By any measure, 2017 was an exceptional year for investors. Virtually every major asset class advanced in 2017 and investors around the world were optimistic as a “global synchronized” economic rally has unfolded. U.S equities returned 21.8%1 in 2017 as measured by the S&P 500 Index while Emerging Market equities was the top asset class with the MSCI EM Index returning 37.3%1. After years of debate about which direction the “Goldilocks” economy would eventually break, the final months of 2017 brought resolution to this question (upward) in a manner that suits risk assets. We’ll discuss later that perhaps the biggest worry most investors have entering the new year is the lack of something to worry about. This cheery outcome far surpassed most investor’s expectations coming into 2017. To reflect on the year, we begin with an analysis of what investors missed a year ago…. what went wrong with the 2017 consensus forecast? Looking back, what were consensus expectations a year ago and why were they so off?
U.S. Economy – Following the Trump election and with talk of boosting infrastructure spending and cutting taxes, consensus expectations called for the U.S. economy to accelerate in 2017. While this did occur in the back half of the year, the first half was viewed as a disappointment with two quarters of GDP growth that averaged ~2.0%2. The lack of improvement in the economy for half the year was the primary reason most expectations were not met in 2017.
Value vs. Growth Stocks – Value stocks (and small caps) significantly outperformed the overall market following the Presidential election and entering 2017. Value stocks were expected to continue outperforming on the back of strong economic growth and rising interest rates. Growth stocks ended up significantly outpacing Value stocks (except for a late-year rotation into value stocks,) led by the Technology sector, resulting in a record performance gap favoring Growth over Value for trailing 10-year periods2.
U.S. Dollar – Expectations of surging U.S. economic growth, concerns in the Eurozone over Brexit and populist elections, and tough talk of a new President around building walls and renegotiating trade agreements led investors to the comfort and safety of the U.S. Dollar. The USD rallied following the election and was expected to continue to rally in 2017. This was perhaps the consensus pick with the strongest conviction and as is so often the case, markets confounded expectations where investors were firmly set on one side of the argument as the trade-weighted USD declined 9% in 20173.
Tail risks that were contemplated a year ago, but didn’t occur, included 1). the potential for trade wars initiated by a new, unproven President who was openly hostile towards many existing trade agreements, 2). Brexit and the potential it had to disrupt the nascent economy recovery throughout Europe and 3). populist uprisings that led to elections in Spain, Germany and The Netherlands, which had potential to do the same. What did transpire was ideal for capital markets – acceleration in economic growth around the globe (with the expected impact it had on earnings) which occurred without inflationary pressures that would normally surface. In the U.S., the result was an equity market driven by ~50% earnings growth and ~50% valuation expansion (16.8x NTM EPS to start the year vs. 18.5x at the close and 10% EPS growth).2
Below are total returns for various asset classes for 2017:
|Asset Class||Index||2017 Total Return
(Source: Morningstar Direct)
|US Large-Cap Equities||S&P 500||21.8%|
|US Small-Cap Equities||Russell 2000||14.7%|
|Global Equities||MSCI ACWI||24.0%|
|Developed Market International Equities||MSCI EAFE||25.0%|
|Emerging Market Equities||MSCI Emerging Markets||37.3%|
|US Investment Grade Fixed Income||Bloomberg Barclays US Aggregate||3.5%|
|US High Yield Fixed Income||BofA ML US High Yield||7.5%|
|US Large-Cap Growth Equities||Russell 1000 Growth||30.2%|
|US Large-Cap Value Equities||Russell 1000 Value||13.7%|
Most investors we know (and virtually all the good ones) are constantly worrying. While they may be optimistic by nature, they are trained to be skeptical and paid to worry. If the economy is poor, they worry about earnings. If inflation is rising or if the Fed is raising interest rates, they worry. If these things (the economy, earnings, inflation) are too good, they still worry as after all, investors care about the future and the thought quickly becomes how conditions can’t get any better. As we enter 2018, the biggest worry many investors have (especially those that have been around a cycle or two) is the shocking degree to which there is (virtually) nothing to worry about! Coming off a record year of low volatility, where global economies have settled in a synchronized recovery, driving healthy earnings growth and where inflationary pressures still seem slight, markets around the world are enjoying a consistent move higher. The S&P 500 experienced only a 2.8% drawdown over the course of the year (compared to a 14% average annual drawdown over the past 40 years)4, the smallest intra-year decline in over 20 years4. 2017 was extraordinary in that it was the ONLY year on record where the S&P 500 didn’t experience one negative month!1 The Organization for Economic Development (OECD) reports that the economies of all 45 countries they monitor are advancing, only the third such occurrence in the past 50 years. The International Monetary Fund (IMF) has recently raised its forecast for Emerging Market economies to 4.9% for 2018, up from the 4.5% 2017 estimate, and here too, inflation remains well-behaved. On top of all of that, the US economy is likely to get further stimulus in the form of the much-discussed year-end tax bill.
