The fourth quarter of 2017 capped an extremely strong year in global equity markets. Our global equity market index of choice, the MSCI All-Country World Index IMI,d was up 5.7% during the quarter and 24% for the entirety of 2017. As in the previous three quarters, emerging markets led the way, up 7.4% in the quarter and 37.3% during the year. The S&P 500a was up each and every month in 2017, the first time this has happened over a calendar year.
Fixed income markets were a mixed bag during the quarter and full year as the flattening of the yield curve hurt short-term bonds, but helped longer-term bonds.
The Federal Reserve (Fed) raised its benchmark lending rate during the fourth quarter by 25bps (0.25% points) to a range of 1.25% to 1.5%, its third increase of 2017. The Fed’s slow but steady increase in lending rates triggered short term rates to increase — the yield on the 2-Year Treasury increased 70bps during the year to end at 1.9%. However, longer-term rates remained relatively static — the yield on the 10-Year Treasury decreased 5bps during the year to end at 2.4%.
On February 3, 2018, Jerome Powell is set to replace Janet Yellen as chairperson of the Fed. Although Yellen is an academic economist nominated by President Obama, while Powell is a investment banking lawyer nominated by President Trump, investors generally expect continuity in Fed monetary policy. The Fed is guiding to three (3) 25bps rate increases during 2018, however the market is currently pricing in only two.
The US unemployment rate tacked down 0.1% during the quarter (and down 0.6% year on year), to end the year at 4.1%. Although at a level most economists consider to be full employment, wage inflation remains subdued. Exiting 2017 the wage for the average American was up 2.5%, just slightly ahead of the 1.9% inflation rate that investors expect to occur over the coming five years. Production and nonsupervisory employees (i.e. blue collar workers) continue to struggle in the current environment, with their wages up only 0.3% in nominal terms (so a real decline of 1.6%).
The primary driver of US markets during the quarter was the passage of Republican tax cuts. As I discussed in some detail in my 3Q17 CIO Commentary, the big winners from the tax cuts are companies (more accurately, the owners of companies). The marginal corporate tax rate was permanently cut from 35% to 21%, while owners of pass-through entities will be allowed to deduct 20% of their taxable income, subject to some cutoffs. The average individual taxpayer will also see a reduction of her tax bill over the coming nine years, but this flips to a large increase in the 10th, and all subsequent, years (see graphic to right; in order to pass the tax cuts without support from Democrats, Republicans had to craft a bill that did not incur an incremental deficit 10 years out).
The average individual will also be burdened with an estimated $1 trillion in additional federal government debt (over $3,000 per American), which will result in higher taxes and/or lower benefits down the road.
The biggest losers from the Republican tax cuts are individuals currently receiving healthcare through Affordable Care Act insurance plans (i.e. Obamacare) and Medicaid, and many upper and upper middle-class families living in high tax states (California, Oregon, and New York, to name a few) — a result of the bill’s removal of the health insurance mandate, and the bill’s limitation of state and local income, sales, and property tax deductions to $10,000, respectively.
From an individual investor’s perspective, the final bill does not change capital gains rates, or the choice of accounting methods available to calculate capital gains (the Senate version of the bill had proposed forcing “first in, first out” treatment on all individuals). However, the bill eliminates the ability to deduct the amount of investment advisory and tax preparation fees that exceed 2% of your adjusted gross income (AGI). As for the public US companies we invest in, we expect a one-time step-up in earnings of about 8-11% due to the Republican tax cuts. While the corporate tax cuts are “permanent,” we believe they may ultimately be reversed should Democrats regain control of the presidency and Congress, or should government deficits rise more quickly than anticipated.
While the change in economic conditions during 2017 was favorable for US companies, it was even more so for foreign ones. The gap in economic activity growth between the US and other large developed countries, as measured by the purchasing manager index (PMI), has diverged as of late in favor of foreign countries (see below). This helped contribute to a 7% decline in the value of the trade weighted US dollar index during 2017. And in turn, this helped foreign equity markets, both developed and emerging, to outperform the US equity market in 2017 by 3.2% and 18.7%, respectively in US-dollar terms.
