The bull market continued for another year, and 2017 will go down in history as a highly unusual economic year. Nearly every major sector, country, region, and asset class had positive performance. This rarely happens! Why did this occur? There are 3 main reasons:
- Earnings were strong globally
- There was a tremendous amount of liquidity supplied by central banks ($2.2 trillion)
- Inflation was relatively muted
The global economic expansion is expected to continue in 2018 by a wide range of economists and research firms. In 2017, US Gross Domestic Product expanded, the unemployment rate fell, and upwards of 2 million new jobs were added.
The Conference Board US Leading Index Ten Economic Indicator is at 50-year highs:
Source: Conference Board, Bloomberg, Astoria.
US household net worth is also at 50+ year highs:
Source: Federal Reserve, Bloomberg, Astoria.
It should be noted that the US expansion is already the second longest in history although the magnitude of the expansion (as measured by GDP growth) hasn’t been nearly as impressive. The unprecedented amount of liquidity supplied by the Federal Reserve since 2009 is largely the driver.
The US Federal Reserve Committee forecasts three 25 basis point rate increases in 2018. The US Federal Reserve has been incredibly diligent in resurrecting the US economy from the depths of the Great Recession in 2009. We believe the probability that they raise rates more aggressively than what is implied in the market is low.
The international expansion is much further behind the US and valuations overseas are more attractive; international central banks are currently still accommodative.
Cheaper valuations, earlier stages of the economic cycle, and more accommodative central bank policy are the primary reasons why we believe international equities will outperform US securities prospectively.
Despite the 25%-35% rally in International Developed and Emerging Market equities in 2017, it’s important to realize that they have dramatically underperformed the US equity market since 2009.
Morgan Stanley’s Developed Markets Cycle Indicator continues its upward trajectory:
Source: Bloomberg, Morgan Stanley, Astoria
In the bond markets, coupon rates on 10-year Treasury bonds have risen incrementally to 2.41%, while 30-year government bond yields have fallen slightly to 2.74%. Five-year municipal bonds are yielding, on average, 1.70% a year, while 30-year municipals are yielding 2.62% on average.
The Great Recession was a generational scare for many Americans who lost jobs, houses, or income. Because of the psychological damage, investors have largely crowded into defensive and high-income strategies despite the tremendous rally in equities as previously noted.
Due to the basic economics of supply and demand, tremendous demand for income strategies has lowered bond yields to generational lows.
Investors should be cautious with fixed income. Historically, this asset class provided high income, diversification, and were a hedge to equities. These characteristics are not as prevalent at present. Nearly $2 trillion dollars has gone into fixed income strategies since 2009. Hence, these historical attributes of fixed income are ostensibly waning.
The current yield of the US 10-year treasury is approximately 2.41%. The average since 1965 is approximately 6% (see chart below):
Source: Bloomberg, Astoria
There are parts of fixed income that remain attractive; as such we are suggesting them in our client portfolios. Preferred
securities, senior bank loans, high yield municipal bonds, and emerging market debt are yielding between 4-6%; we believe these offer value compared to traditional fixed income segments.
Since March 2009, the Bloomberg Commodity Index has underperformed the S&P 500 by 392%. As a result, investors have largely ignored commodities ever since. Historically, commodities have done well during periods of rising inflation. We think an allocation to commodities is appropriate.
There are numerous signs that inflation is increasing. We are watching the New York Federal Reserve Underlying Inflation Gauge which shows that inflation is nearing 3%.
Commodities are attractive in a multi asset portfolio given they are 1) uncorrelated, 2) under-represented in portfolios, and 3) historically do well as inflation rises.
As noted above, 2017 was a highly unusual year and nearly every major asset class had positive performance. However, 2018 will likely see divergence between asset classes.
Timing the market top (or bottom) is impossible; the most sophisticated institutions can’t do it on a repeatable, systematic basis. Investors are more incentivized to stay fully invested and to consider asset classes which are uncorrelated to stocks and bonds to ensure their portfolios are properly diversified during market downturns. We believe it will be prudent to continue to include alternatives in portfolios.
Gold didn’t get the attention it deserved last year given the substantial rally in equities in 2017. However, gold produced a more than respectable 12% return mainly due to (1) a weakening U.S. dollar (2) concerns over international affairs (3) ongoing concerns over central banks debasing their currencies.
Gold is an asset class that has been time tested for many centuries. We think it’s an attractive portfolio hedge against risk events such as a North Korean conflict and rising inflation. Gold remains under-represented in portfolios particularly when compared to investors recent love affair with cryptocurrencies. Furthermore, gold remains uncorrelated to equities.
A Look Ahead at 2018
Our view is that the three variants that were responsible for the large rally in global equities in 2017, will decline, on the margin, in 2018. We can’t emphasize how important the rate of change on inflation and rates are for the markets.
- Liquidity, on the margin, will likely begin to deteriorate next year as the:
- Federal Reserve is expected to hike an additional 3 times in 2018
- The Federal Reserve will also be facilitating their Quantitative Tightening program
- The European Central Bank is expected to slow their Quantitative Easing program
Liquidity has been the biggest driver of risk assets in recent years, so we would expect a reduction in liquidity to have negative implications, on the margin, for equities (as compared to the rally experienced in 2017).
The rate of change for inflation is turning. The Bloomberg Commodity index posted back to back positive years for the first time since 2010. The New York Federal Bank Inflation Gauge is nearly 3%.
The year over year comparisons in earnings will be more challenging in 2018.
We look forward to your feedback on this revised market review and forward looking commentary. Please reach out to us with any input as we continue to strive to provide our clients and our community relevant and useful insights.