January 2, 2018
As we entered 2017, all eyes were on the new president. What policies would be proposed? Which policies would be successfully executed? And most importantly, how would markets respond? Throughout the year, as these uncertainties played out, the strong economy provided a superb foundation for continued positive domestic returns. Outside the U.S., there were also many questions about Brexit, pending elections in the Eurozone, and growing security threats from North Korea. As in the U.S., however, world markets performed well in spite of the many continuing and unresolved political matters.
The still-firming economy provided a solid foundation for domestic equities over the past 12 months. The U.S. unemployment rate, which began the year at 4.7%, stood at 4.1% as of the November jobs report—a 17-year low. Strong November readings in The Institute for Supply Management indices demonstrated that the manufacturing and services sectors remained healthy. Against the backdrop of rising consumer confidence and robust business demand, the U.S. Bureau of Economic Analysis revised Q3 annualized GDP growth upward to 3.3%.
U.S. Equity Markets
When the year began, observers anticipated that fiscal policy would replace monetary policy as the primary market driver. Yet it was the continued strength in corporate earnings that ultimately drove equities higher. The S&P 500 finished the year up 21.8%, surpassing 2016’s impressive 12% gain. The index logged a 6.6% advance in the fourth quarter as the tax reform bill added further oxygen to the markets (Exhibit A).
Ultimately 2017 was an earnings story for investors. Nearly three out of every four companies in the S&P 500 reported Q3 earnings that exceeded consensus analyst expectations. As of the end of December, every sector was expected to report positive Q4 profits, with an estimated earnings growth rate of 10.6% for S&P 500 constituents. This, of course, would be a welcomed development given the escalating market valuations. The S&P 500’s forward 12-month P/E ratio finished the year at 18.5x, outpacing a 25-year average of 16x. Further, the length of the market’s run is also testing investors’ collective psyche. Assuming the equity market’s strength continues through August 2018, the current 105-month bull market will eclipse the length of the 1990s bull market—the longest extended run on record since World War II.
As long as fundamentals continue to improve and the economy remains steady, observers are confident that stocks will grow into their current valuations. Moreover, market watchers speculate that the recently passed federal tax reform could provide added catalysts through the corporate income-tax reductions (from 35% to 21%), accelerated tax write-offs on capital expenditures, and incentives on repatriated overseas profits. The move to a “territorial” tax system is particularly appealing to U.S.-based multinational companies as well.
Of course, unintended consequences are always possible whenever there are major policy changes in an economic system. In the case of tax reform, we will continue to analyze the possible scenarios through multiple lenses. In addition to modeling the obvious, such as possible earnings improvements, we will study other paths currently considered by most as low-probability options. Possible paths include a scenario in which no tax savings flow to earnings, as companies take other actions with the additional cash flow. Another possibility is that companies choose to further leverage their balance sheets as stronger cash flow supports higher debt-service payments. We know from experience that the best intentions of past policies can create unexpected outcomes that have surprised many unprepared market participants. We work to identify such possibilities ahead of their outcomes.
U.S. Interest Rates
There was little net movement in long-term interest rates this year. The 10-year treasury yield finished the year at 2.40%, close to where it started 2017 (although it did drop to 2.05% in the third quarter). On the short-term rate front, the Federal Reserve raised the Fed Funds rate by 0.25% in December, as expected. This elevated the benchmark interest rate to a 1.25%-1.50% target, even as inflation failed to reach the Fed’s 2% long-term objective.
In the fourth quarter, market watchers also paid special attention to the nomination of Jerome Powell as the next Chairman of the Federal Reserve’s Board of Governors. We expect his nomination will be approved and that he will assume the role in February. At his confirmation hearing, Powell signaled that, under his watch, the Fed could be expected to continue its policy of gradual rate increases and would also take steps to shrink the size of its balance sheet, assuming economic growth maintains its current trajectory. Powell also revealed the extent to which the Fed is aiming to reduce its balance sheet, which he expects to shrink from $4.5 trillion to between $2.5 trillion and $3 trillion by 2022.
The future pace of rate hikes will depend significantly on where inflation is headed. We expect the most likely theme of 2018 to be a replay of 2017’s inflation levels. However, we also must consider the possibility of even lower unemployment rates—like those not seen since the 1960s—in the mid- to high-3% range (Exhibit B). The main uncertainty is whether there is additional slack in the labor market, which is an estimate that has traditionally proven difficult for economists to size (Exhibit C). As a result, we must consider the possibility of lower unemployment and resulting higher inflation, a scenario that would drive the Fed to be more aggressive in raising rates. But even if rates were to increase more sharply than consensus estimates, such an increase would signal an economy that is even more robust and growing at a faster pace than current expectations, which would bode well for the U.S. markets.
