2017 was an excellent year for many investments. Synchronized global economic growth, low inflation, below-average volatility in equity markets, generally improving employment conditions in the United States, stability in China, and continued economic recovery in Europe, among other factors, all contributed to global Goldilocks conditions. Going into 2017, these conditions were uncertain, and we are pleased that this scenario materialized.
Most stocks and bonds gained. U.S. equities in the S&P 500 Index rose 21.83%, and the broad MSCI All Country World Index ex-USA climbed 27.19%. Not to be outdone, the MSCI Emerging Markets Index advanced 37.28%. Bond markets were stable yet positive. Despite 3 interest rate increases by the Federal Reserve, the yield on the 10-Year Treasury Note declined 0.05 percentage points to 2.40%. Core bonds, represented by the Bloomberg Barclays U.S Aggregate Bond Index, moved up 3.54%. The U.S.-dollar denominated emerging market bonds index (JPM EMBI Global Diversified) rose 10.26%.
What was perhaps most interesting in 2017 was the synchronous investment gains across so many global markets and asset types. U.S. stocks, which had performed well in prior years, continued their positive momentum, and assets such as foreign developed and emerging market stocks, which turned positive in 2016 after negative performance in 2014 and 2015, made even greater positive strides in 2017. The main exception was the Alerian Master Limited Partnership (MLP) Index, which retreated 6.5% in 2017 after jumping 18% in 2016 in a rebound from the commodity price downturn in 2015.
If 2016 provided a reminder to investors that chasing the latest hot investment and fleeing the underperforming asset often makes for poor investing, then 2017 reminded investors that occasionally most major investments can simultaneously fire on all cylinders.
As we turn to our outlook for 2018, we wonder if investors may need to recall the prudence involved in tempering expectations after experiencing a phenomenally positive investment year across the board. We will touch on our views on the U.S. and global economy, the outlook for the Federal Reserve and interest rates, and the implications that all of this may have for your portfolio in the coming years. Because it is impossible to capture all of the items that could affect investor portfolios, we will do our best to provide our perspective on what we believe to be the most pressing matters.
Heading into 2018, we believe that global economic conditions will be generally positive. We anticipate a slight uptick in the rate of economic expansion in the U.S., additional positive growth in Europe, and continued stabilization and increase in emerging market economic growth. In the following table, we map out our base case for 2018 and include two other scenarios that we judge to be possible, but less probable, than the base case (one more adverse, another more positive).
We have organized our thoughts around the three regional complexes—U.S., Europe, emerging economies/China—that are dominant economic and market spheres. We find this organizational approach a helpful way of viewing potential developments over the next calendar year.
What key shift occurred from 2016 to 2017? A major theme in 2016 was the rise in populist political movements, both in the U.S. and abroad. After the election of President Trump in 2016, questions arose about whether presidential elections in France and Germany, both key cogs in keeping the European Union stable, might result in political and economic disruptions. Those disruptions did not materialize as feared. Although Chancellor Merkel (who won re-election) still must form a coalition government in Germany, and some extremist parties in Austria and Poland made political inroads, 2017 witnessed populism recede. Brexit negotiations continue slowly, but a “divorce deal” was in outline agreed to in December that will lead to additional discussion of a trade compact between the United Kingdom and the European Union when the U.K. eventually departs. Overall, clear political risks have lessened somewhat from a year ago. Similar to a year ago, however, economic growth remains on firm footing in the U.S. and abroad, and labor markets continue to improve.
In essence, we observe the following as components contributing to likely continued steady growth in the U.S. and abroad in 2018: a largely stable global political environment, continued improvement in the job market and improving consumer balance sheets, generally clear forward guidance from global central banks (chiefly the Fed and the European Central Bank), among other factors. Within this environment, we think that asset classes including stocks may notch additional gains in 2018, but we caution that market volatility may rise this year, an equity correction is possible, and investors may need to lower return expectations from last year’s above-average levels for many assets.
