Room to Run (4Q17)


What a difference a year makes for investors.

Last year at this time, markets had little to go on as we all sought answers to key questions. Would we see a measurable strengthening of the economy under Donald Trump? Would the outsider new president be market-friendly or market-unfriendly – would he be able to achieve his goals of mtax reform, deregulation and infrastructure, or would he impose protectionist tariffs, risk trade wars and disrupt labor markets by tightening immigration?

Would the Federal Reserve’s actions extend the bull market or kill it? Would international stocks finally outdo the U.S. market?

As we wrote last January, when markets were based largely on sentiment: “The outcomes could be drastically different depending on what actually happens in Washington in the months ahead.”

We now have some answers. Plenty of hard questions and risks certainly remain. Entering 2018, however, markets can factor in a concrete legislative result in the new tax law along with significant deregulation. And all-time highs now are tied to the synchronized acceleration in global growth, a firming U.S. economy and a full year of strong corporate earnings.

Yes, valuations are very high. But high valuations are not predictive of short-term performance – they impact long-term returns. As outgoing Fed chair Janet Yellen said in her final answer at her final press conference: “The fact that valuations are high doesn’t mean that they are necessarily overvalued.”

We expect stocks to rise further as fiscal stimulus from the new tax law takes over from monetary stimulus – with an additional boost if Congress can pass an infrastructure spending package. Bolstering our view is the fact that most of the recession indicators we watch, including manufacturing gauges and the yield curve (more on this below), remain out of the danger zone.

There is a very high probability, though, that we will not have another year like 2017, the least volatile in modern market history.

Between geopolitical risks such as North Korea and near-constant political uncertainty in Washington, it may not have seemed calm. But the Standard & Poor’s 500 Index advanced in every month for the first time, tied a record with a positive return for a ninth consecutive year and saw its largest drawdown at just 2.8 percent. The CBOE Volatility Index, or VIX, hit an all-time low and fell 17 percent overall.

History tells us that market serenity is fleeting: There have never been back-to-back years in the past 90 years without a 3 percent drawdown.

Careful maneuvering will be needed by a Federal Reserve in transition – with a new chair in Jerome Powell and three seats vacant on the Federal Open Market Committee (FOMC) – to avoid impeding the nine-year-old bull market. Inflation is finally showing signs of creeping higher, but we believe the Fed would be overreacting by hiking interest rates three or four times this year unless it climbs more sharply. As with Goldilocks’ porridge, a certain level of heat (inflation) is just right for the economy, and right now we do not see it anywhere close to too hot.

Internationally, stocks continue to have a positive outlook after outperforming the U.S. market for the first time in five years in 2017, thanks largely to the weaker dollar. Emerging markets in particular enjoy strengthened economic fundamentals, with continuing momentum for corporate earnings in most of the world. As with the Fed, though, global central banks must approach the unwinding of their monetary stimulus programs with caution or market risks may rise.

Fears of trade wars erupting because of President Trump’s aggressive campaign rhetoric were not realized during his first year in office. But this remains a concern, particularly after his recent imposition of steep tariffs on imported washing machines and solar panels and with NAFTA negotiations ongoing.

We expect market risk to rise as the year moves along. The Fed will face hard decisions on rate hikes, midterm elections will add to uncertainty and increase the potential for gridlock and U.S. companies will face stiffer year-over-year profit comparisons to hurdle.

Clearly we are a step closer to the end of this bull market. A pullback of 5 percent or more, if and when it occurs, will feel especially painful after last year’s tranquility and there may be the temptation to overreact. Overall we remain cautiously optimistic for at least the first half of 2018.

We advise clients to stay allocated according to their long-term asset allocation targets but are watching the economy and markets carefully.

Please read on for a deeper look at these issues in our quarterly discussion of five key topics for the markets and our clients:

1. U.S. economic indicators have finally kicked into a higher gear, yet there is no sign of overheating.

“Ain’t nothing like the real thing baby
Ain’t nothing like the real thing.” – Marvin Gaye and Tammi Terrell

For the last few years, we have all been asking “what’s going on” with the slowest economic expansion since World War II, to cite another Marvin Gaye classic. Now we have a welcome change in tune.

Until recently, hard, quantifiable economic data could scarcely justify investors’ exuberance and animal spirits, to use John Maynard Keynes’ term for the human emotion that drives consumer confidence. Sentiment indicators and other survey data were flying high since Mr. Trump’s election; evidence of significant fundamental improvement in the economy – not so much.

