Quarterly Commentary

4Q 2017

2017 was a year that started with high hopes, big concerns, and many questions. Might the incoming president’s agenda of lighter regulation, a push for infrastructure investment and tax reform boost the economy and markets? Could protectionist trade rhetoric escalate into measures that would depress business prospects at home and abroad? Consideration of an uncertain future starts with having a grasp on where things stand today. Here’s our list of questions from a year ago, with our updates:

How much of the Trump agenda will be enacted and will it be viewed as effective reform? Share prices have moved higher since passage of the Tax Cuts and Jobs Act in December. The administration’s crusade to undo regulation has likewise been viewed as business-friendly. Both provide short-term stimulus with unknown long-term consequences.

Will the Fed follow through with its telegraphed rate hikes? Yes, and more are promised.

Will we see a “hard” Brexit or one that supports continuing trade between Britain and the EU? Lots of posturing, but no answer yet.

 Will the populist agenda be supported by election outcomes in France, Germany and elsewhere? Not the case so far, and less of a concern for now.

 Can China finesse its way to sustained growth? This is a question every year – for 2017 the answer was yes.

Are other economies around the world finally ready to grow on their own, independent of global economic and political developments? 2017 provided a resounding YES – making it one of the year’s biggest surprises.

 Could the negative impact of an even stronger dollar (up almost 5% since the election) outweigh the pro-growth policy benefits for large US multinational businesses? The dollar reversed course, and its decline supported shares of the largest companies that dominate US stock indexes.

Positive developments related to the last two questions provided a “Goldilocks” backdrop for stocks in 2017. Bonds also performed beyond expectations. Most who thought that the Fed would tighten by raising short-term rates three times and by starting to unwind its $4.5 trillion bond portfolio, or foresaw that unemployment would fall to 4%, would probably also have predicted a yield for the US ten-year bond of 3% or higher. Yet that yield ended the year at 2.4%, a bit lower than where it started, and stayed within a range of 2.1% to 2.6% over the course of 2017.

US stocks returned 21%. While earnings for large multinationals benefited from the weaker dollar and restrained labor and energy costs, technology was the center of attention – social media, self-driving cars, identity theft, and Amazon’s increasing presence. Tech-related shares accounted for 40% of the year’s gains in the US, with the largest (Facebook, Alphabet/Google, Apple, Amazon, Netflix, Microsoft) doing most of the lifting.

After seriously lagging from 2013 through 2015, overseas markets continued their recovery versus US indexes. It had appeared that 2017 could bring escalating trade wars. Instead, increasing demand (much of it from China) for resources and capital equipment ignited an unexpected trade boom. Emerging market shares started the year at lower valuation levels – they raced ahead by 37% by year-end. Foreign debt also posted better returns than domestic, though most of the outperformance resulted from currency gains.

Gains for US indexes remained in single-digits through the summer amid a still-murky economic outlook and uncertainty regarding pro-business tax reform. The ensuing steady climb through the end of the year favored the momentum style of investing – holding on to “winners” rather than bargain hunting among the “losers.” “Growth” and “large” – tech in particular – were the year’s winners (by a margin of about 15% and 7% over “value” and “small” by year-end, respectively).

Above all, the stock market was notable for its apparent serenity. In 2017, stocks posted a positive return in all twelve months – the first time since 1970. It’s also unusual to see markets of all types rising in unison. Simply put, above-trend economic growth usually boosts stocks and puts pressure on interest rates, hurting bonds. Below-trend growth tends to work in reverse (part of the rationale for balanced portfolios).

Our questions entering 2018 are similar to those on last year’s list. We would add the inflation outlook as a concern, specifically because it seems to be less of a worry for others. Wage pressure has been modest – the source of inflationary pressure is not yet evident.

Our 2017 stock market call was comfortably consensus. We and many others were wrong about the muted volatility and we certainly didn’t expect such robust returns. We cannot assume a repeat performance, despite a somewhat similar backdrop. Hence, we reiterate last year’s forecast: by year end, neither the bulls nor the bears will have had their way – 2018 may be more volatile than 2017, yet will ultimately yield an acceptable result, characterized by modest returns. This puts us on the conservative side of today’s consensus.

It’s increasingly clear that the Financial Crisis is fading from memory. Forecasts from Wall Street are cheerier than usual – the future is bright, and markets will march upward. Both consumers and producers are exceptionally positive, and increased consumption and investment are expected to drive economic performance. We confess to be naturally suspicious of such widespread enthusiasm. But we agree that the new tax act seems to add support to an already healthy economy over the next year or two.

Our investing experience informs us that no one (and especially not us) can claim to know what the future has in store. We consider where we are today and position portfolios accordingly. Mood and momentum are subject to change and fundamental valuation (eventually) matters.

If the tide keeps rising, we will do our best to enjoy the ride. As we did in 2017, we will assume choppier waters lie ahead – and dedicate our efforts to buying securities where the price is attractive relative to intrinsic value. We believe that the gap between the current price and our perception of value provides a “cushion” in the form of a reduced risk of selling at a loss. Assembling an all-weather portfolio with many such securities is how we invest in an uncertain world.