Island Light Quarterly Commentary (Jan 2018)
“Don’t cry because it’s over, smile because it happened.” Dr. Seuss
By any measure, 2017 was a wonderful year for equity investors. Stocks rose around the globe, often by more than 20%, and market volatility disappeared. If you were in any stock market at the beginning of the year, you needed only to sit and watch your holdings gradually increase. Optimism reigned. Faster economic growth materialized because of changes in regulation and a dramatic lowering of the corporate tax rate at the end of the year. As Dr. Seuss points out, we should smile because it happened.
The optimists view is that the bull market in US equities, now in its 9th year, will continue. Corporate profits and global economic growth, mixed with a heady dose of monetary accommodation drove this market to new highs. Global liquidity remains high, fueled by nearly a decade of easy money. Also, for the first time in many years, economic growth is global. Global employment is strong, with little wage pressure. International economies, a cycle behind the US, have more room to grow. US companies will benefit from lower corporate tax rates and there is pressure on foreign governments to respond to these lower tax rates. Technological change leads to higher productivity. Optimists will keep smiling.
The pessimists say however, that the easy monetary factor is changing; in the US, the Federal Reserve has forecast three interest rate increases in 2018 and a reversal of quantitative easing. Overseas central banks are also signaling changes from current policy. Recessions often start with restrictive monetary policy. Also, a sudden economic shock (debt in China, regional warfare in Korea or the Middle East), a trade war in the US) is certainly possible and could spook markets. An increase in market volatility from historic lows is likely and can lead to a painful correction. Expect weaker growth as companies can’t find enough qualified workers. A political crisis in the US is also a real possibility. And the bull run is 9 years old and stocks are fantastically expensive. The pessimist’s party is over. Bring out the hanky.
Somewhere between the optimists and the pessimists lies the truth. The fact that there are still pessimists around is, counter-intuitively, a positive indicator. My own view is that 2018 will be another good year for stocks, perhaps better in the first half than the second and modestly better for international stocks than US stocks. On the other hand, fixed income will have a tough time overcoming tightening monetary policy and risking interest rates.
Global equity markets grew steadily in the fourth quarter, rising 5.7% for the quarter and finishing 2017 up a remarkable 24.0% for the year (MSCI All Country World Index). Nearly every equity market in the world was up double-digits amid signs of expanding global growth prospects. Non-US developed and emerging markets outperformed US equity markets in dollar terms for the year, further boosted by the weak dollar.
The US market (S&P 500) was up 6.6% for the fourth quarter and 21.8% for the year. Growth assets outperformed value assets by 12.1% for the year with the S&P 500 Growth index up 27.4% while its Value counterpart returned 15.4%. Small cap stocks underperformed large cap stocks by a wide margin as the Russell 2000 returned 14.7% for the year. At year- end, the S&P 500 forward P/E ratio was 18.2x versus 16.9x at the beginning of 2017. The 25 year average is 16.0x.
Non-US equity markets (MSCI ACWI x US) returned 5.0% for the quarter and 27.2% for the year with developed markets (MSCI EAFE) up 4.2% and 25.0% and developing markets (MSCI EEM) up 7.4% and 37.3% for the quarter and year respectively. The dollar lost -1.0% for the quarter and -9.9% for the year against a basket of currencies. A weakening dollar helps international returns. As in the US, non-US Growth equities outperformed non-US Value equities, 32.0% to 22.7% (MSCI ACWI x US).
US bonds were modestly positive for the quarter and year as the Bloomberg Barclays US Aggregate Bond index returned 0.4% for the quarter and 3.6% for the year. Riskier bonds outperformed more conservative bonds as long duration, emerging and high yield bonds each earned more than 6% for the year. The 10-year US treasury bond yielded 2.40% at the end of the year, nearly even with the 2.45% yield at the beginning of the year. Bond prices go up when bond yields go down. Credit spreads also tightened, to a multi-year low of 1.77% from 2.28% (Moody’s Baa v 10-year Treasury). High yield bonds go up when credit spreads tighten. US Inflation, as measured by the 10-year breakeven inflation rate, increased in the quarter to 1.96%, just below the Fed’s 2.0% target levels.
Our outlook for US equities remains modestly positive but cautionary. US earnings are projected to grow to near $36 per share at the end of 2018 from $27 per share in the second quarter of 2017. While forward-looking growth estimates are frequently over-optimistic, the expansion of earnings expectations (above) ties directionally with the global economic growth outlook and the changes in corporate tax policy in the US. While much of the recent growth in US equity valuation is due to an expansion of the price earnings spread, this expansion may not be entirely irrational. If forward-looking earnings have not yet priced in the changes in corporate tax policy in the US (and possibly on other parts of the world, due to competitive pressures), then this rise in multiple may be warranted. However, recent history and low volatility in US markets makes it all too easy to forget past corrections. The market is overdue for a correction of 10% or more. The interesting question will be whether that represents another good buying opportunity or the beginning of a longer decline.
While valuations may be stretched in the US, overseas markets look to be better positioned for future growth based upon relative valuation, the direction of the US dollar, and cyclical factors. International markets forward looking P/E ratio is 14.3x (12/31), below its 25-year average. Not only are non-US equities valued lower than their US counterparts, international markets should continue to benefit from a weaker dollar. Market expectations are for the dollar to further weaken, due to expected monetary tightening in Europe and Japan as well as increasing US federal debt levels arising from the new tax policy. This outlook, combined with strong commodities demand from China and other manufacturing countries, and multi-year underperformance by non-US markets, provides further fodder for the long term positive outlook for non-US equities, relative to the US. We expect to continue to move slowly towards a more neutral US / non-US position equity position while maintaining our selective exposure to high expected return growth alternatives.
In comparison to equities, fixed income markets are less attractive due to the expectation of rising interest rates and inflation as well as very tight credit spreads which may put negative pressure on the asset class. We expect to maintain our current shorter duration / lower quality exposure and a lower overall exposure to fixed income.
We remain cautiously optimistic; not yet ready to cry that the party is over. We prefer equities to fixed income in a tightening monetary environment. But we can’t let ourselves get too excited because we can’t know with complete certainty the direction of markets. We do know that a well-diversified portfolio will give us opportunity for gain while limiting exposure to losses. This approach to managing risk has worked well over the long term and should continue to work for us in the future.
Matthew V. Pierce