January 15, 2018
The stock market climbed a wall of worry, disdain and disbelief as it registered consecutive years of double-digit returns. Along the way historical milestones were set, as 2017 recorded the 9th consecutive year of positive equity returns. The S&P posted a positive total return (including dividends) every single month for the first time in its history. It would appear the broad skepticism has turned to optimism. 2017 was also the beneficiary of low volatility. While 2016 experienced a 10.5% correction in the S&P during the first quarter, 2017 logged over 265 days without a 3% downturn; the longest on record based on data available since 1930.
The strong equity performance has been driven by the on-going backdrop of improving global economic growth, better than expected corporate earnings, low inflation, accommodative monetary policy from all the major central banks, and a weaker U.S. dollar which supports U.S. exports. We note that the current economic expansion dating to 2009 is within 18 months of breaking the post-war record. More recently, the market strength has been further supported by the tax reform bill which lowered corporate tax rates and allowed for a much lower repatriation rate for foreign earnings on U.S based companies. This legislation resulted in analysts boosting their estimate of earnings in the S&P Index to grow by 16% in 2018 based on a current consensus of $146 (according to S&P Dow Jones Indices).
The beginning paragraph of Barron’s December 9, 2017 article put it best regarding this bull market witnessed in 2017: “Wall Street’s eight-year love affair with stocks kicked into overdrive this year, spurred by a stronger economy, the likelihood of tax cuts, and a lack of compelling investment alternatives.” Let’s examine all the reasons behind this bull market and discuss whether they will continue to be the support of another strong year in 2018.
The stronger economy – there is a synchronized global recovery and rising corporate profits. Most investors don’t realize a majority of market performance last year came from earnings growth itself. While cost-cutting had a role in the earnings recovery, all eleven sectors in the S&P 500 grew revenue over the last year in the fourth quarter of 2017 as reported by Factset. According to the MSCI All Country World Index, the global corporation’s earnings came out from the negative growth territory in the second half of 2016 (see Chart 1). The market anticipated the recovery long before we saw it in ink.
Chart 1 – All Country World Index EPS (year-over-year growth, based in US Dollars)
The impact of tax cuts – this is certainly a U.S. centered theme which started right after the 2016 presidential election. Since the tax bill was one of the campaign promises, investors have been following this closely. Even though the actual impact to each taxpayer is different, the general direction is pro-business and pro-U.S. on-shore investment. What we should pay attention to is how this tax bill could affect the behavior of consumers, businesses and investors, and the long-term impact on economic growth and the U.S. federal government’s debt level. The new law moves the money from federal government’s hands into the private sectors, assuming it can stimulate a higher return. However, it did not address how the federal government can support all the entitlements with lower resources. This issue could limit the benefits of lower tax rates.
A lack of compelling investment alternatives – even with elevated market valuation, the expected return on equity remains more attractive than fixed income which we will discuss in more detail later. With this new tax bill, the incentive for homeownership may be reduced and might have a negative impact on the real estate markets. China’s demand for commodities is leveling, so there is not an obvious secular demand for this asset class. Since the financial crisis in 2008, the commodity class’s correlation with the equity market has been increased. Thus, the appeal of using it for diversification also declined. These three reasons could continue to support a bull market in 2018.
However, there are risks on the horizon that we have to pay attention to as well. One to keep an eye on is China. As the second largest economy in the world, China’s risk will be well discussed and monitored by the markets. What gained the most attention is China’s debt ratio to its GDP, which hit a soaring 250%. This is alarming if not addressed. However, a deeper analysis reveals the fact that it is mainly the corporate debt level. There were a great number of interbank borrowings as well as a lack of alternatives for raising capital and state-owned enterprises were greenlighted to invest by leveraging up. The Chinese government has started to tighten the money supply and use regulations and policies to discourage expansion of weaker players in the financial industry. We have been avoiding state-owned enterprises and banks in China in our search for investment ideas, and it will likely remain the same in the near future. However, we remain excited about the Chinese consumer which continues to be the strongest drive for the economy. Although the Chinese markets finally caught up with the rest of the world, the market valuation remains attractive compared to its growth potential. We cannot directly invest in the Chinese markets yet; however, there are companies traded on the New York and the Hong Kong Stock Exchanges that provide the same exposure.
Other than China, we also see further opportunities in Europe. In the past few years, Europe was the hot zone for geopolitical news which was the main source of market volatility. However, none of those issues have dampened the recovery of the region. As for other developed and emerging markets, we prefer individual companies that meet our investment criteria over participating in a regional theme.
One factor supporting the valuation of the equity market is the lack of compelling alternatives, in particular the fixed income market. The 10-year yield for U.S. government debt moved sideways around 2.3% throughout 2017. Likewise, the key benchmark rate for the Euro-zone, the ten-year German government debt yield, made a similar move at a much lower level of around 0.4%. One reason for these low long-term yields is ongoing subdued inflation. Core inflation, which excludes more volatile food and energy items, actually declined in the U.S. throughout the year. The Federal Reserve (Fed) called it a conundrum, despite a strengthening economy and a labor market close to full employment, inflation remains below its 2% objective. A higher wage growth, which stagnated the past two years at around 2.5%, could be the catalyst to move inflation towards the Fed’s target over the medium term.
While long-term yields remained fairly unchanged over the year, short-term interest rates increased as the Fed finally delivered on its own expectation and raised the target rate three times. The strong labor market conditions give it sufficient confidence to estimate three more interest rate hikes in 2018. In addition, the Fed began to gradually reduce its securities holdings in October, which over time should lead to upward pressure on long-term rates. We are starting to see a period of normalization in short-term rates and central bank balance sheet size in the U.S. The European Central Bank, encouraged by an improving economy in the Euro-zone, plans to halve its asset purchases starting in January. Other central banks also announced a reduction of or no additional asset purchases (see Chart 2). On an aggregate level we can expect less liquidity support from the major central banks, which could become a source of volatility in risky assets. A market tailwind might become a headwind during the unprecedented process of unwinding global quantitative easing.
Chart 2 – Global Central Bank Balance Sheets: From Expansion to Contraction
The positive outlook for a slow normalization of interest rates is tempered by the current unattractive valuation as spreads (over treasuries) for investment-grade and high-yield corporate bonds continue to shrink towards their post-crisis lows. The safety margin for credit risk is thin. The yield difference between equity earnings and the 10-year treasury remains fairly unchanged at 1.0% compared to the beginning of 2017 (see Chart 3). This indicator of relative value between equity and fixed income does not suggest a drastic shift in the asset allocation of portfolios.
Chart 3 – S&P 500 Earnings Yield minus 10-year Treasury Yield
There are multiple reasons that support a continuous bull market, but there are an equal number of concerns in the future. Besides China’s debt level, we see greater than expected inflationary pressures, geopolitical events, and investor exuberance as the biggest risks to the continuation of the bull market. We would also anticipate volatility to increase somewhat in 2018 from historically low levels experienced in 2017, given that global central banks are starting to remove excess liquidity from their economies. In the face of these risks, the companies we chose to invest in have strong market positions, solid balance sheets, and good management. They should survive any potential pullback and come out stronger than before.
Thank you for your trust in 2017, and we look forward to working with you in the coming years.