Dave Donabedian, CFA
January 22, 2018
Last year, nearly all major asset classes generated positive returns for investors. For the ninth consecutive year, the bull market in U.S. stocks continued with the S&P 500 gaining a staggering 22%. International equity markets performed even better, with emerging market equities outperforming all other assets. In fixed income, investors were rewarded for taking on risk through longer maturity bonds and credit sectors.
While many investors have begun to question how much longer this period of growth can be sustained, we see no indication of a looming bear market and believe that the current bull market will likely extend through 2018. As we begin the new year, we are encouraged that secular stagnation—the extended period of slow growth we have been experiencing—has finally given way to accelerated growth and a synchronized global economic expansion. For the first time in over a decade, all of the world’s major economies are growing at the same time.
In the U.S., we expect growth and inflation to pick up, with the latter potentially leading the Fed to raise interest rates more aggressively than currently anticipated. Consensus estimates predict three rate increases this year of 0.25% each, but a new Fed chairman and turnover among members of the FOMC board present additional unknowns for monetary policy. Given our expectations for an uptick in inflation this year, we believe that market estimates for both short- and long-term interest rates are too low and expect 2018 to be a challenging year for fixed income markets.
On the bright side, we expect U.S. equity markets to perform well again in 2018. We believe the current estimates for GDP growth of 2.6% are too low as every leading indicator we track continues to improve. Consumer sentiment is at its highest level since 2000 and even higher now than it was going into 2017. Business sentiment is also elevated and was further boosted by the government’s recent tax reform. We believe in the near-term, the new tax cuts will lift corporate earnings and increase M&A activity, providing a tailwind for U.S. equities. That said, we expect the ensuing effects of tax reform to be less fruitful. Tax cuts are typically utilized to stimulate the job market; however, in our opinion the labor market is nearing full employment and any windfall to companies because of lower taxes will be invested in current employees. Rising wages may compress corporate profit margins and stoke inflation, dampening our expectations for longer-term U.S. equity returns going forward.
Despite our optimism for U.S. equities in 2018, current valuation levels are a concern. Forward price-to-earnings (P/E) ratios are well above their five- and ten-year averages and are now entering speculative territory. Whether current valuation levels are sustainable depends on continued earnings growth, and consensus estimates are for double-digit growth in 2018.
Looking globally, international economies have started to catch up with the United States. We expect strong returns from developed market international equities, particularly within the Eurozone this year. Improving consumer confidence, reduced unemployment, a stabilizing political environment, and low interest rates and inflation have all boosted economic activity in developed Europe. While emerging market equities have been the strongest performing asset class over the last fifteen months, we believe potential speculation over central bank policy reversals may cause headwinds and additional volatility within these markets in the year ahead.
Given our outlook for 2018, we continue to over-weight equities and under-weight bonds across our portfolios. Within equities, we are emphasizing developed market international equities as we see the most potential in this market going forward. In fixed income, we expect Fed monetary policy to increase short-term rates while inflation expectations will cause longer-term interest rates to rise. We recommend hedging interest rate risk by holding shorter-maturity bonds in sectors that are not highly correlated with the U.S. Treasury market. For additional bond portfolio diversification, Treasury Inflation-Protected Securities (TIPS) and floating-rate bonds tend to perform well in inflationary and rising rate environments, respectively.
While we believe that 2018 will be another good year for investors fueled by momentum, global economic growth, increased M&A activity, and accommodative global central bank policies outside the United States, our optimism for future gains is returning to more temperate levels. While valuation tends to be a poor predictor of equity market returns in the near-term, it is a relatively reliable forecaster of long-term equity market returns. The current P/E ratio of the S&P 500 suggests that we should expect below-average returns in U.S. equities over the next five to ten years.
We are prepared for increased volatility in the year ahead, especially given uncertainty surrounding central bank policies. Consequently, stock picking and diversification strategies will become more important going forward, as will an emphasis on risk management.
You can listen to the replay of the webinar by clicking the button below. For more information about CIBC Atlantic Trust’s market outlook, download our Q1 Financial Markets Monitor, or contact a CIBC Atlantic Trust Advisor today.
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Dave Donabedian is chief investment officer of CIBC Atlantic Trust, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
CIBC Atlantic Trust’s Asset Allocation Committee recommendations express our views on directional portfolio shifts driven by an assessment of relative risk and reward and do not take into consideration individual suitability requirements. At CIBC Atlantic Trust, asset allocation may be customized for each client, so a client’s particular portfolio allocation may not follow these recommendations. Some recommendations referenced may not be appropriate for your specific situation, so you should consult with your financial advisor regarding your unique circumstances.
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