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Fourth Quarter 2017 - Market Newsletter

What a year!  A prosperous, boring year.  There was plenty of domestic and international news and political uncertainty in 2017, but with the economy on sure footing, global markets held their noses and continued to march higher.  In the US, the S&P500 returned 21.8%, with the strongest performance coming in the fourth quarter.  Volatility has also remained muted as the VIX was range-bound between 10-12% for most of the year.  In fixed income, despite three rate hikes, the 30-year Treasury ended the year lower, and the 10-year bond essentially flat.  Credit spreads further tightened despite increasing balance sheet leverage.  To top it off, the jolt of adrenaline coming from tax reform in December has set up the economy nicely to start strongly in 2018.

Source: Sterling Capital, Wolfe Securities

Everyone talks about how this is a Goldilocks economy.  Well, it looks like Goldilocks has developed a Red Bull® habit.  We think the business cycle still has momentum, and fiscal and monetary support will further strengthen and sustain economic growth at least through this coming year.  Thus, we remain bullish on equities generally.  However, we remain ever-vigilant and plan for the unexpected.  We remain underweight interest-rate sensitive assets and instead are balancing exposures with lower-beta alternatives and private equity strategies.  We expect our client portfolios to participate in current market strength, but still remain resilient and adaptable to its inevitable change.

Economy

We are eight years into a bull market with likely more room to run.  GDP growth is healthy at 2.5% and unemployment is hovering at a low 4% level.  Despite this economic strength, inflation expectations are still controlled and below the FOMC’s 2% target.  We do expect inflation to pick up modestly, especially as the tax stimulus makes its way through company earnings and employee paychecks. This should allow the Fed to continue on its hiking path, targeting three quarter-point moves this year under the new Fed Chair Jerome Powell.

Sources: WSJ: The Daily Shot Brief, Scotiabank Economics, OECD

Digging a little further into the new tax plan, the Federal tax rate coming down to 21% is a meaningful move, which can drive an immediate 10% increase in corporate bottom-lines.  This has caused Street analysts to have to revise earnings estimates higher and thus re-rate stocks upwards as well.

Sources: Sterling Capital, Bloomberg

We think the immediate capital expenditure depreciation recognition, paired with the limitation on interest deductibility, and cash repatriation elements are additional factors that should support longer-term growth and re-investment for domestic entities.

Equity Markets

US

The Technology sector returns was the headline of the year, closing in on 40%, but Consumer, Financials, Healthcare, and Industrials were also strong contributors, returning around 20%.  Telecom, Energy, and Utilities were meaningful drags.  Despite the negative performance in Energy, we think fundamentals around oil have stabilized and now show opportunity for a strong recovery.  We have seen oil prices rebound as the Middle East has been more balanced in pumping and new oil rigs in the US have been controlled.  The surviving E&P companies are in a better balance sheet and operating position and should be levered to an oil recovery.  We are constructive on the Energy and MLP opportunity and happy to discuss further.

Value lagged Growth in the quarter and the year.  We think Value will come back, supported by tax reform effects, but we are essentially balanced between the two styles.  More interestingly, large-cap continues to outperform small-cap.  Domestically, we are tilted towards small- and mid-cap equities as we think tax reform and strong economic growth will have a more meaningful hand in outperformance versus large-caps.

Deal activity remains strong, given ebullient markets and cheap financing.  2017 was a huge year for IPOs with $49 billion being raised, nearly doubling the value of the year prior. Global M&A activity exceeded $3 trillion for the fourth consecutive year, supported by large deals like CVS acquiring Aetna, and Disney buying a big piece of 21st Century Fox in the fourth quarter.  

International Markets

2017 was a strong year for the global economy as growth accelerated across the world as trade improved and commodities recovered.  MSCI World lagged the S&P500 in the quarter, returning 5.6%, however slightly outperformed on the year, gaining 23%.

The Eurozone is growing, with the economy on the continent expanding for 17 consecutive quarters.  The ECB continues to reduce bond purchases but is still maintains an accommodative posture. Brexit will be disruptive, but largely limited to the UK.

Emerging markets performed well, up over 7.3% in the quarter and over 37% on the year.  This was supported by fundamental growth, a catch-up to the rest of the world’s recovery, but also notably the weak dollar propping up other currencies.

