With the first year of the Trump Administration now history, we take a step back to assess the state of the markets and discuss the outlook for 2018. Markets roared ahead for the year ending December 31st, 2017: the S&P 500 delivered a total return of 21.83%; the Dow Jones was up 28.11%; the NASDAQ returned 29.73%; the iShares iBoxx High Grade Corporate Bond Exchange Traded Fund (ETF ticker: LQD) was up 7.06%, while its high yield version, the largest “junk-bond” ETF by assets (ticker: HYG), returned 6.07%.
Many investment managers found it hard to explain such monumental returns in the eight year of a recovery specifically in light of the 10 year Treasury note essentially remaining flat year-over-year. The yield on the U.S. Treasury declined very modestly from 2.44% at year-end 2016 to 2.40% at the end of 2017. We do acknowledge that both the global and the local macro-economic environments were favorable for rising asset prices as a continuing result of a never before seen experiment of global easy monetary policies by the world’s major players. There was no doubt that printing money and piling up of debt on balance sheets was the “in” thing to do by the developed country central banks across the globe.
Having noted that, the U.S. Federal Reserve Bank, in particular, is now in a tightening mode to address concerns about an overheating economy. The unemployment rate continues to be at or near “full employment” levels finally resulting in rising wages. Eight years of rising stock prices have put a solid footing under stock markets, not to mention improving 401(K) values and improved pension fund valuations. In addition, the tax overhaul implemented at the end of 2017 has considerably reduced corporate tax rates and increased company valuations, making the U.S. very competitive in the global race once again. For example, one beneficiary of the tax bill could be Berkshire Hathaway, given the new rules related to the insurance sector. According to a sell side analyst, the company’s book value could increase by about $37 billion just due to a lower deferred tax liability. In addition, a majority of people should see increased earnings beginning in February as a result of lower tax rates, one time bonuses, increased matching contributions to 401(K) plans and an increase in minimum wages.
As we begin 2018, the euphoric markets seem to be expecting more of the same with new records being achieved daily!! However, we believe caution is warranted since the markets do not move singularly in one direction forever. Although a decline may not be imminent, it is likely in the weeks ahead – after all, a good hangover is almost always the result of a great party! A “good” correction will provide an opportunity for long-term investors to add to their investment portfolios, something they have been reluctant to do due to stretched valuations. Although corporate America is still in the process of exploring all of the benefits of the historical tax overhaul passed by Congress and signed into law by the President, undoubtedly the news is positive.
Finally, we cannot conclude without a mention of the potential risks on the horizon. The balance sheets of many central banks, especially in the US, Europe and Japan, remain inflated. We believe that as these banks look to reverse their easy monetary policies, particularly across the developed world, markets will pay a price. The unclear state of the Chinese economy and its respective shadow banking activities, also poses significant risk. Geopolitically, Korean Peninsula tensions and the unrest in the Middle East should not be dismissed. Lastly on the home front, we will avoid speculation on the outcome of Special Counsel Robert Mueller’s investigation.