*In light of the recent sell-off in global equity markets, we want to reaffirm our original outlook as generally favorable for the year, with inflation and interest rates being our primary concern. Should these factors change in a meaningful manner, we will update our outlook accordingly
As everyone knows, change is constant, and nowhere is this more evident than in the markets. For those of us who had parents or grandparents born in the 1920s, your household conversations likely revolved around the expense of consumer goods and the need to store everyday items (in my case mayonnaise jars, rubber bands, and newspaper bags!). This generation was profoundly impacted by the Great Depression and spent the remainder of their years keenly mindful of the potential impact of such an event.
It took a new generation, our beloved Baby Boomers, to shift focus from a tumultuous period for the United States. The Boomers, whose impact continues to drive overall US economic activity, parlayed their optimism and expectations of a brighter future into the wealthiest generation yet.
In 2007 we entered the Great Recession, and though not on the scale of the Great Depression, the event has had a somewhat parallel impact on the US psyche. The experience has impacted decisions of most any nature for the better part of the past nine years, and it will be interesting to see that play out over time with the Millennial generation.
Then came 2017. In our view, 2017 will be seen as the turning point where we collectively stopped viewing the world in light of the Recession and began looking forward to what could be, what will be.
2017 was truly a year for the record books, with few assets losing any ground and most making meaningful gains. Certainly there were areas of weakness, wages come to mind, but on the whole, the economy, employment, and markets delivered.
Overall economic growth, as measured by GDP, showed renewed signs of life in 2017, with Q2 and Q3 printing annualized rates of growth above 3%. While 4q17 was a bit off this pace, the underlying activity was quite strong and points to continued expansion as we move forward. The risk to a full 2018 maintaining such growth, ironically, could be the initial benefits bestowed by Congress’ changes to tax legislation. While the recent changes have largely been well received, the risk is economic activity accelerating into the early quarters of the year, leading to an effective hang over later in the year.
This growth has been reflected in ever upward equity prices over the year, with large-cap US stocks posting returns over 20% for the year. And while much attention has been given to valuations, whether current prices are high or too high, the underlying earnings tend to support current levels. For 2017, corporate earnings for S&P 500 companies increased 18%, with consensus expectations for 2018 in the 15% range. Moving into 2018, the growth of earnings will be key to maintaining the current market course and will likely be the key variable for the next few periods. That said, we are looking to maintain target weights in equities and see room for continued appreciation looking out six to 12 months.
Perhaps the weakest link in the overall economic landscape has been subdued increases in wages. This was a key element in the 2016 presidential election cycle and remains a source of frustration for many workers. Consistent with the previous seven years, 2017 failed to provide any meaningful improvement in the trend. Oddly, this was paired with an overall improving employment landscape, where unemployment rates are at, or near, 50-year lows. Federal Reserve Chairman Yellen has noted throughout her tenure that the wage question continues to challenge economists of many stripes. In her estimation, the headline unemployment rate, now at 4%, is somewhat misleading due to the rate of underemployed and below trend participation rate. According to Yellen, these pockets of workers are likely providing a supply of workers not reflected by the headline numbers and keeping the supply/demand pressures in more balance than one would estimate. We see no fault in Yellen’s analysis but see an end to the trend sooner or later, with a likely shift in 2018.
An improved wage landscape will only further the Federal Reserve’s resolve in relation to increasing short-term rates. On the heels of three rate increases in 2017, the Fed has displayed increased confidence in their ability to “normalize” rates without negative consequence to the economy at large. Despite stubborn inflation readings, we feel the Fed will remain on course in 2018 and see little risk to their estimate of three changes over the calendar period. Should wages and inflation pick up, it is likely another increase will be added to their current projection.
Creating some concern looking ahead is the Fed’s ability to continue increasing short-term rates with seemingly intractable intermediate and longer-term rates. While the yield curve has been flattening over the past year, we feel there will be some improvement in the coming months. Pressure on the middle and back of the yield curve will come from a combination of the Fed’s reduction in repurchasing maturing bonds, as well as our expectation of European Central Bank’s shifting policy in the latter half of the year. Reduced central bank purchases, coupled with increasing inflation, should lead to an improved “shape” to the interest rate structure. That said, demographic trends still support a “low” rate environment, so improvements should not be judged against historical averages but relative to where we have been. We see the risk to this forecast being to the downside, with rates not responding and an effective cap on the Fed’s desired changes if the expected rate shift doesn’t materialize.
While the US market and global markets are not always in synch, the current expansionary period has been one of near-unprecedented coordination. We see no obvious reasons for this to end and look to maintain non-US holdings at above target weights. There is further opportunity for US investors, as the US dollar has shown recent weakness vs other global currencies. Whether this is because of presumed increases in US debt levels as a result of the new tax legislation or simply a rebalancing of accounts based on the past year’s global growth patterns remains to be seen. But foreign holdings will benefit US investors if, and as, the dollar continues to weaken. The other positive is increased competitiveness of US goods abroad. A declining dollar makes US manufactured goods cheaper on the global stage and could set the stage for increased demand as well as improved export balances. The bad news is increased costs if you’re looking to travel abroad!
A note of caution is warranted in relation to the highly irregular lack of volatility over the past year. More broadly, the entire recovery period has been one of few hiccups and largely inconsistent with the history of markets in general. It is our belief that such is unlikely to continue. Further, the nature of risk-based assets almost assures us that volatility will return. We would look to near-term setbacks as an opportunity and not, given current conditions, a signal to take flight.
One of the difficulties with a yearly outlook is the presumption that market trends align with the calendar; experience suggests otherwise. On balance, we are looking for a continuation of current trends but are mindful of relative outperformance. From a portfolio construction perspective, we are looking to rebalance to target weights (growth vs value, for example) while maintaining both credit and duration positions in our bond holdings. One of the few poorly performing sectors for 2017 was MLPs. We will rebalance to target weight and look to add where appropriate for further diversification and added exposure to an improving energy sector.
It is our opinion that current trends are supported by both broad market fundamentals as well as an underlying health of corporate America in general. Such an environment supports our positive outlook, and we are positioning portfolios to benefit from continued improvements. That said, while looking forward is the fundamental charge of any investment professional, we will not lose sight of the lessons learned from past generations and, as ever, will continue to keep a watchful eye for risks. Our experience, and the experience of those who came before us, should never be ignored, especially in such bullish markets.
John E. Sawyer, CFA
Chief Investment Officer
What questions do you have regarding the markets in 2018? Connect with our Portfolio Managers to discuss your portfolio.
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