Treasury Secretary Mnuchin’s comments for a weak dollar, while retracted by the President, is indicative of the path of the greenback over the past several quarters.  The chart below shows how the Dollar has been weakening since mid-2016, which has supported international and emerging markets but also propped up US multi-nationals as a significant portion of their business comes from overseas.  The end of QE in Europe and Japan, and reduced purchases from China, will likely continue to be a headwind for the Dollar.

Year-over-year % change of USD

Source: JPMorgan Asset Management

Bottom Line: We continue to remain constructive on equities, but remain cognizant of its relatively higher valuations.  Thus, we are leaning more towards small- and mid-cap companies domestically and have increased international and emerging market exposure.  We expect tactical investments, such as in Energy, to enhance returns.

Fixed Income

The Barclays Agg was up 40bps in the quarter and 3.5% for the year.  The consistent theme has been the yield curve flattening as the front-end has pushed higher with rate hikes, but buying from other sovereigns and low inflation has kept the longer end pegged low.  There is greater concern of a potential inverted yield curve and how it portends a recession if that were to occur.

Source: Barclays Capital, MQS

We currently do not anticipate a meaningful flattening from here as demand is slowing while supply is increasing.  Japan is surreptitiously reducing their own QE program and reports of China also slowing its buying of US Treasuries, likely will put pressure on the 10 and 30 year and somewhat normalize the curve. Furthermore, Torsten Slok at Deutsche Bank, expects to see the dramatic increase in US fixed income supply in 2018, so long-term rates will likely have to rise to attract demand.  After year-end, we saw the 10-year rise above 2.5%, off of a near 2% low in the fall.

Source: Deutsche Bank Research

In credit, performance in the quarter for both loans and bonds were muted, but overall for the year did better than our expectations, notably supported by cyclical and more equity-like credits driving the bulk of returns.  High yield bonds returned slightly over 1% in the quarter, but a solid 7.2% on the year.  Loans were up 1.2% and 3.9% on the quarter and year, respectively.

Source: Eaton Vance, S&P

Markets were wide open as borrowers took advantage of further tightening spreads.  Issuance was strong with loans setting a new record for the year at $924bn and High yield bond issuance also up at $281bn.

Annual Bond and Loan Issuance

Source: Thomson Reuters LPC

Fundamentally, loan defaults increased slightly in the quarter to 1.7% but is still well-contained.  Bond defaults were low as well, at 2.9% as distressed Energy-related companies are moving through the reorganization process.  Retail remains an area of focus for distressed investors but in relatively small size.

Bottom Line: We have been underweight fixed income and credit, and have shied away from duration-sensitive products.  While we missed out on the continued tightening, we do not think the return opportunity is worth the risk of inflation and rates continuing to rise.

Alternatives

Hedge funds ended on a strong note, locking in positive returns for every month of the year.  The broad index was up 7.3%.  Equity hedge was the strategy leader, benefitting from broad market tailwinds, followed by Event-Driven, which capitalized on healthy M&A activity.  Macro strategies continued to lag, however with shifting QE and monetary policies occurring globally, we anticipate modest improvement in the opportunity set for the strategy looking forward.

Private equity deal activity was actually lower than expected given the massive fundraising in the year.  This could partially be equated to higher valuations for deals that didn’t meet investor return expectations as well as uncertainty around tax reform that likely pushed some deals from December into the new year.  Nonetheless, overall performance in private equity investments remained solid, with returns through 3Q estimated at over 12%.

Source: Pitchbook

Source: Pitchbook

Bottom Line: We continue to rely on liquid alternatives as a means of generating uncorrelated, absolute returns, especially in the current environment as equity valuations are high and rates are very low.  Differentiated, high risk-adjusted returns can help protect a portfolio when broader markets sell off.  We remain overweight private equity opportunities as they offer attractive long-term return potential.  We recognize valuations have crept higher in this space as well, but private companies are under-followed versus the public markets and active value-add strategies can be better implemented in this space.

Conclusion and Outlook

The market does feel somewhat complacent, expecting the upward trend to continue.  This is not without reason as we laid out the constructive factors earlier. However, we remain ever diligent and focused on the risks as much as potential returns and trust thoughtful asset allocation will protect in unexpected volatility and deliver strong long-term appreciation.  Thank you for entrusting your capital with us.

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