2018 Investment Outlook/Market CommentarySubmitted by Jodi Vleck , Beta Wealth Group on January 19th, 2018
Fourth Quarter/Full Year 2017 Market Update
The fourth quarter rally in global equities capped off one of the best years for global assets since the 2008 recession, which was spurred in part by strong third-quarter earnings worldwide, easier monetary policy, positive investor sentiment and optimism about the final passage of a much-hyped tax plan in the US. In 2017, the synchronized global recovery was led by Emerging Markets, especially China which is navigating a transition to a consumer-driven economy, and India which is undergoing large scale reforms including a recent revolutionary-but-at-times-painful currency demonetization. In the US, political turmoil and concerns of a brewing conflict with North Korea was offset by tax reform and a year-end commodities rally that was driven by OPEC discipline on oil production costs. Consistent with prior quarters, global volatility was at its tamest levels over the past several years, which is likely unsustainable given the litany of geopolitical or market shocks that could occur.The fourth quarter rally in global equities capped off one of the best years for global assets since the 2008 recession, which was spurred in part by strong third-quarter earnings worldwide, easier monetary policy, positive investor sentiment and optimism about the final passage of a much-hyped tax plan in the US. In 2017, the synchronized global recovery was led by Emerging Markets, especially China which is navigating a transition to a consumer-driven economy, and India which is undergoing large scale reforms including a recent revolutionary-but-at-times-painful currency demonetization. In the US, political turmoil and concerns of a brewing conflict with North Korea was offset by tax reform and a year-end commodities rally that was driven by OPEC discipline on oil production costs. Consistent with prior quarters, global volatility was at its tamest levels over the past several years, which is likely unsustainable given the litany of geopolitical or market shocks that could occur.
As evidenced by the above chart from Alliance Bernstein, it was a banner year for global markets with positive returns across most risk assets led by Emerging markets and Japan. Main themes in the US were:
- Large cap companies handily trumped small caps
- Growth equities trounced value equities led by technology and healthcare names
- Financial Sector bellwethers rebounded strongly
- Bond-proxies such as Utilities and Real Estate retreated toward the year-end while the energy complex rebounded
While European equities lagged US equities in local currency terms despite Europe’s strongest growth since 2011 and receding political risk, a stronger Euro meant that European equities, which rose 23%, outperformed US equities when returns were translated into US dollars.
Our Brief Take
Typically, long rallies such as the current one that started back in 2009 tend to be driven by growth companies. That can explain the consistent outperformance of growth equities both in the US and overseas markets since then. However, we believe that as the rally gets longer in the tooth especially in the US, value might regain leadership. This might not be true nearer-term, as evidenced by the YTD outperformance of cyclicals such as Industrials and Energy. The rally has also been driven by the headlong investor rush into passive vehicles such as Exchange Traded Funds (ETFs), which tend to overconcentrate in the more expensive areas of the market such as high-growth technology companies. However, in contrast with some prevailing views that low-cost passive vehicles are the only way to invest, we have seen our active managers (especially in the International realm) and our individual US equities handily outperform their respective benchmarks, as illustrated by the sample performance comparison below comparing one of our international holdings against its benchmark.
We believe a blend of active and low-cost passive assets is appropriate in most portfolios. In our quest to generate robust risk-adjusted returns over multi-year timeframes, we believe choosing actively managed funds or individual securities, especially in categories such as International & Small Cap Equities or Long/Short Equities and complementing them with passive vehicles, makes sense. In a world where correlations across asset classes is bound to fall and dispersion between highest and lowest quality assets is bound to rise, active management can add value. Our individual large cap holdings such as Visa and International asset managers such as Oakmark have been able to demonstrate that value.
It is notable that international equities finally regained momentum after several underwhelming years, which had led institutional and individual investors alike to question why they deserved a meaningful allocation in their portfolios. The MSCI World index added $9 trillion in market cap last year and posted positive returns across every single month. Emerging markets trumped US and developed markets. This occurred even as prior concerns such as slowing Chinese growth, de-monetization driven turmoil in India, political upheaval in Brazil, a rapidly rising US dollar and a commodities meltdown waned as the year progressed.
Portfolio Positioning – Asset Allocation & Sector Considerations
We believe thoughtful asset allocation, periodic rebalancing and ongoing prudent selection of investments is key to superior long-term performance. Demonstrating this point is a chart courtesy JP Morgan stretching over a 15-year period through 2017, which illustrates best-to-worst performing asset class performance annually across US and International markets.
Upon closer scrutiny, we see a continual shift in the best and worst performing asset classes year-to-year. This chart helps to explain why we rebalance portfolios periodically to ensure that the overall portfolio mix is in line with broader objectives of a globally diversified portfolio, thereby preserving investment discipline.
