January 2018 Investment Commentary

January 2018 Investment Commentary

2018 OUTLOOK: Talk about a Tough Act to Follow

  • Markets in January have picked up right where they left off in 2017. How much of the good news is already priced in?
  • The global economy is reaching full capacity, which has both positive and negative implications.
  • Tax reform gets all the headlines, but deregulation efforts by the Administration have made a meaningful impact as well.
  • Commodities have been out of favor, but could turn around based upon higher inflation and a weak U.S. dollar.
  • We continue to favor equities, but expectations for a repeat of 2017 seem unrealistic.

For almost every global equity market, 2017 was an impressive year by any standard.  We spent much of last year highlighting and commenting on the economic reasons which justified why the stock market was continuing to climb higher.  The top reasons, just to name a few, included globally synchronized growth, strong corporate earnings, low unemployment, and accommodative central bank policies (i.e. low interest rates) which all supported further economic growth.  These factors have not changed, and in fact will probably remain in constructive mode for several months to come.  All of that being said, we are on the heels of equity returns north of 20% in the past year, and we all know that returns of this magnitude are not sustainable.  Eventually this bull run will come to its end, and when it does it will likely occur quickly and painfully.

This brings us to the trillion-dollar question, which is how much of the current rosy economic scenario is already priced into the market, and how much farther can the market possibly go?  In addition, now that the Tax Cuts and Jobs Act has been passed, how much of the potential future benefits have already been priced in?  Unfortunately, both of these questions are difficult to quantify, but given the record high optimism levels and positive business surveys, it appears that the market’s momentum may carry on for some time.  So far in 2018, global equity markets have continued to rally just as they did throughout last year.  As of January 18, the S&P 500 was up 4.87% on a total return basis, while international developed markets as measured by the MSCI EAFE index were up 4.56%.

Fixed income, on the other hand, has broadly experienced negative returns thus far, as rates have rallied in the past few weeks.  Growing concerns about a pickup in central bank normalization as well as growing inflation concerns appear to be the primary culprits.  Nowhere has the rise in rates been more noticeable than in short treasuries.  An interesting convergence has recently occurred, in that the yield on a two-year treasury is now producing a yield higher than that of the S&P 500.   The last time this happened was back in 2008, during the height of the financial crisis.  While this comparison alone doesn’t equate the current economic situation to that of 2008, it does highlight how expensive stocks have become in relation to bonds, and therefore should not be ignored.  Considering that the two-year treasury is considered as one of the safest investments in the world, these lower risk bonds are now looking a little bit more compelling.

The global economy is operating near peak capacity, is this a good thing or a bad thing?

The World Bank, in its January 2018 report titled ‘Global Economic Prospects’, estimated that global GDP growth picked up from 2.4% in 2016 to 3% in 2017, which was well above their June forecast of 2.7%.  They also noted that for the first time since the financial crisis, all major regions of the world are experiencing an uptick in economic growth.  However, the World Bank also suggested that the tightening of monetary policies by central banks will likely place limits on further economic expansion.  In addition, the bank also cited that 2018 should mark an inflection point for the global economy, as for the first time since 2008, the negative global output gap is expected to turn positive.  The global output gap captures the difference between the level of actual output versus its potential.  A positive output gap implies excess demand, while a negative output gap indicates weaker demand and the presence of global spare capacity.  One could consider the global output gap turning positive as a healthy sign that the world economy is finally operating on all cylinders after a prolonged period of slow growth.  On the other hand, it may also imply that we’re nearing the end of this expansion, and prompt a shift towards more restrictive policies which could slow down global growth and eventually lead to a recession.

Several other notable indicators also point to the strength of the global economy. One example, the Global Purchasing Manager’s Index (PMI), reached 54.5 in December which marked a multi-year high.  This indicator highlights the strength of manufacturing industries, and was particularly strong across nearly every international region, in both developed and emerging market countries.  Europe and the U.S. have been particularly strong, as have Taiwan and India.  It is certainly fair to wonder how much better these indicators can get.  With many economies reaching full employment, and the days of easy monetary accommodation coming to an end, we must prepare ourselves for an eventual slowdown.

Deregulation Efforts have been Swift and Far-Reaching

In addition to tax reform, deregulation was one of the key initiatives for President Trump and in 2017 the Administration lived up to its word.  In mid-December, the President touted his own deregulation efforts in a ribbon-cutting celebratory manner, and promised that the pace of deregulation would likely pick up in 2018.  According to a White House memo on December 14, the Trump administration had issued 67 deregulatory actions while only imposing 3 new regulations.  The White House also claimed that the Administration had effectively withdrawn or delated 1,579 planned regulatory actions.  While some of those numbers could be disputed, there is no question as to the intent of the Administration.  In the short-run, it appears that the high confidence levels amongst CEOs and small business owners can somewhat be attributed to the current deregulatory culture.  According to the National Federation of Independent Businesses (NFIB) which is responsible for the NFIB Small Business Optimism Index, “Driving record optimism in 2017 was the expectation of better economic policies from Washington. Suspending the regulatory assault on business and now a massive tax cut answered two of the three top concerns for small business owners.”  The NFIB Small Business Optimism index average level set an all-time record high in 2017.