The U.S. Economy
We believe that 2018 will see continued, if less pronounced, improvement in the U.S. labor market, which is already at a level (4.1%) that many consider at or near full-employment. The unemployment rate may end the year lower, likely between 3.8% and 3.5%. If it moves below 3.5%, it would pass through the trough reached in April 2000 and enter levels not seen last since the late 1960s.
We also anticipate a slight uptick in GDP growth, which may post a full-year rate between 2.5% to 3.5%. There are still largely accommodative financial conditions, signs of a modest lift from recent tax reform legislation, and strong current momentum. In our view, it is difficult to foresee the passage this year of any pro-growth legislation that would have a material effect on the economy. That, however, may not be needed to propel this extremely long economic recovery forward. As you can see in the nearby chart from the Wall Street Journal, manufacturing activity continues to be well into expansion territory (i.e., a reading above 50).
It is true that the economic expansion in the U.S. is more advanced than that in other places, for instance in Europe. Sometimes the question arises whether the duration of the current expansion implies that it is soon to end. To this question a couple of responses may be made. First, although this expansion’s length has been pronounced, the chart below on the next page (“Strength of economic expansions,” see the light blue line) illustrates that its magnitude has not been. In fact, the cumulative GDP growth has been below that of other prior recoveries of comparable duration.
Second, as we have mentioned in prior commentaries, economic expansions in the U.S. typically do not die of old age. They are, to stay with the metaphor, more often killed by spikes in inflation or overreaching monetary policy by central banks. This observation leads us to consider the Fed and likely interest rate policy in 2018.
The Fed and U.S. Interest Rate Policy
In 2017 the Fed raised its benchmark rate 3 times, and the current consensus is that the U.S. central bank will in 2018 raise rates another 3 or 4 times. The current target rate is 1.25%-1.50%.
If the Fed raises just 3 times by a quarter-point each, that would bring the policy rather to 2.00%-2.25% by the end of 2018. We believe that this is quite possible given no signs at present that inflation is, or will be, accelerating excessively, given the potential economic push from tax reform, and given the upward wage pressure from extremely low unemployment and demand for skilled workers.
From our perspective, we believe that the Fed under its incoming Chairman Jerome Powell will continue to act cautiously and err on the side of hiking at a modest pace. We do not anticipate major policy direction changes under his new leadership, which bodes well for continued economic expansion and is one reason that we do not foresee a recession in 2018.
Core inflation is still slightly below the Fed’s 2% target, and we think that core inflation may rise only marginally through 2018. We imagine, further, that economic growth will not run so hot, even with essentially full employment, that the Fed will be tempted to dampen economic activity through aggressive policy actions. It will likely, though, continue its process of balance sheet reduction by not reinvesting interest payments and maturing securities. The current plan calls for the magnitude of the reduction to increase gradually throughout the year. The process of balance sheet normalization poses some risks to bond markets but will likely proceed smoothly without much disruption.
U.S. Stocks in 2018: Modestly Positive with Potentially Bumpy Ride
In light of our expectations for the economy and the Federal Reserve, as well as for continued solid earnings and earnings growth, we expect U.S. equity returns in 2018 to be modestly positive, but with levels of volatility higher than what we experienced in 2017. Last year there was no pullback in the U.S. stock market (as measured by the S&P 500 Index), and, in fact, the S&P has posted a record 14 consecutive months of positive returns. We believe that this string will likely be broken in 2018, and it is quite conceivable that there will be a drawdown of 5% or more at some point along the way. Investors in 2015 and 2016 witnessed 10% “corrections” in the U.S. stock market (S&P 500 Index) due to geo-political events and recession fears; however, the S&P 500 ended both of those years in positive territory. Similarly, we anticipate that U.S. equities will end 2018 with positive returns, but we think that U.S. stocks will experience a pullback at some point along the way. If a correction does occur, it may be unsettling for investors, but we would urge them to remain disciplined and stick with their equity investments for the long-term, since volatility may be short-lived.
