Year-End 2017 Key Takeaways
The fourth quarter capped a stellar year for U.S. stocks. Larger-cap U.S. stocks gained 6.6% for the quarter and ended the year with over of 20% total return. This was the ninth consecutive year of positive returns for the index—tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis.
The broad driver of the market’s rise for the year was rebounding corporate earnings growth, which was supported by solid economic data, synchronized global growth, dormant inflation, and accommodative monetary policy. U.S. stocks got an additional catalyst in the fourth quarter with the passage of the historic corporate tax cut, reflecting investors’ optimism about its potential to further boost corporate after-tax profits, at least over the shorter term.
By year-end, the S&P 500 Index had rallied for more than 400 days without registering as little as a 3% decline. This is the longest such streak in 90 years of market history, according to Ned Davis Research.
Foreign stock returns were even stronger, with developed international markets gaining 26.4% and emerging markets up 31.5% for the year. In the fourth quarter, however, these markets couldn’t match the S&P 500, gaining 4–6%. Our portfolios benefited from meaningful exposure to emerging-market and international stocks.
Moving on to bonds, the core bond index fund gained 3.5% in 2017. This return was close to the index’s yield at the start of the year, as intermediate-term interest rates changed little. Although the Federal Reserve raised short-term rates three times, yields at the long end of the Treasury curve declined and the yield curve flattened.
Corporate bonds across all credit qualities and maturities had positive returns. High-yield bonds gained 7.5% for the year. Investment-grade municipal bonds rebounded from a flat 2016, returning 4.5%. Our long-held tactical positions in several flexible, unconstrained and absolute-return-oriented bond funds added value, outperforming core bonds.
Our investments in liquid alternative strategies fulfilled their portfolio diversification roles while generating mid to high single-digit returns. Managed futures strategies experienced a difficult first half of the year, but the second half was significantly better. Net long exposure in global equities and emerging market currency has been a positive contributor. These funds have outperformed core bonds but, not surprisingly, trailed the 20%-plus stock market returns.
The year 2017 was a very good one for most financial markets. While the macro outlook remains positive, unprecedented central bank policy shifts could trigger increased volatility, a stock market correction, or even a recession sometime in this business cycle. During this uncertain time, it is all the more important to stay disciplined and patient. We remain confident in our diversified portfolio positioning looking ahead over our long-term investment horizon.
Looking Back: Key Drivers of Our 2017 Portfolio Performance
Our globally diversified balanced (stock/bond) portfolios generated strong returns for the year, consistent with the positive overall return environment for most financial markets and asset classes. Our meaningful exposure to international/European and emerging-market stocks was a significant contributor, as foreign stocks outpaced U.S. stocks in 2017.
On the whole, our portfolios benefited from our larger-cap U.S. equity managers. We invest with concentrated, active managers across a range of investment approaches and “styles,” including growth-oriented managers, which soundly beat the growth index in 2017. However, after a strong rebound in 2016, value stocks and many valuation-sensitive managers struggled to keep up with the surging market. We are confident our diversified active manager lineup remains strong and believe our value-oriented managers will be rewarded once this growth-oriented cycle turns, as it historically has.
Stocks were not the only contributors to our portfolio returns. Our tactical positioning toward flexible, unconstrained fixed-income funds resulted in outperformance versus the core bond index’s 3.5% gain.
Looking Ahead: Updates on Our Asset Class Views
U.S. Stocks: As noted above, U.S. stocks were up over 20% for the year, driven by double-digit earnings growth, accelerating GDP growth, and (in part) expectations of a historic corporate tax cut. Many analysts expect US corporate earnings to grow an additional 10% because of the benefits of the tax reform act that was passed in December; however, we suspect much of the benefit of the tax reform bill might already be priced in to the market.
Foreign Stocks: Political uncertainties notwithstanding, Europe continues its economic recovery within what appears to be a benign fiscal and monetary environment. Europe is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Earnings have rebounded strongly, with Ned Davis Research’s analysis showing continental Europe and the U.K.’s local-currency earnings growing over 25% and 35%, respectively, over the past 12 months. (The United States has seen earnings growth of 14% over the same period, according to NDR.) While earnings were up strongly, investor sentiment was relatively depressed (especially during the fourth quarter), leading valuation multiples to compress.
Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20%. Yes, earnings growth is very good; but, after the last two years of very large gains, we would expect more normalized gains moving forward.
Fixed-Income: Our return expectations for core bonds remain muted looking out over the next five years, in the range of 2.5% to 3.2% (from a current yield of 2.7%). Today, we’re faced with taking on elevated levels of interest rate risk for low yield. The yield per unit of duration is near its all-time low. For context, a 50-basis-point yield increase in the Bloomberg Barclays U.S. Aggregate Bond Index would wipe out more than a year of income. This explains our meaningful positioning away from core bonds in favor of flexible unconstrained strategies, which we believe will outperform core bonds in a period of flat or rising rates. That said, we still maintain core bond exposure in our balanced portfolios to serve as ballast in the event of a risk-off environment.
