During the quarter U.S. large cap growth and emerging markets continued to lead markets while securities sensitive to interest rates, such as U.S. REITs and utilities, continued to lag.
The year will be remembered for broad-based global growth and gains across asset classes.
While the ultimate impact of the Tax Act will need to be judged over the long term, it has already begun to influence the behavior of corporations, municipalities and investors.
Significant U.S. Treasury issuance in February and March has the potential to create a step-up in capital market volatility.
The same trends the market experienced throughout 2017 continued this quarter, and most asset classes enjoyed broad-based gains. Growth outperformed value, U.S. large capitalization stocks outperformed smaller companies, and emerging market stocks were the top performer. Equities that are sensitive to interest rates, such as U.S. real estate investment trusts (REITs) and utilities, stalled as the ten-year Treasury yield rose slightly to 2.40%.
As expected, the Federal Open Market Committee (FOMC) raised interest rates by 25 basis points in December from 1.25% to 1.50%, its fifth raise of this hiking cycle. The press conference that followed was Janet Yellen’s last, on the heels of her resignation announcement earlier in the quarter. Current Fed Governor Jerome (“Jay”) Powell has been nominated as her successor when her term ends in early February.
Congress was busy during the quarter, passing not only the Tax Cut and Jobs Act of 2017, but also a bill necessary to fund the federal government through January 19. The scope of the tax bill was wide-ranging, but most notably it lowered the corporate tax rate from 35% to 21%. The final impact will be company specific, however.
Q4, 2017: Key Market Total Returns
Citigroup’s Chief Financial Officer indicated that the company could take a $20 billion charge in order to write-down deferred tax assets. Several other major companies, such as Boeing, Wells Fargo, AT&T, Comcast, and U.S. Bancorp, announced new spending measures, including special bonuses, raising of the minimum wage, and capital expenditure programs. On balance, telecom, financial, and consumer-related sectors are expected to receive the biggest boost to earnings while technology, utilities, and real estate companies will likely enjoy the least.
Aside from the lowered corporate tax rate, the bill provides a tax repatriation holiday on overseas cash. When a similar plan was enacted in 2004, roughly one-third of cash held offshore, or just over $300 billion, was repatriated. Currently, an estimated $2 trillion in overseas cash could potentially be used for stock buybacks, dividend raises, or capital expenditures. For context, over the past three years, S&P 500 companies have distributed, through buybacks and dividends, roughly $900 billion per year.
Municipal bond issuance exploded in December to over three times the normal amount as issuers rushed to beat certain tax law changes that would go into effect in the new year. Municipal bond issuance for 2018 is expected to be meaningfully lower because advanced refunding bonds, which generally represent 15% of annual supply, will no longer be considered tax exempt.
Also due to the tax bill, some highly indebted companies will have to deal with new provisions that limit the deductibility of interest expense, should it exceed 30% of earnings. A Moody’s study showed that seven of eighteen high-yield sectors averaged levels higher than 30%.
Earnings remained solid, although they fell from the high-teens growth recorded earlier in the year. Third-quarter operating earnings for the S&P 500 were up 9.2% when compared to a year earlier. Operating margins eked out another record high at 10.16%. According to Standard and Poor’s, fourth-quarter operating earnings are expected to be 23% higher than the same time last year, which would push full-year earnings 18% higher than in 2016. Standard and Poor’s analysts are similarly estimating 2018 earnings to grow by 16% (from $125 to $145 per share). The S&P 500 currently trades at a relatively high price/earnings ratio of 21.4 times, making earnings growth a critical factor for investors to watch.
The Fed’s preferred inflation measure, the Core Personal Consumption Expenditures (PCE) inflation index, rose closer to the Fed’s 2% mandate (from 1.3% to 1.5%) in its most recent November reading. Although non-farm payrolls increased by just 38,000 in September (possibly due to hurricanes), the three-month average ending in November was a solid 170,000.
Third-quarter real GDP growth was finalized at 3.2%, the highest point since the first quarter of 2015. The Atlanta Fed’s GDPNow measure, which attempts to estimate current-quarter growth using real-time economic data, has fourth-quarter GDP penciled at 2.8%, while a similar measure that is tilted more to “soft” (survey-based) data calculated by the New York Fed puts fourth-quarter growth a full percentage point higher. The International Monetary Fund (IMF) estimates U.S. growth will be 2.3% in 2018, but has yet to update those forecasts to include the impact of the tax bill.
