Island Light Quarterly Commentary (Oct 2017)
“The bull market in everything.” — Cover of the Economist Magazine, October 7, 2017.
You may have noticed the recent disconnect between political rhetoric and investment performance. Investors are ignoring the political chaos that is now standard operating procedure in Washington and Europe. “The bull market in everything” is the October 7th cover story of the Economist Magazine, describing multi-year or all-time highs in US and global equity indexes, real estate markets and non-traditional assets such as crypto-currencies and works of art. This boom in asset prices has many causes, not the least of which is global liquidity due to years of monetary accommodation and quantitative easing. While the US is at the tail end of monetary accommodation, if the Federal Reserve is to be believed, overseas central banks aren’t listening.
It is not only monetary accommodation that is driving this asset inflation; the global economy is growing and corporate earnings are solid and rising. Examples of improved market sentiment abound, from greater consumer confidence and business spending in the US, solid growth in global manufacturing and world-wide low inflation. While the price to earnings ratio is well above average in the US, and somewhat lower but still high in the rest of the world, there are still good reasons to be cautiously optimistic. Global growth equates to earnings growth. Earnings growth should lead to higher equity values. If earnings are further boosted by a cut in the corporate tax rate, then we should see even more market highs.
We are optimistic, but would raise a few cautionary flags. First, much of this global prosperity is built on a foundation of expansionary monetary policy and liquidity. This policy can not last forever. How, and when, the central banks reduce liquidity is important. Second, a shock to the system, such as a debt crisis (China?), regional fighting (Korea?), real estate crisis or trade war (USA?) or technical failures (systematic hacking) could provoke a crisis of confidence. Recessions happen, but we think the next US recession won’t happen for a year or more.
As we note above, global equity markets continued their steady upward pace in the third quarter, rising 5.2% for the quarter and 17.3% for the year (MSCI All Country World Index). Non-US developed and emerging markets outperformed US equity markets in dollar terms, helped by the weak dollar. The US market (S&P 500) was up 4.5% for the third quarter and 14.3% for the year. Non-US equity markets (MSCI ACWI x US) returned 6.3% for the quarter and 21.5% for the year with developed markets (MSCI EAFE) up 5.7% and 20.7% and developing markets (MSCI EEM) up 7.6% and 27.1% for the quarter and year respectively. The dollar lost -2.7% for the quarter and -8.9% for the year against a basket of currencies.
Fixed income markets were flat or modestly positive although risky bonds did somewhat better. The Bloomberg Barclays US Aggregate Bond index returned 0.9% for the quarter and 3.1% for the year. Long duration and high yield bonds have earned more than 6% this year. The 10-year US treasury bond yielded 2.33% at September 30, down from 2.45% 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 2.00% 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, remained below the Fed’s 2.0% target at 1.84% at quarter end. High and rising inflation is not of current concern to the Fed.
Our outlook for US equities is modestly positive but cautionary. We expect US earnings to grow over the next year in line with market expectations. While valuations are stretched in the US, positive earnings can lift prices further into 2018. The potential boost to earnings from a change in tax policy could also help equities to rise, although we won’t bet the farm on Congress approving anything. Overseas markets look to be better positioned for future growth than the broad US market based upon valuation and cyclical factors. Emerging markets should continue to benefit from a weaker dollar and strong commodities demand from China. We expect to move towards a more neutral US / non-US position equity position gradually while maintaining our selective exposure to high expected return growth alternatives.
Fixed income markets are less attractive due to rising interest rates and very tight credit spreads which may put negative pressure on the asset class. We expect to maintain our current shorter duration / lower quality exposure.
We could do worse than to ignore the noise and discord that seems to be the new normal. In investing, we try to separate the noise from the signal, look to the past for guidance and make informed choices about the future. While we can’t know the direction of markets, we know that diversified portfolios give us opportunity for gain while limiting exposure to losses. This is the conscientious way to manage risk and return over the long term and we think the consequences of this approach will be long term beneficial to our clients and ourselves.
Matthew V. Pierce