2017 in Retrospect—With a View Toward 2018 and Beyond
February 12, 2018
Executive Summary (for those short on time):
Stock markets around the world finished 2017 sharply higher, and the momentum initially carried over into 2018, with global equities rising by another +5.6% in January. (1) However, starting in late January, stocks gave back these gains and then some before rebounding somewhat in the past few days, as volatility has finally returned to the markets. And while interest rates were surprisingly stable last year, they have started to climb again in 2018, putting pressure on bond prices. The February drop in stock prices can be largely attributed to these rising interest rates, while the rate of decline, especially on Monday, Feb. 5, was accelerated by computerized trading, which is far more prevalent today than in years past. We fully expect stocks to regain their composure in due course, but bonds may continue to be under pressure for the rest of 2018.
In 2017, KCS’s investment gains were broad-based, as virtually every asset class contributed positively to our results. This robust performance was driven largely by globally synchronized economic growth, a phenomenon that we haven’t seen in over 10 years. (US stocks were additionally juiced by the recent corporate tax cuts, but we feel this move has run its course.) We believe that this globally coordinated economic growth presents an ideal environment for investors, and we see still more upside from here for investors who stay the course, at least for another couple of years.
We do see a few signals that are flashing yellow, such as equity valuations that have become rather high, primarily here in the United States. In addition, we don’t expect the unusual calm of 2017 to continue going forward, as the recent spike in volatility during the past two weeks’ correction has made abundantly clear. As higher volatility and rising interest rates will likely continue throughout 2018, we think investors still need to position their portfolios prudently. For our part, we’re continuing to underweight relatively pricey asset classes such as US stocks and foreign developed bonds, while overweighting more attractive assets such as foreign developed and emerging market equities. We briefly discuss our rationale for these stances below; if you would like to have a more in-depth discussion about any of these topics, please don’t hesitate to contact us.
2017 in Review:
We have repeatedly quoted the saying that “bull markets climb a wall of worry,” and last year epitomizes this maxim. Many investors were far from optimistic at the start of 2017; this was particularly true for those who did not vote for Donald Trump. As we have said many times, however, the person in the White House has only a modest impact on the US economy and virtually no effect on markets. Globally, both the economy and equity markets did very well last year, neither in spite of Trump or because of him. They did well owing to the work of millions of individual consumers, investors, employees, and managers.
Last year featured the continuation of a globally synchronized economic expansion that began in the middle of 2016. In response, stocks repeatedly hit all-time highs during the year, with the S&P 500 ending 2017 with a convincing gain of +21.8%. (2) This was actually one of the weaker stock market returns last year, as emerging markets, Japan and Europe posted gains (in US dollars) of +37.3%, +25.5%, and +24.0%, respectively. (3) These stronger international returns helped our own stock benchmark, the MSCI ACWI (All-Country World Index), to a higher gain of +24.0%. In addition, as our portfolios have recently been overweight in non-US stocks, our clients benefited even more than our benchmark from this outperformance of international equities.
Our fixed income positions also enjoyed solid performance, aided by two factors that helped bonds throughout 2017. First, the interest rate environment remained benign, with 10-year US Treasury rates ending the year essentially flat at 2.40%. Second, foreign currencies strengthened by nearly 10% versus the US dollar, helping bond holdings denominated in foreign currencies. These two tailwinds helped our bond benchmark, the Bloomberg Barclays Global Aggregate Bond Index, gain +7.4% for the year. Within our portfolios, we were hurt slightly by our underweight to debt denominated in foreign currencies;(4) however, we were able to keep pace with our benchmark by having a relatively greater weighting of corporate bonds versus government debt.
As we look to 2018 and beyond, we are focusing on the following major themes:
#1. We expect the synchronized global economic expansion that began in 2016 will continue for at least another couple of years.
Last year, the 45 leading economies all experienced economic expansion, and growth accelerated in most of these. More broadly, 186 of 192 IMF participants are expected to grow this year as well. (5) The last synchronized global economic expansion was over 10 years ago, in 2005 to 2007, and we think the current strength of the global economy will enable stock markets to absorb any minor economic hiccups that may pop up along the way. What are the main risks to our forecast? Two of the most publicized concerns are a geopolitical crisis and a hard landing in China, but these risks have been present for quite some time.