With nine months completed in the 24-month Brexit negotiation process, the United Kingdom (UK) has agreed to many of the European Union’s (EU’s) demands. The first concession agreed to is that there will be no “hard border” between Ireland and N. Ireland (the former a country in the EU and the latter a part of the UK), nor between N. Ireland and the rest of the UK. The second concession is the preservation of rights to live, work, and study in the UK for EU citizens currently there, and in turn, UK citizens currently in the EU. Lastly, the UK agreed to pay the EU between £35 and £39 billion ($47.5-$53.0 billion) to settle its EU funding obligations. From an economic and investment standpoint, we believe these concessions are positive as they are all steps toward a “softer” Brexit. At this point in the negotiations, it looks like the future UK-EU economic relationship will be modeled after the Canada-EU one which was recently strengthen by the Canada-EU Comprehensive Economic and Trade Agreement (CETA) — a free trade agreement that targets nearly universal tariff-free trade between the two entities.
On a less positive note, Europe’s largest country continues to operate without a government more than three months after its election. Angela Merkel, the German Chancellor since 2005, failed to bring the CSU, FDP, and Green parties into a majority ruling coalition with her CDU party. She continues to attempt to form another ruling coalition, but it increasingly looks like the country is heading for new parliamentary elections to break the impasse. Meanwhile, the EU is missing its traditional and usually stable German leadership as it tackles the challenges of Brexit negotiations, Russian hostility, and economic and political instability among its southern members (e.g. Spain, Italy, and Greece).
Tensions in the Middle East worsened during the fourth quarter as the US announced it would move its embassy from Tel Aviv to Jerusalem. The move effectively killed two-state peace talks between the the Israelis and Palestinians, and drew swift and strong condemnation by a large majority of the world’s nations, including from traditional US allies in Europe and Asia.
Rhetoric between N. Korea and the US escalated from already high levels during a quarter in which N. Korea tested a missile with range sufficient to strike any US city. Although global investors keep shrugging off the possibility of a nuclear conflict between N. Korea and the US, the Nobel Foundation has not — it awarded the 2017 Nobel Peace Prize to the International Campaign to Abolish Nuclear Weapons (ICAN) “for its work to draw attention to the catastrophic humanitarian consequences of any use of nuclear weapons and for its ground-breaking efforts to achieve a treaty-based prohibition of such weapons.” Although we think the probability of nuclear war with N. Korea has always been small, we fear that it is increasing quickly. Given the dramatic negative consequences to global investing markets should it occur, we think responsible investors should take it into consideration when choosing their mix of assets.
President Trump acted on many of his campaign pledges during his first year in office, including the promise to cut taxes, lower government spending on its citizens’ healthcare, withdraw from the Trans Pacific Partnership (TPP) and the Paris climate agreements, beat back ISIS in Syria and Iraq, restrict immigration and Muslim travel into the US, and to roll back environmental and worker protection regulations. Still on his pledge list is a plan to upgrade the country’s infrastructure over the next decade with a $1 trillion spending plan, and to renegotiate trading terms with many of the US’s largest trading partners, including Canada, Mexico, China, Japan, and S. Korea. We think Trump will address both issues this year, but only the latter may have a meaningful, and possibly severely negative, impact on the global investment landscape.
The fourth quarter played out much like the rest of 2017 for AlphaGlider strategies — with our conservative footing we matched about 80% of the performance our benchmarks during a period of extremely strong global equity market returns.
As throughout the year, we were underweight equities, particularly domestic equities, due to high valuations and concern that the economic cycle is in its late innings. Another dimension of our conservative positioning was a skew to shorter duration in our non-equity holdings. One measure of this is in what we consider to be non-correlated assets — assets that aren’t correlated with moves in the equity markets and interest rates, such as cash, short-term bonds, and market-neutral equities.3 Exiting 2017, nearly 30% of our “down-the-middle” balanced strategy (AG-B) was held in these non-correlated assets. AG-B’s benchmark’s exposure to non-correlated assets is less than 10%. During the fourth quarter our strategies benefited from ownership of Singaporean stocks (iShares Singapore, EWS)2 which which were up 8.8%. Our strategies also owned strongly performing segments of the US equity market, including technology (Vanguard Information Technology, VGT), growing dividend (Vanguard Dividend Appreciation, VIG), and value (Vanguard Value, VTV), up 8.7%, 8.2%, and 7.2%, respectively. Our strategies were held back during the quarter by their heavy short-duration exposure in fixed income, high levels of cash and market-neutral equities, and overall underweight exposure to US equities. Our short-duration bond holdings (Vanguard Short-Term Bond, BSV and Vanguard Short-Term Corporate Bond, VCSH) were down -0.5% and -0.3%.
