A Glass Half Full – A Commentary on the Fourth Quarter and Year 2017

To borrow a phrase from former Yankee catcher Yogi Berra, “It’s tough making predictions, especially about the future.” With 2017 officially in the rear-view mirror, one obvious takeaway is the stark contrast between the expectations last January versus the actual results of the year.

Many pundits predicted turbulence in equity markets in the follow up to Donald Trump’s unexpected presidential nomination and eventual appointment. Instead, while political volatility was on the rise in 2017, equity markets experienced one of the calmest years in history with nine of the 10 lowest readings ever posted by the Volatility Index (VIX).

In addition, many people thought North Korea’s experimentation with nuclear weapons or other forms of geopolitical risk would lead to the first market correction since February 2016. Instead, the S&P 500 set ­­­­­­­62 record highs in 2017 and never drew down more than 3% from any high.

Countless others said that equity valuations had gotten ahead of their proverbial skis and the Federal Reserve’s talk about raising interest rates would bring a dose of reality. Instead, valuations remained undeterred as corporate earnings grew at their fastest clip since 2011 and the 10-year interest rate finished the year lower than where it started, despite three rate hikes from the Fed.

The purpose of listing these declarations is not to dispute the logic of those who made them, but rather to make a point that the predictions business is fickle. Markets can go into a random tailspin for a variety of reasons, but trying to make near-term predictions tends to be a foolish endeavor more times than not. Using history as a guide, we know that markets tend to go up more often than they go down, rendering the “glass half full” a more appropriate posture. And while 2017, like most years, was difficult to forecast, it was another year where more things went right than wrong.

Asset Class Total Returns

Source:  Morningstar Direct, 2017. All data includes reinvested dividends and is the gross return of the specific index. You cannot invest directly in an index. Past performance is not a guarantee of future results. Data are through 12-31-2017.

The fourth quarter continued the trend of the first three of 2017 as virtually all asset classes posted positive returns. Market leaders continued their route as emerging market stocks led the way for equities, and global bonds led fixed income in the quarter. In a year where the 10-year Treasury rate barely nudged from 2.45% to 2.40%, taxable and municipal bonds posted positive returns of 3.5% and 5.5%, respectively.  In equities, while the S&P 500 dominated the headlines finishing up an impressive 21.8%, its best year since 2013, the reality is that foreign markets deserve much of the credit for putting winds in the sails of global equities. For the first time since 2012, both international markets (MSCI EAFE) and emerging markets (MSCI EM) outpaced the S&P 500 in a calendar year.

Foreign markets, which outperformed their domestic counterpart, are a testament to the synchronized global expansion that began in 2016 and has been gaining steam ever since. In the earlier years of this bull market, the burden to propel this growth fell squarely on the shoulders of a few select countries, but that narrative has reversed recently as many more countries have added their own contributions to the mix. For example, the economies of all 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) are on pace for GDP expansion in 2017, something that has only happened three other times in the past 50 years.

While the U.S. has shown consistent, albeit modest, growth since 2009, a global economic recovery had always been missing from the equation and returns in foreign equity markets reflected that. Since October 2007, when equity indexes hit their pre-crisis peaks, only the S&P 500 has broken out meaningfully, while the MSCI EAFE and MSCI EM have both risen less than 13% from those highs. The resurgence last year in foreign markets appears to be closer to its infancy than its retirement.

By all accounts, many commentators who held a cynical view throughout this past year had plenty of reasons to be pessimistic. To their credit, many of the normal ingredients for an unfriendly equity market were present, appearing in the form of contentious political rhetoric, natural disasters and stretched equity valuations in the United States. In other years, these issues could have compounded on one another to create angst among investors. But a strong global economic recovery combined with record corporate profits ultimately outweighed any offenses.

As 2017 closed on the back of a bountiful year for investors, there is much debate about where markets are headed next. It’s logical to assume that some people stand to be let down if 2018 fails to bear similar fruits. While following perfection is never easy, the market has been good at responding to big returns throughout history. Since 1943, the S&P 500 has returned 20% or more in a single year 26 times and has proceeded to follow it up with another positive year 20 times with an average return of 12%, per Gluskin Sheff Research*.  Stated simply, positive returns tend to beget more positive returns.  To borrow another one from Yogi Berra, “It ain’t over till it’s over.”

*Rosenberg, David, Breakfast with Dave, Gluskin Sheff, December 2017