Until about 2 weeks ago, we were virtually alone in saying that the biggest risk to the current economic expansion would be a major error by a central bank, as most recessions are caused by excessive central bank tightening (that is, raising interest rates too quickly). We suspect that whenever this global expansion finally ends (and we promise, eventually it will), the cause will be excessive tightening by the US Federal Reserve (Fed) and/or another central bank such as the ECB. Since the start of the current stock market correction, many have fretted that the Fed may need to raise interest rates rapidly this year in order to fight rising inflation and an overheating economy, snuffing the life out of the economic expansion. We believe they are mistaken, that the greed/fear pendulum has swung too far, and that the chances of the Fed or any central bank tightening too much in 2018 are overblown. For this reason, among others, we believe that stock prices will recover once investors regain their composure, probably within a few weeks.
If you think that higher interest rates alone can cause a bear market, history is not on your side. For example, during the 15-year period from 1947 to 1962, US interest rates were rising rather consistently, yet the S&P 500 managed to rise 936% during this period. Interestingly, that period bears more than a modest economic resemblance to the current one, as it also represented a time when the world was recovering from a major financial crisis. Thus, even if we do have a bear market (a drop-in stock prices of more than 20%) sometime in the next few years, it will not necessarily break the trend of the current secular bull market, which could well last 15 years or more.
#2. Interest rates will likely move significantly higher in 2018 & 2019.
We think that most investors don’t realize just how much further interest rates can rise from here, as markets have grown accustomed to the benefits of loose monetary policy. Globally, central banks continue to keep interest rates artificially low in relation to current levels of inflation and GDP growth. In a more typical economic environment, interest rates tend to closely track nominal GDP growth (real GDP growth + inflation). As you can see on the graph below, current US nominal GDP growth is 4.1%, which means that the “normal” US long-term rate should be over 4%. And if inflation or GDP growth pick up, the “normal” long-term interest rate would be even higher.
For years after the financial crisis, the Federal Reserve continued to keep interest rates below their “normal” rate in order to boost the economy, but this stimulus no longer appears to be necessary. In moving toward interest rate “normalization,” the Fed thinks it will raise interest rates three more times in 2018, followed by three additional rate hikes in 2019, according to their most recent statement. That would put the overnight borrowing rate at about 2.75% by the end of the next year (compared with 1.25% now).
In other words, the era of super-cheap borrowing may soon be coming to an end. Already, 10-year US Treasury yields have risen by 0.45% since the start of the year, to 2.85%. We think they will continue to move higher over the next several years but may continue to lag behind their “normal” rate for some time, continuing to provide a tailwind to the economy.
#3. We are mindful that the US economic expansion is getting long in the tooth.
Economic expansions rarely last a full decade; in fact, the lengthiest expansion since the Civil War lasted exactly 10 years, from April 1991 to March 2001.(6) The current expansion is already over 8 ½ years old, already making it the third longest in US history; if it lasts another 18 months, that would make it the longest one ever.
But length alone does not fully describe an economic up-cycle: total growth is also key, and by this measure, the current expansion is not particularly remarkable, with real GDP only increasing by +20.3% since the trough of the last recession. As comparisons, during the 10-year expansion cycle that ended in 2001, US GDP grew by a much more impressive 43.4%, and during the go-go 1960s, the economy grew by a whopping 53.7%. The gradual growth rate of the present expansion suggests that it could set a record for length while still being only modestly above average in total output growth.
In addition, while the US has been growing steadily since June 2009, several large foreign countries were in recession as recently as 2012, making their expansions less than 6 years old currently. If we pair this global perspective with the subdued US growth rate compared to prior expansions, the current recovery may still have several more years to go.
#4. Stock markets valuations are flashing some warning signs, especially here in the US.
You’ve probably heard that US stocks are relatively pricey (though obviously less so today than 2 weeks ago), and indeed they are based on one popular measure, known as the “cyclically adjusted price to earnings (P/E) ratio” (or “CAPE ratio,” a smoothed-out measure of current prices to the last ten years’ average corporate earnings). Two weeks ago, the CAPE on the S&P 500 stood at 32x,(7) a level that has been crossed only twice before in US history—1999 and 1929. As you may recall, the periods that followed were not particularly kind to equity investors.
