year. Fixed income returns were modest as a result, with the Barclay’s Intermediate Sovereign/Credit Index up 2.0%. While not providing outsized absolute returns, bonds continue to play an important risk reduction role in portfolios.
Wish List for 2018
Like most years, hindsight proves how difficult it is to accurately envision the vagaries of the stock market. That does not stop the majority of Wall Street from issuing annual predictions. When we see these prognostications come out, we are reminded of an old Chinese proverb; “Those who have knowledge do not predict, those who predict do not have knowledge.” As investors, we are forced to position portfolios with an eye to the future, but rather than predict what 2018 will bring, we will follow a tradition we started last year and put together a list of things we are hopeful for in 2018.
1. Productive Business Investments
Congress’ recent passage of tax reform should provide a short-term boost to economic growth and corporate profits. One of the key features of this package is an allowance for companies to immediately expense capital equipment purchases. This provides an increased incentive for companies to invest back into their businesses. Increased investment theoretically leads to job and wage growth and a healthier economy. It is our view that business leaders do not make investment decisions based on tax law alone. However, all investment decisions are impacted by their cost, and this tax reduction positively changes the calculus. The ultimate success or failure of this initiative is whether or not it can spur long-term economic growth. Investments that improve U.S. business assets and enhance the training and skills of U.S. workers, can achieve productivity gains with long lasting results.
2. A Return to Normal Volatility in Equity Markets
Last year was one of the least volatile years in U.S. equity market history. The largest decline from a previous high was only 2.6%, the second lowest reading in fifty years! Undoubtedly, this has helped investors sleep easier with very few “gut checks” to live through. On the other hand, it risks making investors complacent. Even more unfortunate, this kind of price action makes it incredibly difficult for investors to proactively benefit from stock fluctuations. It might be cliché to say markets are “due” to return to more normal levels of jumpiness, but we hope to benefit when volatility does eventually return.
3. A New Leading Stock Market Acronym
The most popular equity trade of 2017 was the so called “FANG” stocks. FANG, (Facebook, Amazon, Netflix, and Google), as a group significantly outperformed the rest of the market with an average annual return of 49%. Given their size, they had an outsized impact on market cap-weighted indices like the S&P. When a small number of companies have such a big impact, active managers have difficulty outperforming without significant holdings in those names. And since none of the four stocks pay a dividend, it makes it even worse for income focused investors. We hope this year’s best investments have a broader participation than a four-letter acronym.
4. Rational Regulatory Policies Around Energy Infrastructure
With the advent of shale fracking techniques, natural gas prices have fallen precipitously across much of the United States over the last 10 years. Transporting natural gas by pipeline has been a contentious issue, with a combination of environmental concerns and “not in my back yard” politics. Few places know this more acutely than the Northeast, where getting adequate pipeline infrastructure has been challenging. Over the last month, we found out what happens when a “bomb cyclone” meets a lack of energy infrastructure. As heating demand rose with falling temperatures, natural gas prices in the Northeast spiked (see Figure 1 below). We would love to see a scenario where smart regulation and policy around energy infrastructure can solve some of these issues in an environmentally sensitive way.
5. Growth in Loan Demand
We periodically review hundreds of economic data series trying to assess the health of the U.S. economy. As we enter 2018, most of that data signals a low risk of recession and continued economic growth. The one fly in the ointment that has been difficult to explain is a slowdown in commercial and industrial loan growth (see Figure 2 below). Loan origination is growing modestly, but has decelerated significantly from a year ago. This is inconsistent with other signs of economic acceleration. With business confidence metrics soaring to new highs, this is the exact opposite of what we would expect to see on the loan front. It is possible that many management teams have paused to assess regulatory and tax changes expected from the new ruling political party. With the tax change finally in place, we hope to see a resumed demand for loans.
6. Tom Brady, Age 40 MVP
Tom Brady has been a model of hard work and preparation for his entire career. For New England Patriots fans, it has been a rewarding dynasty. At age 40, quarterbacks in the NFL are supposed to start losing their luster. Tom Brady, however, is not a typical player. For 16 years, he has stuck to a plan with long-term success as the ultimate goal. His discipline has led to incredible results. For investors, working hard and staying true to a long-term plan is critical to investment success. We appreciate seeing this model rewarded in other disciplines outside investing. We hope it is further recognized with Brady being awarded his third most valuable player trophy.
7. Health and Happiness
Last on this list, but first in priority, we hope for health and happiness for all our clients, colleagues, family, and friends. It was an easy year to get caught up in the markets, politics, and world events. This year looks to be just as exciting, so it is important to remember what really matters. We at BFM all wish you a very happy New Year!
¹November projections by the OECD
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy, or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.