For calendar 2017, our strategies were helped by their equity exposure to foreign markets (iShares Singapore, EWS; Vanguard FTSE Developed Markets, VEA; Vanguard FTSE Emerging Markets, VWO) and US technology (Vanguard Information Technology, VGT). They were up 35%, 26%, 31%, and 37%, respectively. As during the fourth quarter, our short-duration fixed income exposure and high levels of cash and market-neutral equities held back performance during 2017. Our short-term bond funds were up only slightly while our market-neutral equity fund (Vanguard Market Neutral, VMNFX) was down -6%.
OUTLOOK & STRATEGY POSITIONING
Hop in my time machine — we’re going back to October 2007 when life was good, at least financially. We were enjoying newly lowered income and capital gains tax rates courtesy of President George W. Bush. Our home values were going through the roof, and jobs were plentiful (only 4.7% unemployment) five plus years into an economic expansion. The stock market had doubled off its 2001, post-dotcom bubble lows (as measured by the S&P 500), and was trading at “only” 19x that year’s earnings and 27.3x cyclically adjusted earnings. Yes, life was good — what could go wrong? As we know in hindsight, plenty.
The stock market more than halved over the following 18 months. National home prices fell by a quarter over the following four and a half years. Perhaps you got laid off during the 2008/09 recession (unemployment reached 10% in 2009). And then our income tax rates went back up in 2013 (but the lower capital gains tax rates remained).
Now let’s ride back to today. Last month we got our new individual tax cuts thanks to President Trump and the Republican controlled Congress, plus even bigger tax cuts for the companies in which we invest. Our home values recovered nicely, thank you very much (10% higher than October 2007 values, in inflation-adjusted dollars). Jobs are even more plentiful than they were in 2007 (4.1% unemployment). And the US shares we owned in October 2007 doubled, with dividends reinvested (and nearly quadrupled from their March 2009 low). They are now “only” trading on 21.5x last year’s earnings, and 32.5x cyclically adjusted earnings, 13% and 19% premiums to October 2007 valuations, respectively. The current economic expansion is in its 103rd month, and by summer is set to become the longest such stretch in post-war US history. Life is good once again, even better than back in October 2007. What could go wrong?
I have no clue when the next global recession, or the next bear market, will arrive. I don’t believe anyone can predict such things consistently, and I strongly recommend that you ignore those who confidently say that they do know. I find that these people usually have something to gain by getting you to act on their prognostications. In my mind, the best we can do when looking to the future is to identify possible outcomes, estimate their economic impacts and probabilities, consider valuations — and then invest accordingly. The most dangerous time for an investor is when economic expansions are long, valuations are high, and euphoria rules the day. I think we’re there now, or at least very close. We are investing accordingly.
We know this economic expansion is long in the tooth and that with the exception of a few years during the late 1990s’ dotcom bubble, valuations are at their highest in post-war history. But gauging investor euphoria is a bit more subjective. The data below, which measures US household and nonprofit exposure to the stock market, is one way to gauge investor euphoria. It is now at levels last seen in October 2007, and once again, is only exceed by a few years during the late 1990s’ dotcom bubble.
But bull markets don’t die because of old age, high valuations, or investor euphoria directly, but rather by other means that just happen to be correlated with them. One common driver to the end of bull markets is the cessation of easy, cheap capital. Rising interest rates, particularly short-term rates which drive the borrowing costs for many households and companies, are frequently the culprit here — and interest rates are most directly driven by actual and expected changes in inflation. So let’s take a closer look at them.
