Increasing economic growth, both domestically and internationally, buoyed financial markets in the fourth quarter. Importantly, global growth appears to be synchronizing across international economies for the first time since the financial crisis. Adding fuel to the market rally was the late-quarter passing of the Republican-led tax reform bill.
The U.S. economy experienced its best sustained growth in several years, with back-to-back quarters of real GDP growth exceeding 3.0%. A recent statement from Federal Reserve Chairwoman Janet Yellen supports the view that the economy will continue to expand at a moderate pace. Yellen stated in mid-December that “household spending has been expanding at a moderate rate, business investment has picked up, and favorable economic conditions abroad have supported exports.”
Consumers appear poised to continue to spend, supported by a strong labor market and confidence levels just off their 17-year highs. The number of Americans filing new applications for unemployment remained near historic lows per a late December reading of the Department of Labor’s initial jobless claims report. Weekly initial unemployment applications have now remained below 300,000 for 147 straight weeks, the longest streak since 1970, when the U.S. population and workforce were far smaller than they are today. Employers have added 174,000 jobs on average per month this year, bringing the unemployment rate to 4.1% through November, the lowest rate in 17 years.
The housing market remains firm with national home prices up 6.5% year-over-year through the third quarter. Strong housing-price trends appear to be extending into the fourth quarter, with data from the S&P CoreLogic Case-Shiller National Home Price Index indicating October home prices rose 6.2% from the previous year. This marks the 16th consecutive month of accelerating home values. Consensus economic forecasts call for a 4.4% increase in the fourth-quarter. New tax legislation, that caps at $10,000, the amount of state and local taxes that homeowners can deduct may pressure housing prices in higher-tax states as we move into 2018.
The manufacturing side of the economy continues to perform well. The Institute for Supply Management’s Purchasing Managers Index (PMI) registered at 58.2 for November, down slightly from October levels, but still solidly in expansionary territory. A reading above 50 indicates that the manufacturing economy is expanding; below 50 indicates contraction. The September reading of 60.8 marked the PMI’s highest level since 2004.
After a concerning decline during the second quarter, oil prices rebounded significantly in the last half of the year. WTI crude oil closed 2017 at slightly over $60 per barrel, its highest level since mid-2015.
In lockstep with the U.S., international economies are also experiencing heightened growth. Japan’s economy has expanded for seven straight quarters after decades of stagnation. Unemployment fell to 2.7% in November, the tightest labor conditions in 24 years for Japanese businesses. If fourth quarter estimates hold, Eurozone economic growth will come in at 2.2%, which will mark the fastest pace of growth in a decade. European businesses appear enthused, with confidence indexes reaching record or multi-year highs.
As we head into the first quarter of next year, markets will need to digest the impact of tax legislation on company earnings and growth prospects. Investors will also need to balance optimism surrounding increasing global growth against above average market valuations.
Longer-term rates have remained generally subdued despite the Federal Reserve increasing its Federal Funds Target Rate three times in 2017. The 10-year Treasury Bond finished the year yielding 2.41%, very close to where it started the year.
Although economic data suggests continued expansion, the yield curve (the yield gap between short- and long-term Treasury issues) is now at its narrowest since 2007. This “flattening” of the yield curve has more often than not preceded an economic slowdown. However, current readings of economic data suggest that the expansion will continue well into 2018 and potentially beyond.
Corporate bond spreads (the yield gap between corporate and government bonds of the same maturity) continued to narrow throughout the fourth quarter, resulting in higher corporate bond returns as compared to their like-maturity government counterparts. Credit spreads, from investment-grade to high-yield, are at the tightest of the expansion.
The Federal Reserve increased its Federal Funds Target Rate range to 1.25%-1.50% during December. This follows 25 basis point increases in March and June. The Federal Open Market Committee’s December statement indicated that they anticipate future Fed Funds rate increases in 2018 while the economy continues to expand at a moderate pace and labor market conditions remain strong. The Fed has started to shrink its $4.5 trillion portfolio of Treasury and mortgage-backed securities purchased during the three rounds of quantitative easing following the 2008-2009 financial crisis. Tentative plans call for a $450 billion reduction by the end of 2018.
Despite low unemployment and burgeoning economic activity, the Fed continues to contain inflation expectations, with 10-year inflation-linked Treasury bonds yielding a mere 0.50%. Most economists expect inflation to rise in 2018 as low unemployment and continued economic expansion put upward pressure on wages.
