Q4 2017 Economic and Market Perspective

Threats of a nuclear conflict between the U.S. and North Korea, increased tensions between right and left here at home and the aftermath of the spate of major hurricanes would in a typical environment likely lend to a pullback in risk assets and a flight to quality. However, the rally in U.S. equity markets continued in the fourth quarter at a pace consistent with what investors experienced in the first three quarters of the year. A strong earnings season, continued healthy economic growth and U.S. tax cuts have helped equity markets. Over the year, we saw a synchronized global growth acceleration, unemployment rates continued to decline and stabilization in emerging market currencies. As economic slack continued to diminish, several central banks modestly tightened monetary policy, although some emerging markets (EM) central banks were able to cut interest rates in response to lower inflation. It was also a quarter when downside political risks failed to materialize and the major upside political risk, in the form of U.S. tax cuts was delivered, as a result risk assets remain in demand.

U.S. equities had a good quarter and an above average year, remarkable not only for their strong returns, but also for their consistency and lack of volatility. U.S. equities delivered positive returns in every single month of 2017, the first time this has happened since 1958. It’s interesting to note in 2017 the maximum drawdown was less than 3% while the average intra-year drawdown hovers right around 14%. While the rally was relatively broad based, bond proxy sectors such as utilities, telecommunications and real estate investment trusts lagged massively for the year and the quarter with a few of those sectors producing negative real rates of returns.

Despite a good year for the European economy, corporate earnings (up 10% year over year) and equity returns, European equities have underperformed several other markets in local currency terms. UK equities have had to contend with the strength in Sterling over 2017 with performance relative to the FTSE 100 has been broadly flat for the quarter and underperformed most other regions this year. Part of the reason for the rally in the pound this year has been an increase in the market’s perception of the probability of a transitional deal on Brexit. The completion of phase one of the Brexit negotiations in December supports the market’s assumption that a transitional deal now looks more likely than it did at the start of the year. The best performing equity markets this year have been in Asia and the emerging markets (EM). The weak dollar, the rally in tech stocks (which makes up almost 25% of the EM index) and the recovery in some industrial commodity prices, such as copper has helped buoy EM equities across the board.

Turning to look at central bank action and fixed income markets. The ECB (European Central Bank), encouraged by the health of the European economy, coupled perhaps with legal constraints on the amount of German bunds it can buy, announced in October that it will reduce its monthly quantitative easing purchases down to 30 billion EUR. The Bank of England increased interest rates in November for the first time since 2007, but denoted that any further rate rises are likely to be gradual and highly dependent on the outcome of Brexit negotiations. In the U.S., the Fed raised rates again in December for the third time in 2017. President Trump announced that Jerome Powell will lead the Fed when Janet Yellen steps down in February. Powell is unlikely to materially alter the path of Fed rate rises, but the new Fed members appointed in 2018 could potentially shift the path and will warrant close attention.

I would like to remind our valued clients not to be coerced into action by headlines in 2018. Volatility was historically low in 2017; that may not continue in 2018. With a Dow Jones Industrial Average of 25,000, a 1% decrease is equal to a 250 point decline. In 1987 a 250 point loss in the same index was a 10% decrease, as markets go higher volatility will create the appearance of greater gains and losses. We simply ask that you be prepared, not afraid of the headline risk I’m sure we will experience if volatility reverts back to the mean.

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