December 31, 2017
Will The Streak Continue?
Fourth Quarter 2017 Newsletter
A Synchronized Global Recovery – Global equities experienced a near-perfect backdrop of steady global growth, low inflation and continued accommodative monetary policy in 2017, leading to strong performance. For the year, all major equity categories and sectors ended the year with double-digit gains; shaking off nuclear threats, populist uprisings and a stalled Trump Administration agenda.
Commodities closed higher on the year, led by gains in crude oil, with WTI rising 12.5%. Precious metals and copper also posted gains, while agricultural commodities were mixed. The US dollar index, which compares the greenback to a basket of global currencies, slid about 10% last year after rising for nearly three years.
Despite fears of US Federal Reserve tightening and fiscal reform leading to higher growth, most US bond indexes closed the year higher. The US yield curve, which has historically been an important indicator of recessions by inverting prior to the previous seven recessions, flattened by about 100 basis points.
Approaching Levels of Significance – The equity bull market is now deep into its ninth year, the second-longest on record. The third (and perhaps final) phase of the bull market kicked off in 2016 as global economic momentum strengthened to include more sectors and countries. The improvements were broad based as nearly every major global economy expanded in 2017. Lower corporate taxes in the US and a continuing rally in commodities bolstered the outlook for 2018.
Strategist forecast S&P 500 earnings to be between $139-$150 per share, an approximate 10.3% increase from 2017 forecasts. Similarly, the earnings multiple has increased, to nearly 18x the next four quarters’ expected earnings. The long-term average multiple is 16.5x; moreover, the multiple was 17.1x one-year ago. Statistically, a 10% setback is plausible if the Price-to-Earnings multiple backs up to 16.5x, even with a $150 earnings figure. However, at this point it appears that any pullback will be merely corrective as the emergence of a recession in 2018 is doubtful.
The ISM Manufacturing Index is often used as a guide for the business cycle. In the US, the ISM is currently experiencing the third-longest expansion in history and its reading is at the second-most elevated level in the last thirty years. Meanwhile, the Conference Board Leading Economic Indicator Index continues to increase while the US Treasury curve remains upward sloping – despite recent flattening. Given the strong economic backdrop and the need for governments to “inflate-away” their debt, we believe commodity-linked equities, including precious metals and agriculture, will outperform. Additionally, this sector is exhibiting favourable valuations.
Volatility may be resurrected in 2018. Possible triggers for spontaneous instability include;
- Failure for capital expenditures and hiring/wage increases to underpin growth.
- Excessive debt levels.
- Accelerated interest rate increases.
- Defiance to the “America First” rhetoric.
The first signs of erraticism may surface in the currency markets. A surge in the US Dollar index is likely in the near-term as tax repatriation increases demand. However, net-investment positions may trigger a USD sell-off while many countries are already seeking alternatives to the dollar system. China and Russia continue to stockpile physical gold while hinting at problems with the Eurodollar system. Meanwhile, the two countries are negotiating with Saudi Arabia for a Yuan-backed oil contract.
In the near-term, bonds are somewhat attractively priced. Originally, economic growth forecasts caused prices to slide and yields to rise. More recently, yields rose when the U.S. Senate reached a short-term compromise to end the government shutdown. The 10-year bond now sports its highest rate in over one year. Longer term, we do not anticipate traditional fixed income to benefit the portfolio from a total return perspective. Yields remain near historic lows and an increase in supply will pressure prices. Deflationary pressures have been prominent recently, as millions of baby boomers leave the workforce; but, a recent IMF research report anticipates that population aging will become very inflationary due higher health care costs. Nevertheless, bonds provide a reliable stream of income, uncorrelated performance and low-cost portfolio insurance.