January 11th, 2018
Dear Valued Clients & Friends:
Market and Portfolio Update – January 2018
2017 equity markets surprised many investors, as synchronized global growth spurred by continued monetary and fiscal stimulus produced strong returns with historically low volatility. The year saw a governing change in the U.S., with one party controlling both houses of Congress and the White House, resulting in a reform of individual and corporate taxation. The economic impact of tax reform will be more fully realized in 2018 and 2019, but we know it represents an estimated $1.5 trillion of fiscal stimulus over 10 years and is intended to provide a tax cut to most U.S. families and businesses. It is projected that the reduction in corporate tax rates will add 5% to 8% of earnings growth in 2018. The turnaround in U.S. earnings in 2017 was a significant driver of market performance and continued optimism. Figure 1 illustrates S&P 500 annual earnings growth since 2015, with Q4 2017 and 2018 earnings estimated based on current corporate guidance.
The U.S. middle class comeback in 2017 has largely gone unnoticed and under-reported. The people identifying as middle and upper middle class have grown to 62% of the population, with lower middle and lower class declining to 36%. A recent survey indicates that 59% of those surveyed see this as a good time to find a quality job.
Business confidence in the U.S., China, Korea, Japan and Europe remain at high levels, while unemployment in the developed world is close to a 40-year low. Inflation has been mysteriously missing, as the Federal Reserve is still in the early stages of imposing monetary restraint. From a broader perspective, Compass Ion Advisors’ research team tracks 26 economic and capital market growth indicators on a weekly basis. The latest reading shows that 65% of the indicators are currently signaling strong continued growth, while only 8% are indicating weakness. While U.S. political stability and the global geopolitical landscape remain a concern, current economic data and the pricing of risk within capital markets are both supportive of continued economic growth and positive equity market performance.
Capital Markets Update
The table below shows that global equity markets had an outstanding year in 2017, with most global indices up well over 20% (the U.S. small cap sector being a notable exception at +14.6%). The S&P 500 produced positive returns every month during the year for the first time in history. International equity markets delivered a payoff for global investors – both the developed and emerging regions significantly outperformed the S&P 500.
U.S. interest rates surprised many (including us) last year, with the 10-year Treasury yield starting the year at 2.45% and ending at 2.41%. The year in rates, however, was anything but stable. The 10-year yield bottomed at 2.04% in September before trending higher to close the year close to where it began. The Federal Reserve raised the Fed Funds rate 3 times in 2017, and the yield curve generally flattened during the year, which is usually considered a bearish market signal. However, we do not believe this is currently the case, as a historically low Treasury supply and the fact that U.S. rates are higher than most developed sovereign yields (both the result of global quantitative easing) are anomalies working to constrain longer-term U.S. rates.
Alternatives posted mixed performance for the year. REIT’s lagged equities (up roughly 9%), while diversified commodities, like U.S. rates, trended down in the first half of the year before moving higher with choppy trading in the second half. MLP’s were down close to 7% while gold was up 13%. Across capital markets we saw a distinct change in trading patterns during the 3rd quarter as risk appetite and growth expectations increased, and positive market performance sustained going into year end.
Going into 2018, Compass Ion Advisors has a positive outlook for equities, however we are bearish on U.S. bonds. As previously mentioned, current economic data is supportive of continued growth, and U.S. tax cuts should bolster consumer demand, as well as corporate earnings and capital investment. We are often asked, “when will the bull market in equities end?”. No doubt equities are expensive by historical standards, as judged by various metrics. We believe we have entered the last phase of the current economic cycle, but note that our research indicates this period typically lasts for 1 – 3 years. For example, historically equity markets continue to generate positive returns for 3 years on average after the Fed embarks on a tightening cycle, which it did in 2017.
Based on historical data, we are looking for the following market conditions which could signal the end of the current growth cycle:
- an inverted U.S. yield curve (i.e. short-term interest rates are higher than long-term interest rates)
- sustained negative trends in corporate earnings, capital investment and unemployment claims
- strong negative signals from Compass Ion Advisors’ economic and tactical indicators
While we believe equities will come through 2018 with positive returns, bonds do not look attractive. Corporate bonds have historically tight credit spreads, and we think U.S. rates will move higher in 2018. Equity volatility will inevitably increase at some point, which should benefit active and quantitative trading strategies. We will continue to digest incoming economic and capital market data and adjust our market view as warranted.
There was one primary portfolio change in the 4th quarter of 2017, which is described below in detail:
- In mid-September, we had a 36 month Euro Stoxx 50 Structured Note mature which had been issued for our clients by Barclays. It provided a 10% buffer against index losses and offered 1.53 times the price return of the index at maturity. The Euro Stoxx 50 index contains many of the stocks of the largest European-based multinational companies. When the note matured, the index had increased by 7.88% since its creation, and clients therefore received an 11.98% return. We did not immediately reinvest the proceeds into a new note as we felt pricing terms might continue to improve in the following months.In early December, we created a new Euro Stoxx 50 Structured Note. The note was issued by Morgan Stanley, has a 27 month maturity, will pay clients 1.83 times the price return of the index, and has no upside cap. This note has a 10% downside buffer, meaning that clients have first dollar protection against the initial 10% of any decline in the Euro Stoxx 50 Index. For additional details on this note and structured notes in general, please read “January 2018 Structured Notes Program” PDF.
We continue to be steadfastly committed to serving your unique financial planning and portfolio management needs. We are never satisfied with the status quo, and are always looking for new, innovative ways to provide sophisticated comprehensive financial planning services and institutional quality investment solutions to our valued clients.