Alternative Strategies: We are often asked to explain what an alternative strategy actually is, and we typically receive glassy-eyed stares when launching into a description of some typical examples, including managed futures, arbitrage strategies, and long/short portfolios. However, the most important thing to understand about our alternative strategies is that they are designed to reduce risk in the portfolio. They are not intended primarily to boost returns; instead, we view them as playing a similar role to that of our bond portfolios, to reduce risk and volatility in the portfolio.
Looking Ahead: A Quick Word on the Macro Outlook
In terms of the near-term macro outlook, the consensus view is that there is little risk of a U.S. or global economic recession in 2018. The market expects the in-sync global growth that we saw in 2017 to continue. Most of the investors and strategists we respect seem to share this view. And without a recession, a bear market in stocks in unlikely—although a run-of-the-mill 10% “correction” can happen at any time. However, when an outlook becomes the strong consensus view, one should assume it is already discounted to a meaningful degree in current market prices. This is where our investment discipline comes in, because we think we have an edge in assessing fundamentals, valuations, expected returns, and risks across different asset classes and over longer-term periods.
Putting it All Together: Our Portfolio Positioning
Currently, our “base case” scenario implies that U.S. stocks are expensive and U.S. growth stocks in particular are very expensive. As such, we remain defensively positioned in U.S. stocks with an eye toward valuation and also tilted toward European and emerging-market stocks, where our return expectations are materially higher. We were heartened to see a strong rebound in European earnings materialize last year. However, we don’t believe our portfolios have been fully rewarded for this yet because European stocks lagged the U.S. stock market in local-currency terms. For this reason, we remain tactically overweight to Europe. We also maintain our tactical overweight to emerging-market stocks relative to international stocks, although valuations are less compelling than they were a year ago.
Our fixed-income positioning remained unchanged in 2017, but we are now making changes to reduce risk further. In light of the particularly low expected returns for core bonds, along with the risk of rising interest rates (which correspond to lower core bond prices), we have eliminated our emerging market bond position. However, we still maintain a meaningful exposure to flexible, actively-managed bond funds. We factor this into our overall portfolio risk exposure, and it’s why we still maintain a meaningful allocation to core bonds for our clients with more conservative risk profiles. Despite their poor longer-term return outlook, we expect core bonds to perform well in a traditional bear market/recession scenario.
Lastly, in our alternative strategies, we are adding an allocation to commodity futures for most clients’ portfolios. This strategy is an “alternative” in that it exhibits different drivers of return and risk than do traditional stock investments. We believe they have superior risk-adjusted return potential relative to equities from which they are funded, and we remain confident that their relatively low correlation to other investments in our portfolios is a valuable long-term diversification benefit.
The year 2017 was a very good one for most financial markets, particularly for global stocks. However, there was one small corner of the investment world that did even better than stocks: Bitcoin gained 1,518%. To be clear, we don’t own Bitcoin or any other cryptocurrencies in our JPH portfolios, because they don’t fit within our investment discipline or circle of competency, and they are by nature speculative investments. Simply put, we do not need to dabble in speculative investments to achieve our clients’ investment objectives. However, the questions we have received about Bitcoin (and cryptocurrencies in general) have certainly become more persistent in the last few months, so our goal is to present you with JPH’s best thoughts on cryptocurrencies.
The technology behind Bitcoin (“block-chain”) is a real technology. It’s a valuable method for processing and recording important data, and it is likely to be employed in many other domains beyond digital currency in the years going forward. From that standpoint, Bitcoin is not a “fraud” (in spite of what some high profile financial figures have claimed), but we don’t believe it’s a fraud because the underlying technology is real.
However, the more salient question is whether cryptocurrency in general (or Bitcoin in particular) is going to become part of our day-to-day society, similar to other currencies: the dollar, euro, yen, etc. The short answer is, of course, we just don’t know the long-term future of cryptocurrencies. Nonetheless, the idea of having an alternative digital currency someday is not inconceivable.
Ultimately, should one invest in cryptocurrency today or not? We are confident that investors currently buying Bitcoin (or other cryptocurrency) today will be disappointed with their future investment return. However, if you want to invest in Bitcoin, go ahead; however, we would encourage you to keep the same viewpoint in your head as you do when you go to Las Vegas – do not invest any more money than you can afford to lose.
As always, thank you for the confidence that you place in myself and the staff here at JPH Advisory Group, we’re looking forward to a great 2018.
Jon Houk, CFP®