As part of a trend that spanned the entire year, growth stocks once again outperformed value. The Russell 1000 Growth Index increased 7.9% for the quarter and 30.2% for the year while the Russell 1000 Value Index gained 5.3% in the quarter and 13.7% for the year. Smaller companies, as measured by the Russell 2000 Index, gained 3.3% in the quarter, leaving them up 14.6% for the year.
Consumer discretionary, financials and technology led the way, producing quarterly returns that ranged from 8.5% to 9.8%. Real estate and utilities lagged behind the market, returning 1.4% and 0.2%. For the year, technology stocks led the pack, generating a spectacular 34% return. Materials, industrials, health care, financials, and consumer discretionary all increased by at least 20% for the year. Energy was the only sector that generated negative returns in 2017.
Fixed income securities were generally higher, although returns were fairly muted relative to previous quarters. The Bloomberg BarCap U.S. Aggregate Bond Index was higher by 0.4%. Tax-exempt fixed income securities fared slightly better, up 0.6%, as measured by the S&P National Municipal Bond Index. High-yield bonds rose 0.5%, as measured by the Bloomberg BarCap High Yield Corporate Index.
The 10-year U.S. Treasury note yield rose seven basis points to 2.40%. Since September, when the plan to reduce reinvestment of maturing bonds (“quantitative tightening”) was made formal and details of the Republican tax plan announced, the yield curve began to flatten materially. Over the course of the quarter, the spread between the 10-year and 2-year yield dropped from 86 to 51 basis points, a move not seen since the second quarter of 2005.
Although the U.S. Treasury did not issue the estimated $500 billion in new debt signaled by the Treasury Borrowing Advisory Committee (TBAC) months earlier, it did issue a full $275 billion. TBAC now estimates it will need to issue $512 billion in the first quarter, with most of the issuance concentrated in February and March.
The MSCI EAFE Index increased 4.2% in U.S. dollar terms. In local currency, the index gained 3.7%, reflecting slight U.S. dollar weakness against the basket of currencies. For the year, however, the weaker dollar proved a meaningful tailwind for U.S. investors in international stocks. The MSCI EAFE Index was higher by 25.0% in U.S. dollar terms, but up only 15.2% in local currency terms. Forget negative returns—only one country, Israel, posted less than a 16% gain for 2017.
The European Central Bank announced it would trim the quantitative easing program from €65 billion to €30 billion per month. The United Kingdom is still trying to find an exact solution to the “Brexit” referendum whereby this past year voters decided to leave the European Union. The UK is now expected to officially depart on March 29.
The MSCI Emerging Markets Index increased 7.4% for the quarter and 37% for the year in U.S. dollar terms. In local terms, the index was up 5.7%, leaving it up 31% for the year. Mexico was one of the few countries to struggle in the fourth quarter, dropping 8.1%. This was the main reason Latin America returned -2.3%. China ended the year higher by 54%. This was in line with the Far East region, which gained 44% for the year. Russia gained 4.3% in the quarter, leaving it up a relatively modest 5.2% for the year.
Investors will be watching how corporations respond to lower tax rates in the coming year and how repatriated cash is deployed. The Trump administration has also set expectations it will announce some details on infrastructure spending in late January. Investors will also be acutely tuned in to any details around the magnitude and timing of an infrastructure spending bill. Although the significant Treasury bond issuance set for February and March may not make as many headlines, we believe it also has the potential to similarly move markets.
The SpringTide Investment Team
Disclosures & Footnotes
The indexes referred in the performance table are as follows: U.S. large cap stocks: S&P 500 Index; U.S. small cap stocks: Russell 2000 Index; International developed stocks: MSCI EAFE; emerging market stocks: MSCI Emerging Markets Index; U.S. taxable bonds: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. municipal bonds: S&P National Muni Bond Index; U.S. high yield bonds: Bloomberg Barclays High Yield Corporate Bond Index; international developed bonds: S&P/Citi International Bond Ex-U.S. Index; emerging market bonds: JP Morgan Emerging Market Bond Index Global; U.S. REITs: MSCI U.S. REIT Index; international real estate securities: S&P Global Ex-U.S. Property Index; commodities: Bloomberg Commodity Index; master limited partnerships: Alerian MLP Index.
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