Based on the above, you might conclude that US stock prices are at risk of a fall in the near future. We think you would be wrong. Why? There are a number of reasons, including issues with comparing CAPE today with history, such as changes in accounting standards over the years that make P/E ratios not always comparable from one period to the next. Perhaps more importantly, stocks almost never fall when earnings are rising. The two prior peaks in CAPE that preceded market declines coincided with rather sharp drops in corporate earnings, something we don’t see happening for at least a couple of years.
A more valid use of the CAPE may be in comparing stock prices among countries. On this basis (as well as other measures), many foreign stock markets are considerably cheaper than the US, including Europe and especially emerging markets. For this and other reasons, we continue to overweight non-US markets in our portfolios. Remember, the US is not the only investment game in town.
#5. Corporate profits are high—perhaps too high.
One other area of concern in the US is that corporate after-tax profits as a percentage of GDP are near all-time highs and are projected to enter uncharted territory if analyst estimates turn out to be correct. While no one knows the “right” ratio of corporate profits to GDP, they have historically been under 10% and yet may hit 12% within a year. We think it’s unlikely that they will stay at this high level permanently, but at the same time, their reversion to the mean should be gradual, dampening any impact on stock prices. In addition, they could remain at these high levels, along with the CAPE, for several years. All the same, we are reducing this risk by emphasizing foreign developed and emerging markets over the US.
#6. Equity volatility is (until 2 weeks ago) historically low.
You may have heard that equity volatility was at record low levels during 2017 and early 2018, both in relation to actual stock price movements and to the “implied volatility” embodied in the VIX index (which measures investor expectations of future volatility). The chart below shows the practical repercussions of this, with the calendar year returns for the MSCI World Index in blue, and the largest price decline for that year in green. We find it fascinating that the maximum drop in that index last year was a measly –2%. We can’t find another year in history when the maximum decline was that low; in a normal year, stock prices drop an average of –7% at least once.
The unusual calm of the recent past obviously came to an abrupt end in late January. The current stock price decline, as disconcerting as it may be, is actually a normal—and rather frequent—occurrence, and should not derail your investment plan. A far more ominous sign, in our opinion, and one that could be a harbinger of a new bear market, would be a significant increase in volatility while stock prices are still climbing. We saw this, for example, in 2007, several months before the market peak. We have not yet seen it during the current bull market.
Bottom line: while there are some clouds on the horizon, we see relatively clear sailing during the rest of 2018.
We will be watching for increased volatility accompanied by rising prices, along with several other indicators, for evidence that this bull market is near its end. These other measures include an inverted yield curve (short-term interest rates rising higher than long-term rates), an increasing spread between high-yield and investment-grade bonds, and rising unemployment. Fortunately, these other indicators continue to be in benign territory.
Given the above, how are we positioning our client portfolios?
Within equities, we continue to overweight foreign developed and emerging market equities and underweight US stocks, partly because of valuations (see above), partly because the expansion is generally at an earlier stage outside the US, and partly because we think the dollar will continue to weaken relative to many foreign currencies (which boosts foreign equity returns in US dollars).
As for bonds, we’ve mentioned in prior newsletters that we have been systematically reducing the duration (sensitivity to rising interest rates) in our fixed income portfolios, in anticipation of continued central bank tightening (increasing short-term interest rates). We do own some longer duration assets, but only when we think the interest rates they pay are adequate to compensate us for the impact of higher rates.
One area of the fixed income market that we have exited entirely is the foreign developed bond sector (mainly, European and Japanese debt). Interest rates remain very low or even negative in many of these countries, resulting in minuscule returns and substantial interest rate risk. For example, an investor would need to lend to the Japanese government for at least seven years to achieve a positive rate, and even then, a rate of 0.008% seems hardly attractive.
Finally, some KCS news:
Overall, 2017 was a very successful year for KCS as a firm. We’ve added some new employees and recently crossed the $200 million mark in assets under management. We’ve also moved to significantly larger offices a few blocks away: as of February 5, our new address is 11150 W. Olympic Blvd., Suite 790, Los Angeles, CA 90064. Phone numbers and emails remain the same.
We’re working hard to build on this momentum in 2018 and to help ensure that our portfolios perform well and meet the required rates of return for our clients’ financial plans. We continue to manage actively, aiming for superior performance while reducing risk. We take our investment mandate very seriously, and we thank you for entrusting us with managing your wealth.