It remains to be seen whether the Administration’s pro-business and anti-regulatory stance will have a longer lasting impact on the economy and society as a whole.  The rolling back of financial, environmental, or other regulations could certainly create unintended consequences with costs that could potentially outweigh their benefits.  We all know that the loosening of lending standards paved the way towards the subprime mortgage crisis, which eventually turned into one of the deepest recessions in modern history.  And of course, there have been several notable environmental catastrophes such as the BP oil spill which arguably could have been prevented by tighter regulations.  Only time will tell whether these efforts will ultimately play out, but in the meantime, it is apparent that deregulation should continue to be a tailwind for the markets in the coming months.

The Case for Commodities

Commodities have long been out of favor for a variety of reasons.  Crude oil has been especially volatile over the past decade, as the price of WTI Crude dropped by 70.23% in 2008, and by 68.93% again in 2014-2015.   Despite its perception as a safe haven asset, gold is still 26.35% below its 2011 peak, after being down as much as 41.4% at its 2015 low.  Agriculture commodities have fared the same, as wheat is still trading 63.7% below its peak in early 2008, while soybeans are down 47.96% from their peak in 2012.  Commodities have long been perceived as a hedge against inflation, which we have noted has been persistently low throughout the current economic expansion.   Assuming that inflation does return to the economy in the near term, it may make sense to revisit this beaten-down asset class.

The fall in crude oil was largely precipitated on a steady increase in supply which outweighed demand, most notably from the U.S.  Since oil established a bottom back in early 2016, it was largely rangebound for most of 2017 but has since broken out to the upside.  The Organization of Petroleum Exporting Countries (OPEC) and allies such as Russia have held true to their 2017 agreement as they have cut output and plan to continue to do so until the end of the year.  This has resulted in declines in U.S. crude stockpiles for nine consecutive weeks as of January 17, as reported by Bloomberg news. This bodes well for the broader S&P GSCI Commodity Index, which carries a 58.58% weight to oil and gas.

In addition, the current weakness in the U.S. dollar could be another reason to reconsider commodities.  As it can be seen in the chart below, commodities generally move inversely to the price of the U.S. dollar, which most commodities are priced in on the exchange markets.  Should the U.S. dollar remain weak versus other major currencies, this would also likely support higher commodity prices.  We also observe that commodities have historically experienced strong returns near the end of economic expansions, in the months (or years) leading up to recessions.  Given the length of the current bull market, high confidence levels, and numerous other positive economic indicators, it certainly feels like we may be in the 7th or 8th inning of this expansion.  If so, then higher demand coupled with higher inflation expectations may help drive commodities higher.  On a final note, commodities historically exhibit very low correlation to both stocks and bonds, and therefore can be an excellent diversifier to a portfolio.

No Euphoria yet, but we are getting closer

As the U.S. equity indices continue to climb, there remains evidence that investors continue to sit on the sidelines.  According to a Wall Street Journal article on January 4, since 2012 almost $1 trillion had been withdrawn from retail mutual funds which invest in U.S. stocks.  It should be noted that this figure did not track funds which are reinvested into institutional share class funds or exchange traded funds, yet more than half of that figure is estimated to have been withdrawn from the market.  In addition, Bank of America’s Sell-Side Indicator, which measures the average recommended equity allocation of Wall Street strategists, is also suggesting that institutions aren’t showing signs of euphoria yet.  The average recommended equity allocation was 56.8% in December, below its 15-year average and well under the contrarian “Sell” threshold of 62.8%.  Finally, respondents of Bank of America’s Fund Manager Survey indicated that average cash balances fell to 4.4% in December.  While this number is a 5-year low showing that fund managers are more bullish as of late and putting their money to work, it is still well above the contrarian “Sell” threshold of 3.5%.  In all, while the market continues to climb to new highs on an almost daily basis, this continues to be an unloved market, which suggests that it may climb even farther.  Perhaps the reason for the high cash balances and below-average equity allocations is simply because investors continue to wait for a pullback which hasn’t materialized.  Volatility was astoundingly low in 2017, as we haven’t experienced a correction of more than 5% since June on 2016 when Britain voted to leave the European Union.

Finally, regarding corporate earnings, we are just under way into the 4th Quarter Earnings Season.  Factset Research has estimated that the final growth rate of earnings could be close to 14%, which would mark the second highest growth since Q3 2011.  Also of note, this would be the third double-digit earnings growth quarter out of the past four, a sign that U.S. corporations continue to grow their earnings at an impressive rate.  It is also evident that the recent tax reform legislation is having a positive impact on 2018 earnings estimates.  For companies in the S&P 500, the bottoms-up earnings per share (EPS) estimates increased from $146.83 to $150.12 after the tax reform passed, according to Factset.  Increases of this magnitude are particularly rare, suggesting that the implied benefits of tax reform were the most likely driver for the increase.  The independent Tax Foundation noted that overall the tax plan should be pro-growth and could boost long-run GDP by 1.7%.

We believe that in the coming months, the stimulus from the tax plan on top of an already healthy economy should help the market sustain its current momentum.  We continue to favor equities, albeit with not as much conviction as we did this time last year.  Volatility will likely return at some point in the year, and we note once again that we are long overdue for a 5-10% correction.  A recession does not appear imminent by any measure, but the market may slow down or run out of steam by the end of the year.  Our outlook for fixed income is largely unchanged, with expectations in the low single digits due to tight credit spreads and rising rate expectations.  As always, we believe in a risk-balanced approach to portfolio management, that blends both growth and income securities to achieve an investor’s desired investment objective.  Now is the time to stay the course, for the economy going into 2018 is about as good as it gets, and the markets should continue to reflect that.


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