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2017 was a remarkable year for capital markets. Beyond the magnitude and broad nature of the positive performance, it is the complete absence of any discernible volatility or price corrections to achieve those returns that is most unique. The largest drawdown for the S&P 500 in 2017 was -2.6% on the way to a 21.8% return on the year. Market conditions were not any more volatile overseas, with the MSCI EAFE pulling back only 2.1% during its journey to a 25.0% return. Emerging markets, historically the most volatile of the broad equity indices, only experienced a max drawdown of 4.8% in 2017 as the MSCI EM Index leaped 37.3% for the year. Figure 1 shows the current year drawdown in the context of the last three years.
Within the US markets, technology was the strongest equity sector, returning 34.3%. Energy was the lone sector with a negative return, falling 1.1%. Elsewhere, MLPs struggled with a -6.1% return as the midstream business model continues to evolve, placing more importance on distribution coverage and self-funding growth models over a sole focus on distribution growth.
What can be attributed to such resilience in the equity bull market? Strong corporate earnings, synchronized global growth, business optimism leading to increased capital expenditure plans and contained inflation have all combined to create a supportive environment for equity prices. The final burst higher for prices towards the end of 2017 and into 2018 can be at least partially attributed to the passage of the 2017 Tax Reform Act, which lowers the corporate tax rate from 35% to 21%. Most economists are expecting the tax bill to add around 0.2-0.3% to US GDP in 2018.
It is easy for a year like 2017 to lull investors into a sense of complacency. In addition to the current conditions listed above, there is a behavioral element of a positive feedback loop that can further impact markets and valuations. 2017 should cause investors to be alert to shifts in sentiment. We should always expect and be prepared for volatility as a normal part of investing. 2017 is an anomaly, not a new normal.
Looking forward, BCA Research has described 2018 as a year where policy and markets collide. The Goldilocks environment that has supported risk assets could shift as the Federal Reserve moves firmly towards continued tightening of monetary policy. The relationship illustrated in Figure 2 is an example of this potential conflict, and it shows something that hasn’t occurred since 2008 – the 2-year Treasury yield is now higher than the dividend yield on the S&P 500.
Rising short term yields are not uncommon this deep into an economic expansion, and it doesn’t necessarily mean a similar shift is on the horizon for equities. But to the extent investor support of equities has been fueled by a relative value argument of stocks over the paltry yields in bonds, it is something to watch closely in the coming months.
Compared to the US, international developed markets have generally more supportive financial conditions and superior starting valuations. After years of outperformance by the US, we could be in the early stages of strong returns for international stocks relative to the US.
The yield curves for fixed income markets have generally flattened over the last 12 months, with short-term yields rising and long-term yields remaining anchored. Among other things, this means investors can finally earn a return on money market funds for the first time in years. As the economic cycle matures, the shape of the yield curve will be an important factor to consider as it tends to invert (short yields above long yields) before economic recessions.
Overall, investors should remain committed to equities as a means to achieve long-term goals. However, in the wake of 2017, it’s a great time to reassess and confirm the allocation decision between safety and growth assets. Rising short-term bond yields offer some compensation to investors while helping portfolios prepare for the return of equity volatility brought on by policy shifts, or some other unknowable factor.
Elevated valuations have reduced the margin of safety in public equities and muted returns should be expected over the next several years. Uncorrelated and unique return streams that have limited exposure to traditional equity/bond markets can be an attractive way to achieve return objectives in this environment.
The above commentary represents the opinion of the author as of 1.18.18 and is subject to change at any time due to market or economic conditions or other factors.Print