Economic and Market Commentary – January 2018
December ended a quarter and a year of superlative gains for most major asset classes, both in the U.S. and globally. Domestically, the S&P 500 tacked on another 6% to end the year with a total return of 21.8%. It was the ninth consecutive quarterly gain for equities and the first year, since data was collected in 1928, that the S&P recorded a gain in each of the 12 months, a “perfect year.” With the Federal Reserve increasing the Federal Funds rate in December, bond returns were mixed for the quarter, but positive for the year. As has been the case for some time, it was a large cap and growth-driven equity market. Growth outperformed value by close to 3 percentage points for the quarter and 13 percentage points for the year, and large cap did similarly by close to 3 and 6 percentage points for each period.
Large cap and growth dominance was a function of the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix, Google), which accounted for more than 6 percentage points of the close to 21.8% rise in the S&P 500. Bullish sentiment was not confined only to the U.S., as globally stocks had the strongest performance in 8 years. The Wall Street Journal, which monitored 22 global markets, showed all producing a positive return, with 13 in double digits, but only 5 outpacing the S&P 500 – clearly the U.S. was a good place to be.
It was also a year marked by low volatility, which confounded many, including us. In the U.S., volatility reached its lowest level since records have been kept. According to Goldman Sachs, U.S. equities have experienced the second longest streak of trading days without a five percent decline. They calculate we’ve gone 386 days, second only to the 394 days stretch during the tech bubble of the late 1990’s. It is likely the U.S. stock market will break that record by mid-January.
Led by the FAANGs, the best performing sector of the S&P 500 was Information Technology, with Materials, Healthcare, Industrials, and Financials also outperforming the index. Others (Consumer Discretionary, Utilities, Consumer Staples, and Real Estate) while still positive, underperformed. The only negative performers were Energy and Telecom.
The dominant theme of the past year has been that nothing seemed able to shake investor conviction and confidence in their frantic search for return. All asset classes looked to be invulnerable – stocks, bonds, real estate, and especially cryptocurrencies (Bitcoin). The markets did not respond to the geopolitical risks or other “gray rhinos” that we mentioned in the past Commentary. They simply responded to good economic news, ignoring anything else. The availability of cheap money – leading to excess liquidity, economic growth and better company earnings – seems to be the only things capturing investor’s attention. Caution has been thrown to the wind, and complacency reigns as investor’s willingness to accept risk seems boundless. All this when there are no cheap assets out there – all classes are expensive in absolute terms. Equities are expensive compared to virtually all measures of valuation – price to earnings (both current and long term) as well as price to sales and cash flow. The value of U.S. equities compared to GDP is about 140% – nearly double the long-term average, and approaching the all-time high reached during the tech bubble in early 2000. According to NYSE data, margin debt was $560 billion (in September) or 46% higher than it was in July 2007, the last peak before the financial crisis. The only metric against which stocks look cheap are interest rates, and they will be increasing. We have not had a significant downdraft in stock prices in almost 2 years (the largest in 2017 was -3%). With complacency high, investors’ frantic search for return, the unabated push of the FAANGs, and the parabolic phenomenon of Bitcoin, one has to ask if we’ve reached a state of euphoria, and are close to a proverbial “bubble.” An interesting measure of sentiment is a recent survey by the American Association of Individual Investors, which showed that 59.8% of investors are bullish and only 15.5% are bearish. Only a month ago, a similar survey showed 37% bullish and 34% bearish. Granted euphoria and psychology are hard to measure, but many signs point to the conclusion that we are close to being on thin ice.
Countering this, and what most investors are totally focused on, is the fact the global economy is in fairly good shape and heading in a positive direction. We are in a “globally synchronized” expansion for the first time in more than a decade. In the U.S., growth has accelerated nicely. After a slow start in the first quarter (+1.2%), inflation adjusted GDP has picked up steam (Q2 +3.1% and Q3 +3.2%) and the final quarter is estimated at +2.8% (Atlanta and NY Fed). This should bring the full year in just shy of +3.0%. The recently passed tax bill (Tax Cuts and Jobs Act of 2017) should be an obvious positive into the current year. It is estimated that this legislation should provide close to $1.5 trillion of economic stimulus over the decade, and should have a positive effect in the current year. Most economists think the added stimulus will increase 2018 GDP by 0.5%, so what had been originally forecast as a modest 2.5% gain could reach 3% or more. From our perspective, the domestic economy is a positive factor in the investment equation. Growth here and globally is accelerating. Inflation is benign and shows little sign of becoming a problem (yet) and money is readily available and cheap. Granted the Fed has signaled its intention to continue increasing short rates, and reduce its $4.5 trillion balance sheet. We fully expect 2-3 Fed Funds rate increases during the year, but we think there is ample room for increased rates before there is a negative impact on the real economy. As far as the Fed’s balance sheet is concerned, we have said before that we think the Fed has ample flexibility through reducing or eliminating purchases of securities, and a run-off of maturities, to reduce their balance sheet, without undue damage to liquidity available to the economy. Clearly both of these actions will get our attention.