We wrote in our quarterly commentary in October that “Increases in consumer and business optimism and other ‘soft’ data have yet to translate to commensurate economic progress beyond what market prices already anticipate.”

Such progress is now clearly visible. The economy has newfound momentum and, with help from the new tax law, it looks like the real thing. A third straight quarter of over 2.5 percent GDP expansion to end 2017 lifted full-year growth to the highest since 2013, albeit a still-modest 2.3 percent. Corporate profit performance was strong in the fourth quarter, with expectations for more capital expenditures in 2018 due to the tax overhaul (more on that later).

Manufacturing growth has accelerated. The Purchasing Managers’ Index, an important indicator of the sector’s economic health, logged its second-highest reading since 2011 in December. Strong readings for new orders, production and backlogs suggest a positive outlook for manufacturing.

Retail sales saw their largest holiday-season increase since the recession of 2008 with a 5.5 percent rise in November and December, according to the National Retail Federation.

The labor market provides a healthy underpinning, although growth has slowed as it nears full employment. The economy created more than 2 million jobs for the seventh year in a row. The upside to less job growth is that it is expected to generate higher wage growth as employers compete for workers in a tight market, which could help revive inflation.

Some indicators suggest inflation is poised to finally reach the Fed’s 2 percent target – further testimony to a revitalized economy. The breakeven inflation rate, a market-based measure of expected inflation that measures the yield gap between 10-year Treasury notes and TIPS (Treasury Inflation Protected Securities), hit 2.05 percent. A gradual rise in inflation is hardly worrisome at this level; a forward-looking rate around 2 percent is just where we want it.

A more vigorous economy does not assure another stellar year for markets; investors already have taken this sunny outlook into account and priced much of it in. It does, however, bolster our confidence that no market-wrecking recession appears on the horizon.

The Leading Economic Index, comprised of 10 economic components, is far above the level that would indicate a recession is near. Even the famously bearish Jeff Gundlach, the DoubleLine CEO whose views we take seriously as one of our recommended fixed-income managers, said during a recent call that the economy is “nowhere near a recession.”

What would concern us would be an inversion of the yield curve – an interest-rate environment in which long-term bonds such as the 10-year have a lower yield than short-term ones. That would reflect a lack of confidence by bond investors in the future of the economy.

The yield curve has flattened persistently over the past year as the Fed hiked short-term rates, leaving the difference between short and long rates smaller than it has been since 2007. A misstep by the Fed or similar setback could potentially cause the curve to invert, so we are keeping an especially close eye on this recession predictor.

Overall, however, the market appears increasingly confident in the economy and so are we.

2. The Fed and other major central banks will make or break 2018 for investors.

Global central banks – including those in Europe, Japan and China – will play a key role in the stability of markets as the era of easy money begins to wind down.

The Fed faces a twofold Olympian challenge of its own starting in February when Powell takes over from Yellen. It must carefully calibrate the number of interest-rate hikes to be carried out this year without jeopardizing economic momentum or panicking markets as it did in the taper tantrum of 2013. It also needs to maintain a prudent pace while reducing its $4.5 trillion balance sheet, a task begun last fall.

We approve of the cautious approach and transparency of the FOMC, the Fed’s policymaking body, since it started gradually raising rates in December 2015. However, turnover in both the membership and voting rotation suggests the newly reconstituted committee could be more hawkish as it looks to normalize rates in an improving economy. That makes it more difficult to count on a consistent, predictable course of action.

Besides Yellen and vice chair Stanley Fischer, some of the other more cautious officials such as Neel Kashkari and Charles Evans rotate off the FOMC this year and give way to Loretta Mester and others who have advocated a faster pace for rate hikes.

If the post-Yellen Fed does opt for three or more rate hikes this year absent a significant pickup in inflation and growth, that could spell trouble for markets and we would position more defensively. Raising short-term rates without inflation and growth most likely indicates that long rates will not increase, therefore almost guaranteeing an inverted yield curve – usually a portent of a coming recession.

Internationally, mere suggestions that the big central banks are debating when to reverse their ultra-loose monetary policies have rattled markets. The European Central Bank’s easy money program may end in September, which would be a setback for investments in European assets. There is speculation the Bank of Japan, too, may scale back its massive bond-buying program now that the Japanese economy is thriving again.

