In October, U.S. and foreign equity prices moved higher yet again. On the month, the S&P 500 Index rose 2.33%, the MSCI All Country World ex-US Index was up 1.88%, and the MSCI Emerging Markets Index of stocks gained 3.51%. Even core U.S. bond prices inched ahead. The broad Barclays Aggregate U.S. Bond Index tiptoed forward 0.06% over the same timeframe. Global economic activity generally continued to expand modestly, and U.S. GDP for Q3 was initially estimated to advance at a 3.0% annualized rate. Although some headlines may have changed, the basic economic and investment conditions remain similar to those a month ago as we began the final quarter of 2017. In this installment of Insights, we refine our economic and investment outlook for the final two months of the year and beyond into 2018. Central to our outlook remain factors contributing to largely stable market conditions albeit with the potential for an equity correction. The key contributing factors are U.S. Federal Reserve policy, the rate of inflation, and consistent economic growth.
U.S. equity performance was positive in October. The Dow Jones Industrial Average was the top performer in our list, up 4.44%, nearly twice that of the S&P 500. The main reason for the Dow’s outperformance is its heavier concentration of multi-national companies which have benefited from an uptick in foreign economic growth, commodity price increases, and a weaker U.S. dollar this year (down about 5.7% on a trade-weighted basis).
The run up in the prices of tech stocks also boosted the NASDAQ past the S&P 500 in October and for the year. Still, the S&P 500 is up 16.9% year-to-date through October. Foreign stocks continue to lead the broad U.S. stock market. The MSCI ACWI ex-USA has gained 23.41% in 2017 through October, and the MSCI Emerging Market Index is up 32.26%, the best YTD return in our table.
Core taxable U.S. bond prices held steady during the month. U.S. high yield bonds rose 0.39% and have now gained nearly 7.5% YTD through October. Emerging market bonds had mixed returns. The JP Morgan U.S. dollar-denominated EM bond index also rose 0.37% for the month and remains up 9.4% for the year. The local currency EM bond index dropped 2.8% in October but has still risen more than 11% YTD. Notable for its turnaround in October was the alternative investment strategy of managed futures. It has struggled YTD, but the Morningstar managed futures category rose 3.5% last month, topping U.S. stocks.
After another month in which nearly all major asset classes that we show above have posted gains, year-to-date returns for diversified portfolios have generally only improved since the end of September. This has come during a time when jitters remain about North Korea’s nuclear program, when Catalonia and Kurdistan have apparently been thwarted in their attempt to break away from Spain and Iraq, respectively, when domestic politics remain unsettled by Special Counsel Mueller’s investigation into Russian election tampering, potential U.S. tax reform, and the question of who will be the next chair of the Federal Reserve. Global assets have largely continued to climb these walls of worry. Why have they done so, and will it continue?
In recent monthly installments of Insights, we have written that we believe that economic and investment conditions are largely stable and positive, albeit with equities in the U.S. running slightly above average valuation levels and without having had a major pullback in equities this year. We continue to believe that this remains the case, and as such it forms the foundation of our outlook. We also want to note that, while the economic foundation is currently positive, the possibility of an equity investment pullback is statistically not trivial. The table below shows that the S&P 500 has had an intra-year decline of 5% or more in 36 of the last 37 full calendar years. The one exception was in 1995. This year has so far had the makings of a second exception.
It is impossible to predict with accuracy whether there will be an equity market correction or what its magnitude might be. We mention the intra-year decline history merely to point out that the approximately 3% intra-year decline so far in 2017 is the exception, not the norm. We ask clients and friends to keep in mind that if an equity market correction did occur, (a) it would be historically normal, and (b) it would not necessarily mean that U.S. large cap stocks such as those in the S&P 500 would not end positively for the year. Even with sometimes steep intra-year drawdowns, the S&P ended in positive territory in 28 out of the last 37 years, and the 16.9% S&P 500 return through October is a nice cushion.
Economic momentum is positive globally. Developments in Asia tend to drive much of the world’s economy and often serves as a cue for emerging markets. In October, China’s Party Congress and the Japanese election in which Prime Minister Shinzo Abe and his party were re-elected point to policy continuity in the largest regional economies. India announced a bank recapitalization plan that could stimulate economic growth further there. Inflation currently remains well-contained not only in the U.S. but other major global economies. Tax reform policy in the U.S. is unlikely in our view to disrupt investment market conditions, even as the House version of the bill continues to be digested and debated. Overall, in the U.S. the typical signs of an overheating economy are largely absent: capital expenditures are not grossly elevated as a part of the economy, residential real estate is improving but not wildly, and household debt has picked up but remains well below peak levels.
As for the Federal Reserve, although the central bank has embarked upon a rate tightening cycle, the pace remains slow, methodical, and data-dependent. Upcoming rate and balance sheet actions have also been extremely transparent, and this clear communication has muted market reactions to individual decisions. Inflation remains moderate and slightly below the Fed’s long-term target level. The appointment of current Federal Reserve governor Jerome Powell to replace current Chair Janet Yellen when her term expires in early February provides continuity of key personnel and likely also interest rate policy direction. The Fed left interest rates unchanged at its policy meeting on November 1, but current market expectations are that it will raise its Federal Funds rate by another 0.25% in December. For instance, a report in Bloomberg on 10/31/2017 estimated an 85% probability of a rate increase in December.