Despite the heightened political risk going into 2017, the Eurozone economy continued to grow. While it remains in an earlier stage of economic expansion than the U.S. Eurozone employment is making gains, incomes have been growing, and consumer spending has been healthy. GDP growth has been trending upward (as you can see from the nearby graph), and current indicators are positive and point to the continuation of current momentum.
What does this mean for foreign stocks? Foreign countries as a whole, not only in Europe, are experiencing improved in economic growth, have equity valuations that are lower than in the U.S., and have central bank policy that remains very supportive. Japan continues to provide monetary and fiscal stimulus, and the ECB is likely still one to two years away from raising rates.
The two graphs below show, first, the gains in global corporate earnings, which can help to drive stock prices, and, second, a comparison of equity valuations, which illustrate that on a relative basis only the U.S. has a price-to-earnings ratio valuation higher than 25-year average over the next 12 months.
Developed foreign markets generally, and Europe specifically, are right around their long-term average (Japan is an outlier because of its decade-long period of deflation), and emerging markets, too, are at their 25-year average price-to-book reading. Despite last year’s 20%+ return from foreign developed and 30%+ return from emerging markets, valuations are not stretched in those areas, and the U.S. remains within its 25-year valuation range.
We are encouraged by the resilience within European economies and their equity markets over the last year. Investors have begun to notice, and we think these economic and investment gains will continue in 2018.
Emerging Market Stocks
Emerging market equities built on their solid positive performance in 2016 by posting an exceptional 37.3% return in 2017 (measured by the MSCI EM Index). Concerns that emerged after the 2016 U.S. presidential election about a potential for tariffs on Chinese manufactured goods, or the abandonment of NAFTA by the Trump administration, largely faded from view. Economic fundamentals, in China and elsewhere, as well as a somewhat weaker dollar, helped to lift EM stock prices.
As 2018 gets underway, we believe that economic data in EM countries will remain positive and supportive of positive EM equity prices. Chinese GDP growth is likely to be between 6.25% and 6.75% this year, a modest deceleration from this year, but still strong. Although the current U.S. administration has pivoted U.S. policy toward protectionism, global trade continues apace, and, if anything, U.S. policy has helped emerging market countries to strengthen ties among themselves. This will help the flow of goods and service across the Pacific Rim region, in particular, where growth in emerging and frontier countries may have the most sustainable momentum.
Fixed Income Investments
As we look ahead to the next 12 months, interest rates are certainly top of mind, and primarily the question of what is the most prudent way to position fixed income investments if rates rise in 2018? Similar to our view in 2017, we would not be surprised to see yields continue to move higher, although we do not expect a sharp acceleration from current levels for two main reasons: (1) global bond yields are likely to remain depressed, and (2) major inflationary pressures appear to be at bay for the time being.
To the first point, both Europe’s and Japan’s central banks will likely remain engaged in quantitative easing throughout most, if not all of 2018, which, in our view, will keep a lid on global rates. Secondly, as the nearby graph shows, U.S. core inflation stayed contained throughout 2017. The advance of e-commerce, primarily Amazon, along with price wars between wireless carriers, has kept the price of goods down. Lower inflation in the U.S. translates to lower interest rates, because investors allocate capital on a real yield basis (nominal yield minus inflation). Higher inflation would mean that investors would demand a higher nominal yield, pushing up interest rates.
It is important to note that not all bonds are the same, and the prospect of higher interest rates does not necessarily mean that there will be negative returns across fixed income positions. The following graphic from Nuveen Investments illustrates how various bond investments have performed during three prior periods of rising rates in the mid and late 1990’s and the mid 2000’s.
From 1994 to 1995, short-term corporate bonds, securitized debt, and high yield corporates were the best-performing U.S. fixed income sectors. From 1999 to 2000, entering the end of the tech bubble, short-term corporates were one of the best performers. Ironically, Treasuries also performed well during this period, but primarily because the Fed Funds rate was already at 5.0% at the start of this period, which is not its starting point today. Then, mid-single-digit income returns blunted price declines. High yield bonds underperformed short-term investment-grade debt during this stretch because economic growth was deteriorating.
