Plum Street Advisors
Q4 2017 Market Commentary – January 3, 2018
The markets anticipated and then celebrated the passage of a business-friendly US tax cut during the fourth quarter. On December 20th, Congress passed a bill that dramatically cut corporate tax rates and taxes for pass-through entities.
For personal income taxes, most people will see a tax cut, but the size of the cut – and the duration – will depend on individual circumstances as well as future legislation. Personal tax rates were reduced and the standard deduction was increased, but itemized deductions were curtailed. Estate taxes were also cut, as the individual exemption rose to $11 million (indexed for inflation). Most of the personal tax changes will be eliminated after 2025, unless they are renewed by a future Congress.
Markets responded positively to the tax changes, as well as continued strong economic news. The Russell 1000 index total return for Q4 was 6.59%. Small Caps trailed large caps, as the Russell 2000 index total return was 3.34% for the quarter. For the year, the Russell 1000 was up 21.69%, with growth stocks leading the way for the index.
US real GDP growth continued at a strong pace. After posting a 3.1% annualized growth rate in the second quarter, third quarter GDP growth came in at 3.2%. According to Moody’s Analytics, fourth quarter growth is forecast to be a slightly lower 2.6%. Housing ended the year strongly, and consumer spending looked to close out the year on an up note as well, although auto sales were down for the first year since the financial crisis.
Corporate earnings are expected to have increased by almost 10% in 2017, according to Factset. The energy sector saw the greatest increase, driven by the continued recovery in energy prices from a low base in early 2016. The materials and IT sectors also saw double-digit earnings growth, and all 11 economic sectors were up year-over-year. For 2018, Factset is anticipating even stronger earnings growth.
Stocks rose in the fourth quarter across the board, making 2017 the best year for stock returns since 2013. US stocks led non-US stocks in the fourth quarter, with the Russell 1000’s total return of 6.59% edging out the MSCI ACWI ex-US 5.00% net USD return. For the year, however, international stocks returned 27.19% (net, USD), led by emerging market stocks’ return of 37.28% net USD for the year, which handily beat the US market’s total return of 21.69% as measured by the Russell 1000.
In the US, growth stocks continued to lead this quarter as they have all year, with the Russell 1000 Growth returning a total of 7.86% in the fourth quarter compared to the Russell 1000 Value index total return of 5.33%. Large cap outperformed small cap, as the Russell 2000’s 3.34% total Q4 return trailed the Russell 1000’s 6.59% total return.
As Jerome Powell prepares to take over from Janet Yellen as Chair of the Federal Reserve, he is not signaling any deviation from the path that has been laid out to date. In December, the Federal Reserve continued its policy of rate hikes with a third increase in the Fed Funds rate in 2017 (to a range of 1.25% – 1.50%). The Federal Reserve is also still signaling three more hikes in 2018. The only significant change in recent forecasts came in the Fed’s projection for US GDP in 2018 (from a 2.1% forecast in September to a 2.5% now). The higher expected growth rate was mainly the result of the expected impact of December’s tax reforms, but it doesn’t seem to have impacted plans for rate hikes.
Inflation has remained subdued to date but a weaker dollar, more fiscal stimulus, and low unemployment could all contribute to rising inflation in 2018 – a risk that bears watching.
Long term bonds have held steady this year, trading in a range of 2.0 to 2.5% yield for the 10-year US Treasury bond for most of 2017. Overall, bonds as measured by the Barclays’ Aggregate Index added 0.39% in the fourth quarter to reach a 3.54% return for the year.
The Bloomberg commodity index gained 4.4% for the quarter, but remains mostly flat for the year. Gold was up only slightly in the quarter, but has risen 13.6% for the year. Crude oil rose 12.5% for the year. Decliners for the year included mostly agricultural commodities such as soybeans, coffee, cocoa, sugar, and orange juice.
Summary – Why are International Stocks Outperforming?
With the US economy doing quite well, why did stocks in the rest of the world outperform?
First, the effect of a weakening US Dollar was significant. When a US investor owns non-US stocks, they have to translate the returns back into US dollar terms. When the US dollar is weakening, it boosts US investor returns of stocks held in a stronger foreign currency. For example, at the start of the year, one Euro was worth $1.05, while at the end of the year a Euro was worth $1.20 – a 14% increase. In net “local” currency terms, the MSCI ACWI ex-US index returned 18.23%, rather than the 27.19% net dollar return that we reported above.
Second, emerging markets helped international stocks to outperform. Even in local currency terms, emerging markets strongly outperformed the US Russell 1000. Emerging economies showed strong growth, and the MSCI EM index was driven in particular by Asian companies. Emerging markets are often seen as heavy on cyclical stocks. Ten years ago, that was true – energy and materials made up 31% of the index. Today, energy and materials are only 14% of the index, while technology stocks represent the largest sector at 28% of the index. The index’s largest holding, Chinese internet giant Tencent, was up over 100% in 2017, and the index’s IT sector was up approximately 60% overall, helping to propel the index to its largest gain since 2009.
At Plum Street Advisors, we won’t make predictions about which markets will outperform in 2018 (we don’t think anyone can), but we will hold substantial weights in all the major markets, taking their volatility into account, because we believe that such a portfolio offers the best chance of optimizing the return for the risk you take on.