Currently the target range for the Fed Funds rate is 1.00% to 1.25%. Although some attention has focused on the fact that the Fed has raised rates over the last two years, less attention has always focused on the level of the key short-term rate in absolute terms and relative to other key central bank rates. At even 1.25%, the Fed Funds rate is well below its level of 5.25% in 2006. In absolute terms, a 1.25% policy rate is low and still very accommodative.
Second, relative to the European Central Bank and the Bank of Japan whose rates are, respectively, near or below zero, the U.S. rate is high. This makes U.S. debt relatively attractive to global investors, and it is one reason that we believe that U.S. government debt yields will remain largely contained despite perhaps even 3-4 more Fed interest rate hikes over the next year. That is, continuing demand for safe U.S. government bonds relative to European or Japanese debt will help to keep U.S. yields from spiking. Further, the Fed itself anticipates a still relatively slow pace of interest rate normalization, which reduces the chance for a massive interest rate shock assuming that the economy continues to grow modestly with subdued inflation.
As for equity prices, U.S. stocks are trading slightly above their 25-year average, based on price-to-earnings levels, but not at anything like the bubble levels reached in the late 1990s. Price-to-earnings ratios for companies in the U.S. and Europe are at the top end of their normal range, but emerging market (EM) equities are relatively more attractively priced and are trading in the middle of their historical average range. This makes good sense in view of how much the U.S. in particular has outperformed foreign stocks in general in recent years.
The graphic below maps the periods in which foreign developed market stocks in the MSCI EAFE Index outperformed or underperformed the broad domestic stock market tracked by the MSCI USA Index. Immediately, one can observe that there are in fact distinct, multi-year periods in which one index has outperformed the other. Most recently, U.S. stocks have outpaced foreign stocks, but that looks as though it may have begun to change in 2017.
The data in the chart is through September. Through October, the current cycle value has increased for YTD 2017: foreign stocks in the MSCI EAFE, a developed markets stock index, are outperforming the S&P 500 Index by nearly 5 percentage points (4.87% to be exact). We believe that economic conditions abroad remain conducive to foreign equity investments, including and perhaps especially in emerging markets because of the still higher growth rate in EM countries over developed market countries. The chart below shows how the growth differential (or gap) has begun to widen again as EM economic growth has picked up a bit in 2017 after several years of decelerating growth and currency weakness against, in particular, the U.S. dollar.
We can observe a similar upward trend in emerging market growth by comparing corporate earnings in different regions globally. The slope of the EM line (in purple) in the chart below is much steeper than the slope of the lines for the U.S. and Europe. After declining for approximately 5 years, we think that earnings in emerging market countries, the vast majority of which by market capitalization within the index are in Asia, should be able to continue over the next year.
In summary, then, our outlook as we move through the fourth quarter and into 2018 continues to anticipate, economically low (if slowly rising) interest rates in the U.S. because of a Fed that is likely measured in its policy approach given low inflation and solid economic growth. This backdrop suggests to us that investors may continue to tilt their portfolios toward risk assets like equities.
Returns in domestic and foreign stocks year-to-date remain, after another generally positive month of gains in October, in the double-digits. We would not be surprised to see some turbulence, retrenching, or profit-taking between now and year-end. If this happened, it would be well within the normal range of historical occurrence for the S&P 500 Index. If the Fed does announce another rate increase at its December meeting, markets may generally take it in stride unless the Fed statement contains particularly hawkish language, or language that would suggest controlling inflation is more important than supporting growth. It is worth recalling that in December the government will also need to revisit questions related to the debt ceiling and government funding that it deferred in September. We believe that those deadlines will pass uneventfully, but market volatility might increase in the weeks leading up to them. We invite our clients and friends to focus on the largely steady economic growth factors and benign inflationary forces that undergird market fundamentals, and we consider these forces to be generally supportive of investment assets.
Finally, and as always, we respect the trust you have placed in us, and we welcome any questions you may have about our views on the current economic and market environment. We wish everyone rich blessings as we head into the end of the year and holiday season.
The information and statistics contained in this report have been obtained from sources we believe to be reliable but cannot be guaranteed. Any projections, market outlooks or estimates in this letter are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of these investments. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. These projections, market outlooks or estimates are subject to change without notice. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. All indexes are unmanaged and you cannot invest directly in an index. Index returns do not include fees or expenses. Actual client portfolio returns may vary due to the timing of portfolio inception and/or client-imposed restrictions or guidelines. Actual client portfolio returns would be reduced by any applicable investment advisory fees and other expenses incurred in the management of an advisory account. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Sage Financial Group. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Sage Financial Group is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Sage Financial Group’s current written disclosure statement discussing our advisory services and fees is available for review upon request.
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