From an economic perspective, the environment is better than it was, and some have said that businesses are close to unleashing Lord Keynes “animal spirits.” Some credit for this should be given to the current administration in Washington. The administration’s stance on the tax legislation and reduced regulation have had positive consequences and are probably causal in stoking the U.S. economy’s “animal spirits.”
As we look at the coming year, we can see real economic growth of about 3%, with inflation close to 2%, leading to nominal growth around 5%. Using the S&P 500 as a proxy for the economy, that should allow revenue growth of 5-7% and conservatively stated, normalized earnings growth of about 7% (FactSet, the data provider, has consensus earnings growth of 13% for 2018). Add to that the expected $10 from the reduced corporate tax rate, and you could see S&P 500 earnings for the year about $150 a share. Clearly the new tax bill will not affect all companies equally, as some (mostly large and multi-nationals) already pay low effective rates. Those with the largest impact are of the smaller and more domestic-oriented variety. For example, most financials would fall into this category.
The bond market finished 2017 with a 3.54% annual return on the Bloomberg Barclays Aggregate Bond Index and a 0.39% return for the fourth quarter. The return is notable, particularly considering that there were three separate Fed Funds hikes during the year and the Federal Reserve began unwinding the $4.5 trillion of Treasury and mortgage-backed securities currently held on its balance sheet, which potentially could have resulted in turmoil for the bond market. The Fed under outgoing Chair Janet Yellen provided tremendous clarity in their process for implementing both actions, which importantly helped to avoid creating bond market volatility from the rate increases and balance sheet operations. That said, we did see significant movements in short-term yields over the course of the year. For example, the 2-year Treasury yield increased from 1.18% at the start of the year to 1.88% by the end of 2017, while the 5-year Treasury yield increased from 1.92% to 2.21%.
Two of the major stories in the bond market this year were the flattening of the yield curve and the continued tightening of credit spreads. Yields in the short and intermediate parts of the curve continued rising in December, driven by the Federal Reserve’s 25 basis point rate increase at the December meeting and the passage of the tax reform bill by Congress later in the month. For the third straight month, the yield curve flattened in December as short-term yields rose more (9-12 basis points) than the intermediate part of the yield curve (2-8 basis points), while the 30-year Treasury yield declined by nearly 9 basis points. Over the quarter, yields increased by 27-45 basis points in the short-to-intermediate maturities and actually decreased by 12 basis points in the longer-term 30-year Treasury Note.
Although some concern has been expressed by bond market participants regarding the possibility for an inverted yield curve (where short-term rates are higher than long-term rates), we do not believe this scenario will occur. We attribute the flattening yield curve to incoming Fed Chair Jerome Powell voicing his plan to continue the Fed’s current trajectory for increasing the Federal Funds Rate, combined with a very cautious view on the timing of when fiscal policy initiatives will be enacted now that the long-awaited tax reform has been signed in law.
On the spread side, investment grade corporate bond spreads tightened from 130 basis points to 99 basis points over the year, based on the ICE Bank of America Merrill Lynch (BofAML) Corporate Bond Index. Incredibly, high yield spreads also tightened further this year from 442 basis points to 363 basis points, as measured by the ICE BofAML High Yield Index. High yield spreads have nearly reached the lowest level seen for high yield corporate bonds over the past decade. This tightening has been driven by a voracious appetite for income, as investors willingly took on additional credit and duration risks to boost portfolio yields. The current path of rate hikes by the Fed should start to alleviate this problem by increasing the nominal yields available to investors, particularly for shorter-term fixed income investments.
Another issue to consider is the impact of tax reform on yields for both corporate and municipal securities. On the corporate debt side, slashing the corporate tax rate from 35% to 21% means many companies will have additional cash available for projects and may be willing to take on additional debt to finance these expenditures since each project’s projected Internal Rate of Return has instantly increased due to the tax cut. For municipal bonds, the tax bill eliminated the ability for issuers to issue advanced refundings as tax-exempt debt, which municipalities routinely do now to take advantage of lower interest rates or changes in security features. This will lower the supply of tax-exempt bonds and could contribute to tighter spreads and lower yields for investors over time. At the same time, the income tax cut for both corporations and individuals decreases the tax benefit from owning municipal securities, which could lead to less demand for tax-exempt bonds with the exception of high tax states including New York, New Jersey, California, and Connecticut. The bottom line is that there are significant impacts on both types of bonds from the new tax law, which makes continuously monitoring available after-tax returns for both taxable and non-taxable securities to obtain the highest after-tax portfolio return essential.
Although the majority of the Federal Open Market Committee officials expect at least 3 rate hikes in 2018, the market is still quite skeptical, with only a 31% probability for achieving those 3 rate hikes this year, based on Fed Funds futures. We expect that short-to- intermediate term rates will continue to rise with longer-term rates rising at a slower pace. This is the rationale for maintaining relatively short durations in portfolios and investing in bonds with staggered maturities, so cash is frequently available to invest in new bonds as rates increase. This results in portfolios that are well-positioned to capture higher yields as rates move up, while mitigating the price impact on the existing portfolio from such rate increases.
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