January 15, 2017
Dear Prospective Client:
Happy New Year from everyone at Highgate Securities Investments! We wish you much health and happiness for 2018 and hope that the new year is an auspicious one for you.
Interestingly, 2017 turned out to be a superb year for most investment markets despite much fretting among investors about how a Trump presidency would impact them. Aside from cryptocurrencies, whose prices rose parabolically, equities rose strongly with few exceptions. This demonstrates that despite many expert predictions and myriad published analyses, the magnitude and direction of future stock returns are entirely unpredictable. The past year reminds us that politics should be far down the list of factors to consider when formulating an investment strategy.
Last year, the S&P 500 was up by 21.7%, the Dow Jones Industrial Average by 25.2% and the NASDAQ Index by 29.3%. These large upside moves are a bit surprising because valuations in US stocks were already high at the beginning of the year. This demonstrates that emotions, liquidity and the credit environment can often play a much more important role in future market moves than valuations do. Valuations tend to serve as a long-term anchor toward which prices revert, but the timing of any reversion is impossible to predict -- especially when we have a Federal Reserve bound and determined to keep asset prices high.
Looking overseas, where valuations were much more reasonable, strong returns were also observed. The MSCI World (ex USA) Index finally rose with a 19.5% increase in 2017 after a miserable 2015 and flat 2016. Particularly strong were the Asian stock markets. Vietnam was up 45%, India 35% and South Korea 34%. Emerging markets stocks as a whole were up 37%. Strong gains were also seen in European stocks, where the Euro Stoxx 50 Index, Europe’s leading blue-chip index for the Eurozone, rose by 22%.
Very few professional investors predicted such large gains for 2017. Of course, today (and as usual) there are no shortage of predictions, so I won’t presume to make any. A couple of observations are interesting to note, however, as they relate to investment markets: 1) the US dollar declined about 9% this year; and 2) the spread between 2- and 10- year bonds narrowed from 1.25% to 0.5% (50 basis points). More on those later.
Looking back to the beginning of 2017, many investors thought that because the Fed was raising interest rates and because market volatility had been so low for so long, that there was a good chance that higher price volatility would return. The exact opposite happened. Without getting too esoteric, there is a measurement of expected market volatility called the VIX index. The higher the VIX index the more volatility participants expect, and the lower the VIX index, the less volatility they expect. The long-term average VIX is around 20. 2017 had 52 days where the VIX closed below 10. The previous record of 4 days closing below 10 was set in 1993. In other words, volatility collapsed. This is why it is not a practice of Highgate’s to make investments based on such predictions…it is just to own compensated risks and to avoid uncompensated risks among stocks and bonds.
Some other 2017 records were 1) 72 days in a row of the Dow Jones Industrial Average going without an intraday move greater than 1%; 2) 305 days (and counting as of the writing of this letter) of the S&P 500 closing within 3% of its all-time high; 3) it was the first year ever where the S&P 500 closed every single month higher than the prior month; and 4) the Dow closed at an all-time high 71 times during the year. Needless to say, it was quite a remarkable year.
The dollar declined 9% despite the Fed’s continuing its path to normalizing (raising) interest rates from the zero-level where they had been held for nearly ten years. This is notable because foreign central banks have not yet signaled any desire to raise rates. A declining dollar can improve profitability for US-based companies that sell abroad and/or have foreign operations. When money is earned abroad in stronger foreign currencies, it translates to more dollars when it comes back into the US, so a dollar decline is like free money for those companies. The opposite is true when the dollar strengthens, which it did for the three years prior to 2017.
The cause of the dollar decline was largely due to improvement in the eurozone’s economic outlook, which puts pressure on the European Central Bank (the ECB) to raise rates. Moreover, Trump has stated that he would “like to see rates stay low”, and to this end he nominated Jerome Powell to the position of Federal Reserve Chairman. Powell, who was brought up in the finance (private equity) business, is a lawyer by training and not an academic like his two Fed Chair predecessors. Powell is thought to be a friend of Wall Street and likely to continue with easy monetary policy. Easy money, of course, helps Wall Street, businesspeople and borrowers, and hurts savers and retirees who do not invest in stocks. The likelihood of continued easy money probably partially accounts for a weak dollar, buoyant stocks prices, emerging market stocks’ outperformance and crude oil prices back above $60 per barrel.
On the fixed income (bonds) front, the yield curve flattened (the difference between short-term and long-term interest rates decreased). This occurred because the Fed raised short-term rates, but longer-term rates did not see a commensurate increase. Since long-bond yields tend to reflect a market consensus of economic growth prospects (higher yields signal more optimism) it can be inferred that bond traders believe economic growth will be hard to come by – probably because of high levels of debt in the economy making growth very sensitive to interest rates. Historically, however, stocks tend to do well in a flattening yield curve environment.
None of these above-mentioned factors are predictive of the direction and magnitude of stock prices in 2018. But the backdrop is certainly favorable for equities: 1) the unemployment rate at a 50-year low; 2) global trade nearing record levels (as measured by US imports and exports); 3) tax reform and a permanent cut in the corporate tax rate fueling earnings growth; 4) incentives built into the new tax reform package favoring capital spending over buybacks; and 5) easy monetary policy.
In considering an investment strategy, it is important to consider where there may be too much complacency. While stock valuations are certainly high, it may be that bond investors are too confident in disinflation and are keeping rates too low. This is especially true given the large supply of so-called ‘yield-enhanced’ investments, where investment managers effectively borrow short-term to invest in long-term bonds. If losses mount among such holders of long-bonds, we may see a more dramatic increase in long-term interest rates.
It is important to know that equity markets are a function of central bank policy. The Federal Reserve can be thought of as still being highly accommodative (supportive of economic expansion) with short rates (of 1.5%) below inflation (CPI of 2.2%) even while the Federal Reserve is raising rates. We expect the Federal Reserve to continue to be accommodative going forward, but perhaps a little bit less so if inflation expectations increase. This makes it tricky for us as investment managers who want to be cautious because the natural skeptics in us look across the investment environment and see high prices, but we also see many positive factors and as new highs in stocks occur almost daily.
A decade of central bank interventions (holding interest rates low) has likely caused inflated prices across many asset classes. The Federal Reserve’s incentives, after all, are: 1) to boost asset prices (because the Fed believes the wealth effect supports the economy); and 2) to be supportive of the banking system. The fallout from the policies created around those incentives, moral hazard and exploding debt levels, are secondary considerations. And once interventions begin, they can be difficult to unwind because of unwinding them can bring adverse consequences that necessitate more interventions. It remains to be seen how this will all play out.
As an investment management firm, it is incumbent on us to make good investments for our clients. Since we can’t predict prices, we want to stack the odds in our favor for strong returns by owning investment with a strong upside case and a low probability of a permanent capital loss. Because of high valuations in equities, we currently want to be on the conservative side with our allocations to equities, and to stay in short-duration bonds (both dollar and non-dollar). We would not expect 2018 to be another year like 2017 in markets, but, of course, anything is possible.
If you would like more information about Highgate Securities Investments, please visit our web site at www.highgatesi.com or call us at 303-968-1230. Our ADV (disclosure document) may be accessed through our web site, or sent via email per request.
John Goltermann, CFA, CPA, CGMA