Such moves, if made suddenly and without heed to the consequences, could send bond prices lower and undermine stocks as well.

We remain confident that these central banks will not take investors by surprise because, as with the Fed, it is in the best interest of their markets and economies not to do so. Despite some market jitters over the potential for the ECB to change course, we also believe incautious actions are unlikely before the pragmatic Mario Draghi finishes his eight-year term as president in October 2019.

3. Interest rates are seeing upward pressure, but we expect them to remain range-bound for now.

Concerns about the potential for abrupt monetary cutbacks abroad have added to Wall Street’s habitual pessimism about bonds for the year ahead. We believe it is important to view the recent rise in rates in context, however.

In short, without evidence of materially higher inflation and growth, we believe it would be premature to underweight bonds.

The likeliest cause of a spike in bond yields would be a surge of unexpected inflation, prompting the Fed to hike interest rates more aggressively to prevent the economy from overheating. Nothing in the latest economic data suggests that either runaway economic growth or a wave of sharply higher inflation is imminent. The gradual pickup in inflation and growth that is now under way is in line with our expectations.

As mentioned in the section just above, we also expect global central banks to be as measured and transparent as the Fed has been so far in unwinding monetary stimulus programs.

So, while rates may climb somewhat further, we do not expect intermediate- and long-term rates to break out of their current range in the near term.

For the last few years, various pundits have called the end of the bond bull market, only to see another collapse in rates and be met with disappointment. Yet the market has remained stable, even as the benchmark 10-year U.S. Treasury yield doubled off its all-time low in the past 18 months. Defying prognostications, the Vanguard Total Bond Market ETF, an investable gauge of higher-quality taxable bonds, delivered a solid 3.6 percent return last year.

Even when the 10-year yield reached a 3½-year high this past month, it was just 0.2 percentage point higher than at the beginning of 2017. The yield should remain range-bound if the Fed raises rates judiciously – in other words, as market conditions permit.

It is important to note that the first line of defense for some of our fixed-income managers is their flexible mandates to adjust the maturity of bonds they invest in, based on changes in the rate environment and other underlying conditions.

Even if expectations for bond returns are reduced from years past, we believe they currently still merit their target allocation in portfolios. Higher rates will affect the entire portfolio, not just bonds. Bonds, too, are important diversifiers that only rarely have annual losses and can help lessen the impact of any major drawdown due to the lack of correlation to equity markets.

4. Tax reform can provide further stimulus for the markets, at least for the first half of 2018.

There is no way to know how long markets will feed off investors’ enthusiasm for the biggest tax cuts since 1986. Ultimately, though, markets respond positively to an improving economy and pace of growth. We expect both to continue to strengthen for the near- to medium-term future.

We have reviewed a wide variety of forecasts of the tax law’s impact on the economy. Even the most conservative outlooks show GDP benefiting in the short run. The International Monetary Fund raised its estimate of U.S. GDP growth in 2018 to 2.7 percent in January from 2.3 percent last October. Any infrastructure spending program passed by Congress would add to that. The Trump administration already is moving to speed the construction process by rolling back regulations for obtaining building permits.

Part of the boost should come from business capital spending, which is fundamental to growth and appears set to strengthen further. The Future Capital Expenditures index, compiled by the Federal Reserve Bank of Philadelphia, entered 2018 on a sharp rise and at its highest level since 2000.

Already this year, a growing number of U.S. companies have announced investment, special dividends and repatriation as a result of the tax overhaul, which reduced the corporate rate to 21 percent from 35 percent. Shareholders will not benefit from all those actions, but certainly from some.

The economy picked up significantly the last time tax cuts were enacted, in 2003. Real GDP growth rose temporarily to a more than 4 percent annual pace after the cuts took effect. During the first 12 months after the changes took effect, the S&P 500 rose 18 percent.

With the extra impetus provided by the most recent cuts, robust corporate earnings growth can continue into the second half, which will bring more challenging prior-year comparisons. Backed by a strong tailwind from the new tax law, FactSet’s latest full-year 2018 estimate is for profits to grow by more than 16 percent.

5. Commodities are benefiting from synchronized global growth for the first time in years.

The worst-performing asset class since the Great Recession is finally showing evidence of sustainable growth.

