2017 is in the books, and equity investors, buoyed by stronger than expected earnings and the potential for tax cut stimulus, continued to push equity valuations higher. The S&P 500 Index delivered a return of 21.8%, its best return in four years, and the fourth best calendar year return since 2000.
Small-cap stocks significantly lagged large-cap stocks, but still returned 14.7%. Growth stocks returned 30.2%, dominating value by a whopping 16.5%, led by the dominant performance of Technology stocks which were up 38.8% in the S&P 500 Index. Non-U.S. developed market stocks returned 25%, outperforming U.S. equities for the first time in four years.
Figure 1: 2017 S&P 500 Index Performance:
While favorable economic prospects and the tax cuts have buoyed earnings prospects in 2018, some underlying characteristics driving these returns warrant caution. Momentum was the dominant driver of return in 2017, indicating stocks that were winners continued to outperform with little regard for valuation.
Investor complacency toward risk helped push valuations higher as stock price increases outpaced earnings increases. Evidence of this complacency is seen in the extremely low levels of volatility that persisted throughout the year. S&P 500 Index performance in 2017, illustrated in Figure 1 above, reveals a straight ascent with little volatility, as there was no single day when the market went up or down more than 2% and only eight days when returns exceeded 1% up or down. Similarly, the CBOE Volatility Index, the VIX, a commonly referenced measure of investor perception of risk, hit its lowest level in more than 25 years during the fourth quarter.
Some investors are beginning to recognize that these conditions cannot go on indefinitely. Active managers are bemoaning the difficulty of identifying attractively valued stocks. And while equity markets continue to be buoyed by near-term economic and earnings prospects for 2018, we believe valuations warrant caution.
Timing a correction has generally proven to be futile as markets have been known to remain overvalued for long periods of time. In such an environment, a focus on risk is especially important. Today, not only do we believe it’s important for investors to rebalance portfolios to risk levels that are back in-line with their tolerance, but to be mindful of the temporal nature of risk. That is, risks that are framed over a longer time horizon can actually materialize in the next quarter or year.
Three such risks we are focused on, yet appear underestimated by the general investing public, are inflation, climate change and gender.
In the recovery from the 2008 Great Recession, inflation has not been a major concern of investors. The consumer price index (CPI) has remained below the Federal Reserve’s stated target of 2%, hovering on average around 1.5% for much of that period.
There are some indications that headline inflation numbers may not be capturing the beginnings of resurgence in inflation from current low levels. The Federal Reserve Bank of San Francisco in its FRBSF Economic Letter in November parsed inflation data into components that are procyclical (more economically sensitive) and acyclical (factors independent of the economic cycle). The article concludes that acyclical factors (primarily attributable to healthcare prices) are largely responsible for dampening headline inflation and that procyclical components have largely returned to pre-recession levels.1
The impact of these procyclical components is becoming more evident. Oil prices have recovered to levels north of $60 a barrel and wage pressure is firming as the labor market continues to tighten. And these procyclical components do not factor in any impact of stimulus from the tax cut on inflation. Indicators of longer-term inflation expectations are starting to trend higher. One measure, the yield premium of the 10-year Treasury note above an equivalent maturity Treasury Inflation Protected Security (TIPS), has recently moved above 2%. We believe even a modest increase in inflation above 2.5% could surprise investors with negative implications for both stocks and bonds.
It is increasingly clear that public policy in America has lost much of its force as a dominant driver of corporate action. The United States has announced its intention to pull out of the Paris Agreement and repeal the Clean Power Plan, for instance. So, can U.S. companies start burning more coal? No. That announcement not only didn’t dent the rest of the world’s resolve to limit greenhouse gas emissions, it probably strengthened it. And even in the U.S., coal production hit a new low in 2017.
Thus, to be competitive in the global economy, even over the next three years, American businesses need to pay attention to the world’s wish to decarbonize. If the rest of the world is more interested in renewable energy than in fossil fuels–ignoring that trend will shrink the economic opportunities for American companies that see the deregulatory trend as a license to ignore energy use and emissions.
“Of course climate change presents a varied landscape of risks, only one of which is regulatory risk.”
The risks that climate change presents go way beyond big emitters, and it’s important that we, as investors, recognize what those risks are, evaluate how companies are adapting to them, and price those decisions accordingly.
Climate change means increasingly severe weather: increasing incidence and severity of things like tropical storms, droughts, floods, and fires. Now that science has advanced to the point where we can better understand the role of climate change in specific events, we understand that companies can start to compute the likelihood of impact based on such events. Initial estimates were that Hurricanes Harvey and Irma could slow U.S. gross domestic product (GDP) growth by 1%; Europe’s 2017 heatwave hammered the Italian grape harvest; heat stress can reduce economic Gross Value Added of cities between approximately half a percent and 10 percent.
Altogether, projections of the economic impact of climate change run into the tens of trillions of dollars over this century. There’s no amount of deregulation that can make those costs smaller. Reinsurers have been aware of these rising risks for several years, and increasingly, investors are waking up to them, but many still think of climate risk as primarily regulatory. That misconception can’t die fast enough.
The gender gap is a global phenomenon: women are less likely than men to be represented in the ranks of leadership (corporate boards and executive suites, political office, etc.), and more likely to be paid less than men for substantially similar work and qualifications. And 2017 was the year of the silence breakers on workplace sexual harassment.
Taken together, these gender issues are part of something that every company should be aware of and should manage: getting the best from the entire talent pool available. Discrimination, inequitable pay on the basis of gender, and harassment are all ways that companies risk disenfranchising half their workforces, and that is not a recipe for competitive prowess.
While the role of regulation and enforcement will likely be diminished at least for the next few years, that is not a reason for diminished attention to diversity and the need for equal, equitable treatment of people regardless of gender, race, ethnicity, sexual preference or other demographic attributes. The overall economic cost of discrimination and harassment is not known; however, it is likely to be substantial, with reports of figures like 80% of women who have been harassed leaving their jobs within two years.2
2017 was a strong year for market performance, but with valuations stretched, caution is warranted on both market and individual stock levels. In such an environment, unexpected risks that manifest themselves can be especially painful. Rebalancing portfolios to the appropriate risk tolerance and being mindful of the breadth and depth of potential risks is especially important.
1Tim Mahedy and Adam Shapiro, “What’s Down with Inflation,” FRBSF Economic Letter, November 27, 2017
2Nilofer Merchant, “The Insidious Economic Impact of Sexual Harassment,” Harvard Business Review, November 29, 2017.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
One cannot invest directly in an index.