Equity market recap - 4th quarter 2017
Global equity investors enjoyed a strong finish to a strong year in the fourth quarter of 2017.
Even more remarkable than the strength of the market’s advance was the absence of volatility. Indeed, 2017 marked the first year on record in which the S&P 500 didn’t experience a single monthly decline, finishing with a gross total return of 21.8%. More remarkably, the U.S. market was a relative laggard on the global stage. That’s right. A wide majority of international markets fared even better, especially the emerging markets variety, fueled by synchronized global growth and a weaker U.S. dollar.
A multitude of themes bolstered the market advance, most notably strong corporate earnings, which surprised to the upside on balance. Market sentiment also enjoyed a further boost during the fourth quarter, thanks to the unexpectedly swift passage of the U.S. tax reform bill featuring substantial reductions in headline corporate tax rates. Both the quarter and the full year demonstrated a strong, pro-cyclical, “risk on” bias.
Investors sentiment seemed particularly impressed by top-line growth improvement during the latest earnings reporting season, which saw aggregate earnings growth of more than 5% for the United States and 6-8% for Europe and Japan, respectively. From a sector perspective, the strength was cyclical in nature led by technology and commodity-linked industries, while lower volatility defensive sectors lagged.
Emerging markets especially thrived in the quarter with the MSCI Emerging Markets index posting a total return of 7.5% and concluded 2017 with an impressive yearly return of 37.8% (in pretax, U.S. dollar terms). The S&P 500 posted a total return of 6.6% during the quarter, bringing its year-to-date advance to 21.8%. Meanwhile, the MSCI EAFE index return posted a 4.3% return for the quarter, finishing with a 25.6% year-to-date total return.
While returns were robust and broad-based, the disparity by investment style was striking. On average, growth oriented benchmarks outpaced their value counterparts by 2% in the fourth quarter and over 10% for the full year, for the MSCI World Index. The differential was even more gaping in emerging markets, with growth ahead of value by nearly 19% for the year. Perhaps unsurprisingly, low volatility and high dividend benchmarks also lagged the conventional indexes by 4% to 6% for the year. In the United States and emerging markets, small-cap shares lagged their tech-heavy mega-cap counterparts, while handily outperforming in most international developed markets.
Improving economic conditions in international markets contributed to a weaker U.S. dollar, helping spur positive fund flows abroad, with a notable tilt toward cyclical sector and emerging markets. From a sector perspective, technology and consumer-oriented companies topped the league tables as investors remained willing to pay up for growth amid low volatility and stubbornly low bond yields. Basic materials companies also performed well for the year, underpinned by improving industrial metals prices, reflecting tightening supply and positive manufacturing and trade data out of China.
In December, retail-oriented companies and financials surged higher in anticipation of the tax-reform bill. Encouragingly, several companies have also signaled that tax relief will, in turn, spur accelerated shareholder friendly capital deployment.
The U.S. dollar depreciated against most currency baskets in the quarter closing out the year meaningfully lower, most notably finishing 14% lower relative to Euro. Most Asian baskets weren’t far behind led by the Korean won which appreciated by 7% in the fourth quarter capping a 2017 advance of 13%. This was driven by modestly reduced tensions from North Korea as well as the South Korean Central Bank raising its key policy rate by 25 basis points (bps); the first hike since 2011. The dollar did perform better in the quarter against countries with political unrest, namely Brazil and Turkey, while faltering negotiations on NAFTA weighed on the Mexican peso and Canadian dollar.
In what has been a significant reversal since June of 2017, oil prices have roared higher with both WTI and Brent closing out the quarter with an advancement of 16% giving the physical commodities a yearly gain after much volatility in the first half of the year. OPEC and non-OPEC members agreeing to extend production cuts through December 2018 while disruptions in Iran and Libya as well as the surfacing of a more balanced market contributed to the gains.
Central Banks moved further away from ultra-loosed monetary levels led by the Federal Reserve (the Fed). The Fed approved the reversal of its historical stimulus measures while the European Central Bank (ECB) also announced the cutting of its massive bond-buying program. The Bank of England hiked its rate by 25 bps and the People’s Bank of China maintained its course of less stimulus to reign in excess leverage and manage capital flows. In Japan, Prime Minister Shinzo Abe and his coalition partners were in favor following a strong showing in snap election results while out of the United Kingdom, reports came out portraying the likelihood of a “soft Brexit”.
Despite the more “hawkish” movements, global yields were largely mixed in the quarter with many remaining almost unchanged for the year. The lack of inflation coming through maintained its grasp on yields keeping them at depressed levels.