A modest turnaround in the past 18 months has gained momentum in recent weeks. After riding a December rally in oil prices to finish in positive territory for a second straight year, commodities have continued to accelerate in early 2018. Several factors are at work, most notably global economic strength and the weak dollar.

Yet our conviction in this category comes as much from a trend that has yet to fully reappear: Commodities historically rally sharply late in economic/business cycles, especially when wages rise and inflation picks up. This was evident, for example, in the early 1980s before raw materials prices went into an extended slump and again in the late 2000s with strong returns.

While no one knows when this economic expansion will end, we think it is safe to characterize the ninth year of the cycle as at least relatively late. Wages and inflation have long been held in check; however, we are seeing increasing signs of expected higher growth in forecasts and recent data. The tax reductions should stimulate both further.

Even without wages and inflation taking off (which is our base case scenario), commodities should continue to draw solid fundamental support from the following:

World economic growth: Forecasters project global GDP rising faster than previously expected in 2018 after its strong increase last year; the World Bank boosted its growth estimate in January to 3.1 percent, which would be the highest since the financial crisis. Other emerging market countries besides China are becoming more influential. Robust growth worldwide fuels demand for raw materials.

China: Even as its growth pace slows modestly, the world’s second-largest economy continues to have a huge appetite for imports as it builds up its infrastructure. China surpassed the United States as the world’s largest oil importer in 2017 and also bought record amounts of copper ore, iron ore and natural gas as part of anti-pollution efforts, somewhat offsetting heavy coal consumption.

Oil and industrial metals: Oil reached three-year highs in January as OPEC and other producing countries vowed to keep supply limits in place through 2018. Metals should continue to flourish in the global economic boom.

President Trump and Congress could provide more fuel for commodity prices if they approve major infrastructure spending.

A rebound in the dollar following its substantial drop since 2016 would pressure the category, since most commodities are denominated in dollars. Overall, however, we believe the ingredients are in place for them to perform well. They also serve as both an inflation hedge and an important diversifier within portfolios.

Our Outlook

Equity markets now have a stronger foundation from the improving global and U.S. economies and should rise further, boosted by fiscal stimulus from U.S. tax cuts.

We expect more market volatility in 2018 compared to last year’s historic calm, but not a return to sustainably high volatility.

We do not expect a recession in the next six months. However, we are closely watching the flattening yield curve for warning signs (i.e. longer-term interest rates are falling in comparison to short-term rates).

We need to see more growth and inflation in order to justify the three additional rate increases Fed officials have projected for 2018. Overtightening monetary policy may spell trouble for the markets and cause us to position more defensively.

We do not yet see evidence of an imminent, sustainable surge in either inflation or yields. Despite their incremental recent rise, we view intermediate- and long-term rates as remaining range-bound in the near term.

Market Data

U.S. Equities

The bull market set records galore as it closed out a ninth calendar year with its best annual returns since 2013. Rebounding global growth, an accelerating U.S. economy and anticipation of tax reform combined to keep stocks on a remarkably steady upward path. The market shrugged off the economy’s sluggish start, political battles in Washington and geopolitical tensions surrounding North Korea in delivering a historically calm, strong year.

Setting 62 new highs on the year, the Standard & Poor’s 500 Index rose in every month for the first time ever en route to a ninth straight positive year, tying the 1991-99 bull run for longest such streak. Fourth-quarter momentum was assured by the new tax law, with significant cuts that should expand corporate profits and stimulate spending. The investable iShares S&P 500 ETF added 6.8 percent in the fourth quarter to finish up 21.7 percent for the year, including dividends.

Small-company stocks, the No. 1 asset class the previous year, lagged large caps but still benefited from enthusiasm for tax reform. The iShares Russell 2000 gained 3.3 percent in the fourth quarter for a 14.6 percent annual return.

Growth trounced value as a preferred investment style at all market-cap levels, regaining its bull-market dominance after value stocks had prevailed in 2016. Led by the giant technology stocks, the iShares Russell 1000 Growth ETF more than doubled the gain of its value counterpart with a 29.9 percent return.

Tech also was the year’s top-performing sector with a 36.9 percent return powered by an average 48 percent gain for the five FAANG stocks: Facebook (54 percent), Apple (46 percent), Amazon (56 percent), Netflix (55 percent) and Google parent Alphabet (33 percent). Only telecom and energy were negative among the 11 S&P 500 sectors, with single-digit losses.

