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January 2018 Investment Commentary
Fourth quarter financial markets advanced, tracking earlier-year trends, generally helping client portfolios build on already solid 2017 returns. Stock markets here and overseas continued to benefit from unusually synchronized economic health across major regions, and sound corporate performance. The political environment, while operatic over President Trump’s first year, was as a whole supportive. It was aided by receding populist threats in Europe, regime reinforcement in Japan and China, and market-friendly tax legislation closing out the U.S. Congressional year, marking Trump’s first legislative win.
|Fourth Quarter||2017||Five Years (ann.)|
|Developed International Stocks||4.2||25.0||7.9|
|Global Hedge Funds||1.5||6.0||2.1|
Accounts benefitted most from performance within the stock group, with virtually all geographic regions contributing to strong returns. Improved economic footing supported a second year of earnings recovery in the U.S., following several dull years, as well as more nascent and pronounced improvement overseas, in both G7 and emerging economies. While deregulatory moves by President Trump arguably helped the business climate here, an absence of follow-through on protectionist threats, combined with a perceived ceding of U.S. power -- such as our withdrawal from the Trans Pacific Partnership in the president’s first week -- contributed to improved sentiments abroad. Perhaps partly reflecting this shift, a 9.9% broad U.S. dollar decline, including a 12.4% slide against the euro, further enhanced benefits of non-U.S. exposure in 2017.
As 2017 transitions to 2018, financial markets are contending with several key issues. Arguably heading this list is the Tax Cuts and Jobs Act, passed at the end of last year and enacted on New Year’s Day. While the scale and duration of its impacts are unsurprisingly subject to much debate, most agree that it will be supportive of near-term economic growth, thanks to new increments in corporate and consumer spending. The tax cuts themselves are significant. They total $1.46 trillion, spread over ten years, but somewhat front-end loaded with the bulk of the benefit occurring in the first four years. This figure comprises $1.13 trillion for individuals (after netting out $314 billion in reduced government support tied to the ACA individual mandate removal) and $329 billion for corporations (the impact of a 35% to 21% headline rate reduction after netting out $324 billion in one-time, required tax payments on repatriated foreign earnings).
As for economic impact, if, by some estimates, 25-30% of the individual cut (or about $300 billion) takes effect over this and next year, and half is concurrently spent, that could enhance growth of our $19.4 trillion GDP by .40% ($75 billion) per year over a similar period. The corporate impact, comprising both lower tax rates and newly repatriated cash, also should be positive. This presumably would come through some combination of heightened capital investment, and hiring and wage increases. Companies including AT&T, Comcast and Boeing already have announced special employee bonuses in response to the bill. Further, any shareholder friendly moves such as stock buybacks or dividends could turn into increased consumption over time. One key caveat, however: companies differ from consumers as pent-up spending needs appear relatively low, with cash coffers already healthy and low-interest financing readily available.
While the outlook for stocks may have been generally enhanced by the tax bill’s passage, the bond market outlook looks cloudier. Supply and demand dynamics in one key sector, our Treasury market, definitely appear less favorable. The loss of government revenue will contribute to higher annual budget deficits, from about $700 billion or 3.6% of our GDP today to something around $1 trillion, or 5% of GDP, in five years, reading Congressional Budget Office forecasts. By extension, this means significantly higher Treasury issuance. Over this same multi-year period, a key buyer, the Federal Reserve Bank, is set to pull its support. Jerome Powell, who will replace Janet Yellen as Chair in early February, has indicated affinity with the Fed’s already established policy path. Importantly, this entails a winding down of its $4.5 trillion bond portfolio to the $2.5-3.0 trillion range over coming years, including a potential $360 billion reduction in annual Treasury purchases.
Other bond sectors could fare a bit better under the tax plan. The municipal bond market already has borne the impact of record issuance in the fourth quarter of last year, driven in part by uncertainty around the tax plan, with indices down about half a percent. Supply now is expected to cool off this year, though this is subject to change if Congress and Trump are able to push through an infrastructure spending bill. Demand from individuals should remain high as top tax rates were reduced only modestly, from 39.6% to 37.0%, preserving the appeal of the muni federal tax exemption, while corporate demand could indeed drop with their more significant rate cut. Meanwhile, the corporate bond market could benefit from both lower issuance, with needs reduced in the wake of new cash inflows from abroad, and improved corporate fundamentals tied to the bolstered economic outlook.