Somberly, the quarter and year for that matter featured several reminders that terroristic acts are far from abating and not segregated to remote corners of the world. Furthermore, tensions surrounding North Korea seemed to temper a bit though the situation remains very volatile.
The almost 9-year-old bull market rally has been extended on the back of robust corporate profits while moderation of the U.S. dollar has spurred cyclical investment across the globe. While we are getting longer in the cycle, particularly in the United States, many aspects point to a continuation of favorable equity market conditions. Future advances seem quite unlikely to be driven by valuation expansion. Earnings growth remains the essential driver. Companies are witnessing positive operating leverage coupled with top-line growth, driving earnings higher. Furthermore, many leading economic indicators are trending positively, particularly the synchronized strength of global Purchasing Manager’s Indices.
Importantly, many companies continue to project a better outlook through guidance updates. Signs continue to point to strength in earnings growth globally, while earnings revision improvement continues to trend positively, with solid breadth across sectors and regions. The market remains positioned favorably in an upgrade cycle where global earnings upgrades outnumber downgrades.
Although most valuation readings for U.S. equities now stand above historical averages, broader global metrics remain reasonable, particularly in terms of earnings yields and cash flow yields relative to government and corporate bond yields. Tighter spreads also make for equities as a more attractive option than credit investment. Valuations and improving earnings growth prospects are within select emerging markets and areas of Europe and in early stages relative to the United States. With bond yields remaining not too far above historical lows, especially at the current low real policy rate, long term accumulation and liability funding objectives have minimal opportunities to be met without meaningful equity exposure. Selectivity is key.
Tax reform made significant headlines as 2017 came to a close, rapidly passing the U.S. House and Senate and swiftly signed by President Trump. This reverberated across the U.S. equity market as investor sentiment shifted to companies who would likely be most impacted by the tax reform in the coming years. In turn, downtrodden retail companies were scooped up as they’re set to benefit from the corporate tax rate getting slashed from 35% to 21% given their higher relative tax rates. Financials also came into favor given the likelihood of deregulation upside as costs are set to come in while capital reserves will be released. We’ve already witnessed impacts from the reform as companies have begun announcing accelerated shareholder friendly capital deployment. More of this is likely to come through in 2018, a further positive catalyst for stocks.
After previous ultra-loose monetary policies across the globe, Central Banks have begun to reign this in as it has been deemed it’s no longer necessary amid the current economic backdrop. The Fed is leading this as they’ve put a stop to their bond buying program and raised its rate by 25 bps in December. Expectation is for two to four more hikes in 2018 though data dependent. The Bank of England initiated a rate hike in the fourth quarter while ECB has begun cutting its massive stimulus program. We’ve noted previously that the People’s Bank of China has backed off its prior stimulus measures to reign in excess leverage and rising home prices as well as manage capital flows.
Depending upon the pace, broad-based tapering could create the potential for a squeeze in liquidity and modestly act as a headwind should earnings momentum falter, though it’s generally a welcomed sign of strengthening global economies.
However, monetary policy measures remain loose globally by historical standards and after the latest policy adjustments by the aforementioned Central Banks, they seem content on pausing to see how economic data points come through in the first quarter of 2018. This is particularly the case regarding inflation that remains at depressed levels and remains below many Central Banks’ targets. Technology advancements are stymieing a rise in inflation though the year ahead could spell a different story as labor conditions tighten, output gaps narrow and energy prices trend higher.
Volatility remains at historical low levels as evidenced by the S&P Volatility index (VIX) which remained under the 10% threshold for most of 2017. Political malaise as well as rising tensions in the Middle East and the uncertainty behind North Korea failed to spur any investor angst. 2018 should bring volatility off the current low levels but for now the market remains comforted by the economic outlook.
Markets will, of course, continue to face some risk of correction due to de-risking and rebalancing pressures by pension funds and sovereign institutions, especially after the continued advance in equities. Other key risks, as always, include geopolitical uncertainty and potential policy missteps, whether monetary, fiscal and/or regulatory in nature. As we have noted repeatedly in recent years, in a market environment underpinned by aggressive governmental policy, even subtle changes in policy expectations can have swift implications for markets and investor sentiment. As always, we find bottom-up analysis of credit conditions and earnings trends to be much more reliable guides than top-down attempts to forecasts macro variables.
We continue to prefer companies with favorable earnings trends and other aspects of improving business fundamentals, rising investor expectations, and attractive relative valuations. Stock selection remains our focus, as always.