David T. DeBellis, CFA
David is the chair of our Trust Investment Committee
2017 was a fantastic year for stocks as the market (as measured by the S&P 500) increased 21.8%, including dividends. Even more impressive than the return, was how the market achieved it. It was the first time ever that stock market volatility subsided to a level below that of bonds. Equities only suffered two days of greater than 1% losses and one day of a greater than 1% gain. In most years this figure is well into the double-digits. It was also the first year ever in which the market had positive returns in every single month.
Financial markets are not easy to interpret and often defy logic. It goes without saying that there are a lot of diverse news events that can have an impact on stock values. Such news and its timing are hard to predict, and generally the impact is more short-term. We find that focusing on earnings, the economy and the Fed provide a longer-term viewpoint from which to judge how the markets might perform.
As 2017 proved out, the market was as much earnings-driven as it was interest-rate driven. Evidence suggests that the strong earnings trend will persist. Based on Wall Street estimates, the S&P 500 is expected to increase earnings by 10.5%. And if history repeats, this may come in higher than expected.
Earnings growth is expected to continue into 2018 for two reasons; the strength of the economy and the lower corporate tax rate. However, there could be a few bumps for earnings, in terms of write-offs, as fourth-quarter earnings are reported. To be compliant with the new tax code, companies will have to write-off the accumulated losses of prior years on the balance sheet. We have already seen this with recent reports from Citigroup, Goldman Sachs and Bank of America, among others. It is important to remember, however, that these are non-cash charges and are not reflected in the adjusted earnings.
Economic growth picked up the pace in 2017, with third quarter GDP expanding by 3.2%. This was the highest rate of growth since the second quarter of 2015. Business spending has begun to rebound over the past two quarters. This is an important consideration since business spending has had a diminishing contribution since 2015. US manufacturing is also reflecting the business optimism as factories are humming.
Much of the economic growth over the past two years has been coming through strong and resilient consumer spending. Consumer confidence in the economy has consistently recorded new highs and has persisted at that elevated level. If business spending is now gearing up as well, then the economy finally has the advantage of the twin engines of growth working in unison to push up economic growth to an annual rate of 3% or higher.
Business optimism is not limited to the United States but is reflected worldwide in key economic blocs. Business sentiment readings suggest a continuation of synchronized world economic growth and provide a helpful tailwind to exports by large-cap US companies.
Corporate tax reform is largely predicated on the argument that a large tax break would spur business spending and elevate economic growth consistently for the long-term. With the passage of the tax cuts, the spotlight is now on the corporate sector to deliver business spending to improve wage and economic growth. Apple’s recent announcement to inject $350 billion into the US economy is a great example of this. Much remains to be seen, but at least the corporate sector already has a running start as business spending momentum has been building.
Monetary Policy is an area that is becoming murkier and can have significant implications later in 2018. The Fed has been steering the economy with a gentle hand, as it tries to find the balance between its twin goals of encouraging full employment and price stability. It is expected that the Fed will make three 25-basis point rate increases in 2018 to a range of 2 to 2 1/4% Fed Funds Rate.
If the economy has entered a true business cycle expansion phase, then besides experiencing higher stock prices, we most likely will also experience higher inflation. This can provoke a faster pace of interest rate increases than what is currently expected.
While markets can rise in a higher interest rate environment, the expectation of an economic slowdown and recession caused by an overly-tight Fed can derail the bull market. If inflation begins to revive measurably as a result of demand expansion, the Fed’s balancing act acquires even greater importance in the second-half of the year and beyond.
Some investors are concerned about stock valuations. The S&P 500 trades at over 18 times forward 12-month earnings, above the 5-year average of 16 times. The higher multiple suggests that higher stock values going forward will need to come from earnings growth instead of multiple expansion. Keeping the above in mind, we are optimistic that this can happen and see no reason why stocks can’t continue their advance well into 2018.
The market is already off to a great start in 2018, with the S&P 500 up nearly 5% in just two-and-a-half weeks (an obviously unsustainable pace). The law of averages says that we will eventually need to suffer through a correction of some kind, but when or how deep is unpredictable at this point in time.
As far as anticipated portfolio changes are concerned, we believe that overseas stock market valuations appear more attractive than those of domestic markets and are increasing our allocation to them. We are also reserving cash for any distributions planned for the next 12 to 18 months. Other than that, we plan on staying fully invested in order to take advantage of the positive economic environment. However, we will be keeping a close eye on factors that might change our opinion of the markets, such as how companies decide to use their cost savings and most importantly on the Fed.