Finally, the the period from 2004 to 2006 is the most striking in terms of illustrating the outperformance of high yield bonds during a rising rate period. This period of time seems to align most closely with our current economic environment: the Fed is coming out of a low rate regime, economic growth is steady at the mid-to-late point in the cycle, and corporate financial health is strong.
Sage has made a point to emphasize areas like high yield corporate bonds and unconstrained fixed income strategies, which invest in short-term corporates, floating rate bonds, and high yield bonds, in order to minimize the interest rate sensitivity of our portfolios and maximize the return potential even if interest rates do rise in the future.
Alternative investments such as managed futures, which are meant to enhance portfolio diversification, were slightly negative last year when many other assets delivered positive returns. We have maintained the managed futures strategy despite its recent negative returns for a few reasons. First, managed futures has a long, proven track record of providing positive long-term returns to investors with low correlation to equity and fixed income markets. Despite the poor performance from managed futures the last two years, the asset class provided positive returns to us in the four consecutive calendar years extending from 2012 through 2015. One reason that we hold alternative investments is precisely because they provide low correlation to traditional assets like stocks and bonds, which performed very well last year.
In addition, alternative investments are attractive because they can provide additional portfolio risk-reduction in the form of a different return source from core bonds but a source that similarly has a relatively modest risk profile. We would encourage investors to be patient with managed futures as we anticipate continued, positive long-term returns in the future despite negative short-term returns over the last year. If volatility returns to some markets in 2018, then holding diversifying assets like managed futures may prove again their worth to portfolios.
One other area of note is Master Limited Partnerships (MLPs), which Sage began allocating to in the second half of 2015. MLPs had a rough patch in the middle of the year largely due to a slump in oil prices, but they began to rally toward the end of the year. They are an investment that provides an attractive yield that is well in excess of Treasury notes and could participate in a rebound of U.S. energy investment.
2017 was the first year since 2013 that oil consumption was equal to or exceeded production, and the U.S. Energy Information Administration (EIA) expects the same in 2018. Consumption growth, as demonstrated in the nearby chart, is driven largely by growth in the U.S. and China. The use of petroleum products in both countries is positioned to continue to expand into the coming year.
Additional consumption and production are typically beneficial for energy MLPs, which charge oil producers to transport oil and natural gas. The charts below show EIA’s U.S. projected crude oil, natural gas, and natural gas liquids production through 2019 in millions of barrels per day:
Additionally, the recent tax reform legislation seems to be a net positive for the industry. The pass-through deduction for MLPs was included in the final bill, and the current presidential administration has shown a willingness to support the buildout of pipelines for transportation (e.g., approving Keystone and Dakota Access pipelines) and increased energy production. We continue to favor this area of the portfolio and believe that MLPs will provide attractive long-term returns to investors.
In conclusion, although we are generally optimistic about investment prospects in 2018, we do think that investors should be mindful that returns on average are likely to be lower this year than last, that equity markets may see a rise in volatility from presently very low levels, and that there are risks to the views we have articulated above. But we are confident that our diversified investment approach across U.S. and international stocks and bonds, as well as alternative investments, will continue to serve investors well over time.
The risks we foresee are largely the standard ones, for instance, an inflation spike and a sharply higher repricing of 10-year bonds at long-end of curve, an overshoot in Fed policy with new member constituents, a market-disappointing outcome in Italian election or Brexit negotiations that destabilizes Euro-area economy or political outlook, and negative economic or policy news from China. An idiosyncratic risk worth noting is associated with any potential findings of the investigation into the 2016 presidential election by Robert Mueller. It is unknown how financial markets might react to a finding that implicates the President himself in some form of wrongdoing. Although the President’s approval ratings are among the lowest in history, global assets generally have performed very positively during his brief tenure.
Disciplined use of diversified portfolios is the best way to proceed in general and especially after an exceptionally positive investment year. We appreciate the confidence you have placed in us and look forward to the opportunity to work with you and help you realize your financial goals.
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