On the geopolitical front, from which determinants of market psychology and behavior so often emerge, we start 2018 with an uptick, if from a negative situation. With the Winter Olympics set to begin in Pyeongchang, South Korea, on February 9th, North Korea accepted the host’s invitation to discuss ways to cooperate in a January 9th meeting -- the first high-level dialogue between the two countries in two years. Most immediately, this should include the North’s participation in the games, while more broadly there are hopes for reduced tensions lasting well beyond the event. No one is opening any champagne bottles, of course, and there are ulterior motives, including the North’s desire to wedge the South from the U.S. with the dialogue. For its part, however, the U.S. and its allies have agreed to put off joint military exercises with South Korea until after the Olympics.
Also under the heading of psychology drivers, albeit in a very different category, last year’s Bitcoin phenomenon brought wide attention to cryptocurrencies for the first time. This was understandable: the “virtual” but still investable currency, valued at a thousand dollars in January 2017, reached $17,900 late in the year, before losing a third of its value in just 24 hours. While getting any handle on a virtual currency may be a fool’s errand -- it lacks any regulatory structure or government backing, and as a stable store of value is questionable at best -- there may be a more substantive investment theme around its underlying blockchain technology. Essentially a digitized and decentralized public ledger, the technology eliminates the need for a third party to step in, facilitating transactions between any two parties, while creating a clear, openly accessible trail (something cash transactions clearly do not do). The music industry, for one, hopes this technology can help it recover lost billions in revenue, now able to track voluminous but minute streaming fees that had been lost in the shuffle.
After the strong 2017, investors will need to grapple with somewhat stretched market valuations. Arguably, this is mostly an issue in the U.S., where price gains for the year outstripped earnings growth by about 10 percentage points. Using figures supplied by JP Morgan as well as Eaton Vance, the S&P 500 now trades at about 18.2 times current forecasts for next twelve-month earnings, compared to a 20-year average of 16.0 times. (Using a ten-year time frame, which excises the dot-com excesses but still includes the financial crisis, the average is 14.2 times.) Meanwhile, in non-U.S. markets, earnings growth, off more depressed levels, more completely carried returns, even outstripping local price gains in Europe and Japan. Overseas markets thus trade more in line with history, at 14.3 times expected earnings, against a 14.5x 20-year average multiple.
Importantly, however, earnings trends in the U.S. continue to support the above-average pricing. Companies should benefit not only from lower tax rates, along with a solid domestic and global economic backdrop, including a recovered energy sector, but also a reversed headwind represented by the lower dollar. Foreign sales account for around 45% of S&P 500 revenues (the energy sector being the highest at roughly 60%), and the lower dollar aids both global price competitiveness and the translation of overseas earnings onto U.S. books. Conditions can of course quickly change, but on current data, with the 9.9% 2017 greenback slide, U.S. earnings could get a boost of perhaps 4-5% on top of already healthy levels.
On this early 2018 backdrop, we maintain our overall modestly defensive positioning, given elevated valuations in both stocks and bonds. We are trimming one emerging market manager on the heels of a 38.2% 2017 gain, and moving the proceeds into the U.S. small capitalization space, where returns lagged last year. While still seeing value in the emerging markets, it would not surprise us to see perceived China strength prompt a renewed Trump commitment to pursue protectionist measures. At the same time, with a relatively high percentage of revenue typically generated within our borders, U.S. smaller companies may see less weak dollar benefit, but should more directly and permanently benefit from lower tax rates, starting this year. Finally, in our more bond-heavy portfolios, we are adding a manager to help diversify the bond mix; this is aimed at tamping volatility and hopefully improving risk-adjusted returns over time.
We wish all of you a great start to the new year. As always, feel free to reach out with any questions.
I’d like to sincerely thank my colleagues Jason Edinger and Michael Bove for their contributions to this piece.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.