Year End 2017 Review of Capital Markets and The Economy

Double-Tightening & Synchronized Global Growth

The intent of this blog is to provide an update on the state of domestic and international stock and bond markets, as well as provide insight into the macroeconomic backdrop.

Stocks & Bonds

In 2017, the S&P 500 Index gained 21% while the Dow Jones Industrial average gained 28.1%.  Smaller firms (S&P 600) gained about half of the larger market for 2017, gaining 13.2%. In 2017, we finally saw the long delayed synchronized global rebound, with developed International markets gaining 26.8% in 2017 and emerging markets gaining 35.6%.  What’s more, markets were unusually calm. Low volatility was highlighted by the fact that the S&P 500 did not post a single monthly decline in 2017! 

Most of the 11 major stock market sectors posted solid gains last year. The lone exceptions were Energy and Telecom, down slightly more than 1%. The top performers, Technology and Materials, gained nearly 39% and 24%, respectively. We’d point out that three of the top four performing sectors (also including Financials and Consumer Discretionary) were cyclical sectors, which means the market and economy were in growth mode. On the other hand, three of the bottom four sectors were defensive—and interest rate sensitive—including Utilities and Real Estate.

In 2017, Barclay’s Capital Bond Index, which represents government and conservative corporate bonds, gained only 3.2%.  Preferred stocks performed better (+9%), while mortgage-backed bonds gained the least (+1.6%).  Notable this year is the narrowing of the gap in yields between 10-year and 2-year U.S. Treasury notes; this gap was cut in half from 1.2% to just 0.5%. While short-term interest rates rose, long-term rates stagnated. The 10-year Treasury began the year yielding 2.45% rate and finished at 2.40%, while the 2-year yield is now back to 2008 highs.

While longer-term rates ended the year right where they started, there was a lot of volatility throughout the year. On our part, this volatility confirmed the need to make some adjustments to ensure that your bonds serve their primary goals – diversification and risk control.  While it is commonly accepted that rates will rise in 2018, investors are hotly debating how fast, and whether long-term rates will catch up to last year’s big move in short-term rates.  Your portfolios are being adjusted to cope with this uncertainty.

The Federal Reserve’s Double Tightening

The Federal Reserve not only increased its short-term policy interest rate three times in 2017 to a 1.25% target, but it also began to reduce its $4.5 trillion-dollar portfolio of bonds.  Think of this as a double dose of monetary tightening.  The Fed is expected to proceed at the same pace this year. Remember, the Fed’s mandate is to promote stable inflation and full employment. But inflation is conspicuously absent right now. No matter, the Fed is looking to the future and sees that we are moving from the middle part of this business cycle to the late stage. And it believes it must get ready for the next recession by tightening monetary policy now. The pictograph below (from Fidelity) describes this transition to the last stage of the business cycle.

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U.S. Economic Growth

After a very weak first quarter, economic growth rebounded nicely last year to an estimated 2.6%. That’s a significant improvement from 2016. Economic growth in the range of 2.5% to 3% is considered very healthy for a mature economy such as ours. Two big reasons for stronger economic growth were rising business investment and higher corporate profits. A number of economic indicators (i.e. Institute for Supply Management manufacturing and service indexes; National Federation of Independent Business surveys) corroborated improving trends for corporate America. Profits for S&P 500 companies likely grew somewhere between 12% and 13% last year.

Furthermore, labor and housing markets improved throughout the year. The unemployment rate fell to 4%, which is historically very low. On average, 150,000 to 200,000 new jobs were created each month. And wage growth rebounded to 2.5%. As for housing, the pace of existing home sales climbed back to levels not seen since early 2007. And home prices continue to rise at a rapid 5-6% pace. Historically, when jobs and housing are healthy, the US consumer is apt to spend money, and that helps drive the economy.

Global Synchronized Economic Growth

The International Monetary Fund (IMF) has predicted 2017 economic growth of about 1.7% for Europe and 4.5% for the emerging markets. Those expectations were likely exceeded. In addition, Japan’s growth pleasantly surprised and China’s economy stabilized after a tough period in late 2015 & early 2016. Global trade volume and demand for commodities increased. For example, oil prices rallied to 3-year highs. In addition, despite increased monetary tightening from the Fed, the US dollar declined about 10% vs. a basket of foreign currencies. That, along with healthier demand around the world, helped US exporters fare better than they have in several years.

Last quarter, we pointed out a few regions with accelerating growth, and Fidelity has a nice illustration of where they stand now. Despite political risks making news in the Middle East, Eastern Europe, Asia, and elsewhere, global opportunities remain. That’s great news for US large-cap companies, which generate over 40% of their sales overseas.

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 The obvious conclusion is that investors sailed smoothly through 2017. And the economic backdrop remains healthy. But while we have reason to believe 2018 will be positive for the economy and stock market, it’s hard to believe we’ll be blessed again with such low volatility.

*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.