Inflation, as measured by the price index for personal consumption expenditures (PCE), has remained low and consistently below the Fed’s targeted rate of 2% throughout this economic expansion. However, many of the precursors to rising inflation seem to be coming together. One is the level of the country’s economic output, as measured by gross domestic product (GDP), versus its long-term potential output running at full (i.e. most efficient) capacity — the economic output gap.
The following chart above that 102+ months into this current economic expansion, the US economy is just now reaching full capacity. The US economy can run faster than full capacity going forward, and most likely will with the stimulus provided by lower corporate tax rates and regulation, and a potential infrastructure spending surge. But as the chart on the previous page demonstrates, pushing an economy harder than its full capacity (i.e. above the 0 line) usually pushes it over into recession. The mechanism for this is rising inflation, caused by a labor and capital supply/demand imbalance.
The Fed helped get the US economy back on its feet by lowering the cost of borrowing for companies and households — achieved by lowering its benchmark rate to 0%, and purchasing over $3.5 trillion in government bonds and mortgage-backed securities (i.e. quantitative easing, QE). But as the economy recovered, the Fed has been rolling back this stimulus by freezing (but not unwinding) QE, and raising its benchmark rate. The Fed’s desired result, higher short-term rates, soon followed. However, long-term rates, and long-term growth expectations, have remained fairly stable, causing the yield curve to flatten (the convergence between short and long term rates). A flattening yield curve, accompanied with a tight labor market, can often presage a coming recession, as the chart below shows.
The degree of “flatness” in the yield curve is shown by the blue line (the difference between yields of the 10-Year and 2-Year Treasuries), the unemployment rate is shown by the red line, and peak and trough S&P 500 price levels are shown around each of the three most recessions, in green and red respectively.
The bulls (bullish investors) say that despite high valuations, the long duration of the economic expansion, full employment industrial capacity utilization, a Fed that is actively raising rates, and a flattening yield curve, “it’s different this time.” They also downplay the possibility that President Trump will lead us into a damaging trade or military war. They are confident that lower corporate and individual tax rates, rolled back corporate regulations, and a potential infrastructure plan will continue to drive up the US economy and stock market, while not overheating it. Needless to say, we are not so confident in this belief.
While we consider the risk-reward tradeoff presented by US equities to be unfavorable, we are able to find relatively attractive long-term opportunities in overseas equities. For example, the Singaporean stock market, which we are exposed to through iShares Singapore (EWS), trades at 11x trailing earnings, 14x cyclically-adjusted earnings, with a dividend yield of 3.1% — a discount to the US stock market of 53%, 54%, and 42%, respectively. This, coming from a developed market that has a GDP per capita that is more than 50% higher than the US, is growing more quickly than the US, is suffering from less internal and external political risk, and has more room for margin expansion in its corporate sector. Another example would be emerging market equities, which trade at 16x trailing earnings, 17.3x cyclically-adjusted earnings, and a dividend yield of 2.7% — a discount to the US stock market of 32%, 43%, and 33%, respectively.
On the fixed income side, we continue to shy away from longer-term durations which we find to be overpriced in this environment of healthy economic growth, tax and regulatory stimulus, rising government debt, and central banks actively tightening (the Fed and the Bank of England), or considering to do so (European Central Bank and the Bank of Japan). With higher short-term rates in the US, our defensive short-term bond investments are beginning to generate some yield for the first time in years.
Bull markets are born on pessimism,
grow on skepticism, mature on optimism,
and die on euphoria.
- Sir John Templeton
In conclusion to this end of year CIO Commentary, I would like to remember all those people who have died, been injured, or suffered property losses due to extreme weather events in the southwest and west regions of the US where so many of our clients, friends, family, and readers reside. When I signed AlphaGlider up for 1% for the Planet last year, I wanted to bring attention to the growing risk to life, property, and investments posed by climate change, and to contribute what my little company could afford to fighting it. Little did I expect hurricanes, fires, and mudslides to affect me and the people around me so immediately, and with such devastation. I fear climate change will continue to increase the frequency and severity of natural disasters going forward, but I remain optimistic that eventually human courage and ingenuity will rise to the challenge to ameliorate it.