At Fundamentum, our thoughts and portfolio positioning entering 2018 is predicated on one key fundamental construct…. the biggest potential risk for investors may be the threat of economic OVERHEATING.
We are firmly in the camp of “be careful what you wish for,” in that attempts to drive an already healthy and fully employed economy higher with fiscal stimulus raises the risk of building inflationary pressures, the top pressure points and focus of our Investment Committee entering 2018. 2-3%, non-inflationary growth is arguably the ideal backdrop for equities and bonds. Too much of a good thing could end the cycle. Given full employment and lack of apparent slack, GDP growth in the U.S. of something consistently with a “3 handle” puts at risk the steady, modest normalization of the Fed Funds rate the market expects, as inflationary pressures could pick up. We aren’t overly concerned about equity valuations given the $145 earnings estimate for S&P 500 Index companies for 20182 where an additional $10 in EPS might be added following the tax bill. If so, $155-160 earnings are in sight, which would put the market at EXACTLY the same multiple entering 2018 (16.8x)2 as we were entering 2017, despite the over 20% price change in the index this year. While earnings are less of a concern to us currently, what investors eventually pay for these earnings is a bigger concern, especially if inflationary pressures increase. A loss of a modest 1 multiple point due to inflation concerns is an approximate 6% hit to equities alone. Without the onset of inflation, we’d expect equities to hold the multiple it has entering the year which would make 2018 another outstanding year for equity investors given the expected earnings growth.
In this environment, we are positioned in our Tactical portfolios in the major asset classes entering 2018 as follows:
- We continue to favor equities over fixed income. Bond markets appear to be discounting Real GDP growth in the 2.5% range. We believe the underlying economic momentum and additional fiscal stimulus raise the probability of growth above this level. As such, we are overweight equities in our tactical models, through foreign equities (both Developed Markets and Emerging Markets) where economic and earnings growth are experiencing similar accelerations as in the U.S. but where valuations are likely more attractive. While admittedly not heroic assumptions, we expect 2018 U.S. equity returns to more muted than 2017, and we would expect volatility to trend higher with more normal drawdowns through the year.
- Tactical portfolios continue to be underweight duration (~4 vs. 6 with Barclays Agg Index), and neutral weighted in terms of credit exposure. The overweight position to domestic high-yield credit was reduced early in 2017, but we still have a modest overweight in high-yield. There is little “value” in high-yield sectors but with the positive economic outlook, we expect to earn the more generous coupon yields in this asset.
- Our use of “active managers” is evenly split in our Tactical portfolios. We employ active management mostly in asset classes with larger expected inefficiencies – international, emerging markets, credit, and fixed income. ETFs and Index Funds are employed to achieve the desired tactical exposures in other asset classes, and to lower underlying expense ratios.
- We are equally weighted regarding style, Value vs. Growth in the Tactical portfolios. The Global Individual Equity portfolio is overweight Banks and Energy sectors, giving it a modest Value tilt, though the largest positions continue to be Google, Apple and Microsoft.
- Our interest in “inflation hedges” has grown given our economic outlook. Exposure to TIPs and Commodities has been increased and will likely increase further should our concerns over inflation come to fruition. Commodities have been the worst asset class for five of the past six years, including 2017, and are increasing in appeal given the outlook.
Finally, as we enter a new year with strong economies and with financial markets performing well, it is worth reminding ourselves that things don’t always work out as they “should.” The heuristics of long-term investing such as “equities deliver 7% real returns” and “bonds are the safe assets” may not occur over shorter time frames. As such, we are on guard for changing asset class correlations and return streams, and think advisors should be stress-testing financial plans for a range of outcomes for their clients. The advances we’ve had over the last few years does not warrant complacency, a mindset we fear is on the rise given the smooth ride that was 2017.
Fundamentum Investment Committee
December 29, 2017
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Investing involves risk including loss of principal. The investment returns and principal value of the portfolio will fluctuate so that the value of an investor’s account, when redeemed, may be worth more or less than their original value. No strategy assures success or protects against loss. The performance data quoted represents past performance; past performance does not guarantee future results. Asset allocation does not ensure a profit or protect against a loss. Investment return and principal value will fluctuate and an investors equity when liquidated may be worth more or less than original cost. Current performance may be lower or higher than performance information quoted above. Investment advice offered through Fundamentum LLC a registered investment advisor.
Sources: 1. Morningstar Direct, 2. Factset, 3. Federal Reserve Bank of St. Louis, 4. JP Morgan Asset Management