In 2017 the global economy benefited from low inflation and accommodating central banks. Each of the 35 countries measured by the OECD remained on track for year-over-year growth in both the second and third quarters. The U.K., in Q3, recorded the slowest growth among the seven major economies year over year, while Germany was the pacesetter. The impact of the Brexit vote is beginning to take shape as economists estimate it will have cost the U.K. economy £60 billion in lost output by the end of 2018.1
While international investors entered 2017 in a cloud of uncertainty regarding the geopolitical landscape, they largely exited the year with far more clarity. Notable elections occurred in France, Germany, the Netherlands, Norway, and South Korea, for instance. And while German Prime Minister Angela Merkel initially struggled to form a coalition following her September re-election, it appears that her conservative bloc will be able to find common ground with Germany’s social democrats heading into the New Year, as exploratory talks were scheduled for the second week of January.
In October, Chinese President Xi Jinping also emerged from the Communist Party’s 19th National Congress having tightened his grip on power for at least the next five years. Japanese Prime Minister Shinzo Abe was also re-elected in October for his third consecutive term. The biggest geopolitical uncertainty heading into 2018, however, continues to be the escalating tensions on the Korean Peninsula.
For 2018, we expect that Brexit will return to the foreground as the self-imposed March 2019 deadline approaches. We may see increasing volatility in the global markets if it appears that various milestones and deadlines will be missed. FTC expects that the Eurozone will continue its robust growth, which may offset some of the Brexit-related market stress. Even though economic growth is expected to continue, like in the U.S., such growth may place more pressure on their central bank’s role in keeping inflation in check. In many ways the E.U. is several years behind the U.S. in its recovery cycle, which may provide investors with a “ballpark” precedent to model market reactions.
As the geopolitical landscape became clearer and the economic recovery progressed, the MSCI EAFE Index, which measures international developed markets excluding the U.S. and Canada, gained strength throughout the year. The Index advanced 4.2% in the fourth quarter and finished 2017 up 25.0% overall. The MSCI European Monetary Union Index seemed to level off in the fourth quarter, posting a small 1.0% gain, but on the year, European equities registered a strong 28.1% gain, underscoring the improving economic picture. The MSCI Pacific Index posted a solid 8.0% gain in the fourth quarter, which contributed to the 24.6% advance for all of 2017. U.S. investor returns across these markets benefitted significantly from a 6.3% decline in the U.S. dollar over the course of the year (based on the Trade Weighted Broad U.S. Dollar Index).
The emerging markets, meanwhile, capped off an impressive run in 2017 as the MSCI Emerging Markets Index posted a fourth quarter gain of 7.4%. For the year, the Index climbed 37.3% higher, marking the second year in a row that the Index registered double-digit gains. EM equities were aided by a weaker U.S. dollar, strengthening earnings, and increasing investor risk taking.
On the valuations front, developed international market and emerging market equities finished the year close to their 25-year historical valuation levels. The MSCI World Index closed 2017 with forward 12-month Price / Earnings ratio of 17.0x and the MSCI Emerging Markets index with a Price / Book ratio of 1.8x (Exhibit D).
For the developed markets, we expect the Eurozone to continue to benefit from its mid-cycle phase of strong economic growth and favorable political resolutions. High levels of producer and consumer confidence should also support strong market performance. FTC will also be monitoring for signs of deterioration in economic growth to inform our investment recommendations.
FTC expects the emerging markets rally to continue as the asset class catches up to more than six years of relative underperformance versus developed markets. Many companies continue to repair their balance sheets and enjoy stable commodity prices as they benefit from improving economic growth. Possible offsets to this outlook include elections and political activity in countries such as China, Mexico, and Venezuela. The asset class will most likely continue to benefit from the strongest economic and earnings growth it has seen in over six years.
One year ago, investors were concerned about the new administration’s impact on markets and feared that a lack of clarity would impair the markets. We have seen that the strong foundations of the U.S. and world economies have mitigated those uncertainties. These favorable conditions will likely persist throughout 2018. We will be closely assessing developments as the year unfolds to help our clients stay well-positioned in a changing world.
1 Center for Economic Policy & Research
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.