International Equities

International stocks outpaced the U.S. market for the first time in five years with their biggest gains since 2009 as the global economy perked up and overseas central banks kept the easy money flowing. The dollar’s 10 percent drop against a basket of other major currencies was key to the outperformance.

Markets benefited from upticks in growth and a year largely free of political shocks in Europe. The iShares MSCI EAFE ETF, which tracks developed-market stocks outside the United States, slowed its breakneck pace in the fourth quarter but still ended the year with a 25.1 percent return, or 3.4 percentage points more than its U.S. counterpart. Measured in local currency, the EAFE’s gains were far less at 15.8 percent. Japan’s Nikkei was up 19.1 percent while European indexes advanced more modestly: Germany 12.5 percent, France 9.3 percent, the United Kingdom 7.6 percent.

The iShares MSCI All-Country World ex-US ETF, a dollar-denominated proxy for international stocks that also encompasses emerging markets, posted a 27.2 percent total return after adding 4.4 percent in the fourth quarter. Every major country ETF in the world was positive for the year, led by Poland, Argentina and Austria all over 50 percent with Russia lagging at 3.9 percent.

Emerging markets led the way as the year’s top asset class, returning 37.2 percent as measured by the iShares MSCI Emerging Markets ETF. Besides Argentina, local indexes in Nigeria and Turkey both surged by more than 40 percent while Qatar’s fell 18 percent.

Real Estate

U.S. real estate investment trusts delivered a ninth straight year of gains while far underperforming the broad stock market as investors looked to high-growth stocks and elsewhere in a fast-rising market. The Vanguard REIT Index Fund increased by 1.4 percent in the fourth quarter for a 4.9 percent return for 2017.

Internationally, REITs benefited from global growth and the weak dollar in far outpacing their U.S. counterparts. The Vanguard Global ex-U.S. Real Estate Fund finished up 26.5 percent for the year after a 5.4 percent return in the fourth quarter.


The iPath Bloomberg Commodity Total Return ETN eked out a 0.7 percent gain for 2017, thanks to a 4.9 percent fourth-quarter rally capped by 12 straight days of gains to close the year. While that left commodities last among major asset classes, it notably marked a second straight positive year for a category that had been on a five-year losing streak from 2011-15. Commodities historically have fared well in the late stages of economic expansions.

The dollar’s 10 percent drop was a big boost for commodities, most of which are priced in dollars. A weaker greenback generally spurs demand by giving the many foreign buyers of commodities more purchasing power.

The pickup in global economic growth also enlivened demand, particularly for industrial metals and energy commodities. Aluminum was a top performer with a 30.7 percent return, due to both China’s plans to reduce excess aluminum production to address pollution and its continued infrastructure buildup, which stimulated demand for base metals. Copper’s 29.4 percent annual return was its largest since 2010, also benefiting from rising expectations for mass production of electric vehicles.


Hedge funds ended 2017 on an upswing as momentum from the tax reform legislation’s final passage lifted strategies betting on stocks to go higher. Their yearly performance collectively was one of their best during the bull market, when the more conservative positioning of many strategies has left them far behind stock returns.

The HFRX Equity Hedge Index, an investable index of hedge funds that maintain both long and short positions in primarily equity and equity derivative securities, rose 2.7 percent in the quarter and finished the year up 10.0 percent, the most since 2013.

The HFRX Global Index, a broad measure of all hedge fund strategies, returned 1.5 percent in the fourth quarter for a 6.0 percent annual gain – also the best in four years.

Fixed Income

Bonds posted modest yearly returns that exceeded those of 2016 and defied the consensus view that they would falter under pressure from rising yields. Even after three more rate hikes during the year, the yield on 10-year U.S. government bonds ended 2017 at 2.41 percent, down four basis points from where it began the year.

The Vanguard Total Bond Market ETF edged up 0.4 percent in the fourth quarter to finish with a 3.6 percent return for the year.

Municipal bonds fell in December to slip below taxable bonds’ return for the year. A blend of the Market Vectors’ short and intermediate ETFs serving as a gauge of the U.S. muni market posted a 2.9 percent yearly gain following a 0.7 percent decline in the fourth quarter. Investors initially feared that the tax overhaul may make munis’ tax-exempt interest less attractive with lower income tax rates. Also, in the early stages of the tax legislation negotiations, there were proposals to take away some types of muni bonds. Ultimately, only advance refunding bonds were affected.

The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.