Treasury yields of selected maturities for recent time periods are displayed below.
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 12/29/17)|
|Barclays Capital US Aggregate||3.54%||Merrill Lunch US High-Yield||7.48%|
|Barclays Intermediate Government||1.14%||Merrill Lynch US Municipal Index||5.42%|
|Dow Jones Corporate||5.99%||JP Morgan EMBI Global||9.32%|
Riding a wave of global economic growth and accelerating earnings growth, stock markets both in the U.S. and around the globe marched higher during the fourth quarter, capping off a very strong 2017. The S&P 500 Index rose 6.6% for the quarter, pushing its calendar year increase to an impressive 21.8% gain, the best year for the S&P 500 since 2013. Also of note, the S&P 500 had a positive total return for each month of 2017, and has now risen for fourteen consecutive months, which is thought to be the longest monthly winning streak in over 50 years. The Dow Jones Industrial Average had over 70 new closing highs during the year, added just under 11% in the fourth quarter, and ended the year at 24,719 for a gain of 28.1% for the year. Strong gains for major market indices were accompanied by low volatility. The S&P 500 did not have a 1% or greater move in the fourth quarter, and experienced just eight trading sessions during the year with a 1% or greater move.
The technology-heavy NASDAQ Composite matched the S&P 500’s 6.6% return for the quarter and finished 2017 with a gain of 29.7%. Technology stocks were by far the biggest winners of 2017. In fact, technology shares now comprise 23.8% of the S&P 500, up from 20.8% at the start of the year. Over the past decade, the technology sector has had an average weighting of 19.6%.
Smaller capitalization stocks also participated in the rally but lagged their larger counterparts, with the Russell 2000 (small cap) Index and the S&P 400 (mid cap) Index gaining 3.3% and 6.2%, respectively, in the quarter. For the year, the Russell 2000 and S&P 400 were up 14.6% and 16.2%, respectively. Going forward, some analysts believe that these domestically focused companies may prove to be relative beneficiaries of the recently lowered corporate tax rate.
Global equity markets experienced a strong year with a backdrop of improving economic growth among nearly all international economies. Emerging market stocks tacked on another 7.3% for the quarter and ended the year with an impressive 37.5% gain, which was the MSCI/EM Index’s strongest return in eight years. Developed international markets gained 4.3% for the quarter and were up over 25% for 2017, outpacing the S&P 500 over the past twelve months. In addition to improving company earnings, international stocks were also boosted by a weakening dollar during much of 2017. The dollar fell to its lowest level in three months on the penultimate trading day of December as investors appeared to be anticipating monetary policy tightening in the Eurozone next year. As per the WSJ Dollar Index, the dollar has depreciated 7.2% against a 16-country basket of currencies this year, its biggest drop since 2007.
The gains seen in major stock market indices have largely been supported by stronger fundamentals. Companies within the S&P 500 posted strong earnings growth in 2017, and analysts expect this trend to continue into 2018, with an extra boost from lower corporate tax rates. While the S&P 500 is trading at above-average price-to-earnings (P/E) multiples, its valuation levels are still well below those seen at the March 2000 market top. Further, given the current benign inflation and interest rate environment coupled with renewed economic growth, above-average multiples may persist until those conditions change. In short, the earnings and economic backdrops remain favorable for stocks heading into 2018.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||4th Quarter 2017|
|Dow Jones Industrial||10.96%|
|S&P 500 Growth||6.79%|
|S&P 500 Value||6.32%|
|Russell 2000 (small-cap)||3.33%|
|MSCI/EAFE (developed international)||4.29%|
|MSCI/EM (emerging markets)||7.34%|
At the sector level within the S&P 500, returns were positive apart from the interest-rate-sensitive Utilities sector, which posted modestly negative returns during an otherwise strong fourth quarter. While a headwind for most higher-yielding sectors of the market, rising interest rates were generally positive for the Financials sector, which finished with above market returns for the quarter. Technology stocks continued their strong run during the quarter, and the sector was easily the best performing for 2017, rising nearly 37%. Along with Technology, Consumer Discretionary stocks were ahead of the market for the quarter and year. Energy and Telecommunications stocks posted positive performance for the fourth quarter, but both of those sectors finished in negative territory for the full year.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||4th Quarter 2017|
|1. Consumer Discretionary||9.46%|
|2. Information Technology||8.65%|
|5. Consumer Staples||5.76%|
|8. Real Estate||2.33%|
|10. Health Care||1.06%|