As we enter the classic later stages (read beginning of the 8th inning) of what has been one of the longest market cycles to date (over 100 months and counting) in the US, we believe it is important to overweight or underweight sectors or asset classes that have characteristically outperformed or underperformed broader market indices at similar stages in prior market cycles. To us, this has meant the following:
- Favoring growth-oriented sectors such as Technology and Healthcare over defensive sectors such as Utilities
- Preferring Later stage sectors such as Financials, which benefit from the easing of financial regulations, higher interest rates and modest loan growth
- Favoring asset classes that exhibit lower market correlations such as long-short equity, private real estate and global infrastructure assets, whether public or private.
We continue to monitor and tweak our investment portfolios with a preference to fine-tuning them versus completely overhauling them, consistent with our long-term (read 3, 5 and 10-year) horizons and our patient approach to growing your capital. This process often requires us to give both our investments and investment managers time to prove their true worth. However, that also means we continue to look to periodically upgrade your portfolio. This has recently meant traveling far and wide to seek private investments in areas such as global infrastructure, private equity and private real estate, while also adding fundamentally-sound equities of high quality companies.
Our most recent addition to our more aggressive growth portfolios was Visa (V), a payments technology company that connects consumers, merchants, financial institutions and government entities to electronic payments and accounts for about 50% of all worldwide credit card transactions. In an increasingly complex global payment processing landscape, Visa reigns at the top, capitalizing on consumers’ tendency globally to utilize electronic payments in place of cash with the largest credit/debit network. Visa offers high recurring revenue, free cash flow as well as double-digit earnings growth at a reasonable valuation when adjusted for growth.
Our Parting Thoughts and 2018 Market Outlook
As we enter 2018 and remain amid the 9th year of this market cycle in the US, we seek not to make precise forecasts, but rather try to handicap a few possible outcomes amongst several potential ones. Our goal is to be approximately correct, rather than precisely wrong. We see global growth remaining strong, but possibly not accelerating relative to last year. We see US growth benefitting from the passage of tax reform, which consensus economist views estimate will raise 2018 GDP growth by 50-100 bps to ~3%. Passage of policy aimed at improving the nation’s infrastructure could improve that number. We do however see anecdotal evidence of investor optimism approaching exuberant levels, which is enough to warrant some caution. 2017 fund flows also suggest investors are still over-allocating to bonds at the expense of equities.
While the US has continued to hover in late-cycle mode in the US, the rest of the world (developed and emerging markets) seem to hover between early and mid-cycle growth mode. As far as the eye can see and barring any unforeseen exogenous events such as war, global terrorism or unanticipated increases in inflation, we do not foresee a recession around the corner across most global markets. However, given how rapidly markets have melted up over the past year, we would not rule out a meaningful correction in 2018. It should be noted that it has been over a year since we had a 5% drawdown and nearly two years since we had a 10% correction.
At present levels, the S&P 500 index is trading a couple of turns above historical median valuations on a price-to-forward-earnings basis, which is not unprecedented since the index has traded well north of the median in prior cycles. However, future up moves are likely predicated more on earnings growth, whether that is driven by fundamentals or share buybacks, than multiple expansion. Developed and emerging markets are more attractively valued, trading either at or below 25-year-median P/E multiples respectively and offer more upside potential, with European GDP growth likely rivaling the US and emerging market growth remaining strong alongside stable currencies. With the 4th quarter earnings season well under way, consensus expectations call for corporations across most major global markets to post double-digit earnings growth.
As we have highlighted during our market-focused client events and countless investor meetings over the past year, we seek to build globally diversified portfolios with a nod to quality and value. We believe international markets may fit the bill better at this time. Given an investing environment that will likely see higher rates, we prefer equities broadly over traditional fixed income. As we review capital market assumptions for various asset classes over the next 5 years, we are compelled to favor Emerging Markets (EM) assets over Developed Market (DM) assets due to the gap between current and historical trend growth, stabilizing-albeit-slower growth in China, relative calm in India post the recent de-monetization, and below-historical-average market valuations. We believe the biggest wildcards exist in the form of protectionist trade wars or unexpected escalation of a political conflict with North Korea. Additionally, a significant wildcard could be a spike in inflation on the back of higher wage growth and tighter employment, which would prompt faster rate increases. A faster-than-expected increase in rates would result in multiple compression as investors use a higher rate to discount future earnings. Typically, the yield curve inverts ahead of a recession.
We expect a reflationary environment to result in higher global bond yields as economic growth picks up. Traditional core bond funds would be put at risk of capital losses and tax sheltered US bond funds would be at risk of losing a little luster in a lower tax regime. Since stocks tend to outperform bonds in reflationary environments as growth picks up across the board and rates rise gradually, we continue to invest in or research:
- Covered Call and other Options Strategies
- Floating rate bond funds
- Preferred Stocks
- Emerging Market debt
- Non-traditional long-duration yield vehicles in the private investment realm that exhibit less correlation with the broader public equity markets.
As always, feel free to reach out to us with questions, comments or observations.
Jodi Vleck (CEO, Wealth Manager), Giri Krishnan (Portfolio Manager) & Gabe Adams (Wealth Advisor)