Quarterly Client Letter – Q4 2017
- January 25, 2018
- Investment Insight
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Dear O’Brien Wealth Partners Investor,
Unequivocally, 2017 was a year of high uncertainty filled with volatile headlines. While cable news channels traditionally expect a decrease in viewership following an election year, in 2017 Fox, MSNBC and CNN all exceeded record viewing levels. Daily breaking geopolitical news stories, nuclear saber rattling with North Korea and months of coverage of natural disasters contributed to the impression of a world on edge. In stark contrast, Wall Street largely shrugged off the news as markets were among the least volatile on record. The S&P 500 posted gains in each calendar month of 2017 for the first time in 90 years, and there was not a single trading day in which the market closed down more than 3%. The markets rose steadily in a banner year for investors. This outcome seems to be largely the result of solid fundamentals, as the U.S. economy grew at a steady 2.5% over the year as measured by GDP. Inflation was held in check, interest rates stayed remarkably low, and the economy added on average 170,000 jobs per month bringing the unemployment rate to 4.1%, its lowest in 17 years. The promise and ultimate passage of fiscal stimulus in the form of tax cuts only served to add additional momentum to risk assets.
The biggest news affecting markets in the fourth quarter was the negotiation and ultimate passage of a sweeping tax reform bill. While this bill will have many different effects for individual Americans depending on their personal situations, the market had been anticipating significant tax reform all year and was stoked by its passage. While many companies will see a hit to their first quarter earnings due to a mandatory one-time “deemed repatriation” tax on overseas assets, going forward most companies will see their taxes drop significantly. This reduction in tax expense will provide an almost immediate boost to corporate earnings and will free up net cash flow for further reinvestment. The new administration is hoping that increased internal reinvestment will provide additional stimulus for the economy.
Under this positive macroeconomic backdrop, most major asset classes finished the year with positive gains. In the U.S., investors saw double-digit gains with U.S. large cap stocks returning 21.8% (as measured by the S&P 500 Index) and U.S. small cap stocks returning 14.7% (as measured by the Russell 2000 Index). Larger cap companies outperformed their smaller peers in large part to the contribution from the technology sector’s “FAANG” stocks (Facebook, Amazon, Apple, Netflix and Google) which again led the markets as they have in years past.
The positive story wasn’t limited to the United States, as 2017 saw real growth picking up across the world in all 45 countries tracked by the OECD. Non-U.S. companies were the best performers on a regional basis, with non-U.S. developed country stocks returning 25.0% (as measured by the MSCI EAFE Index) and emerging market stocks returning 37.3% (as measured by the MSCI EM Index). This dramatic outperformance within the emerging markets was led by Chinese technology companies like Baidu, Tencent, and Alibaba – Chinese equivalents of some of our FAANG stocks.
In the fixed income markets the biggest news was the selection of Jerome “Jay” Powell to replace Janet Yellen as Federal Reserve Chairman. Mr. Powell represents a continuation of the current status quo in terms of controlled interest rate increases, and we don’t expect this to change in 2018. While the Fed was able to coax short term bond yields higher in 2017, the 10-year treasury yield finished the year several basis points below where it began in 2017. This led to a positive year for taxable bonds, finishing the year up 3.54% (as measured by the Barclays US Aggregate Bond Index). As growth picked up around the world and corporate defaults remained low, the spreads between high yield bonds and treasuries declined over the year which was positive news for high yield bonds and other risk-on bond assets.
What does this mean for your portfolio?
While this has been the second longest expansion in history – going on its 9th year – it has also been the shallowest we have seen by far. Despite the age of the current business cycle we are still only about halfway to the cumulative GDP gains witnessed in the last nine business cycles since the KoreanWar. This gives us reason to believe that this expansion still has room to grow, spurred along with new stimulus in the form of corporate tax breaks. While many individual investors continue to sit in cash, our commitment to be fully invested in risk assets has paid off handsomely for our clients. We remain watchful of valuations that are higher than their historical averages in the U.S., but are also encouraged by other regions of the world that are still undervalued based on historical averages.
Diversification outside the United States was an asset for our clients in 2017 as international markets posted the highest gains and boosted our clients’ aggregate returns. Our U.S. large cap growth overweight also added return as the dominant size and style for the year led by U.S. technology companies. Our flexible fixed income managers have found yield and return in unlikely places and were able to position appropriately to take advantage of spread opportunities in an accelerating market. While our reinsurance clients saw some losses due to the four large hurricane landfalls, our partners in the space have negotiated higher premiums on their contracts to start 2018 on an attractive footing.
Finally, while this has been an excellent market for our clients we know that market corrections are a natural and inevitable occurrence. Accordingly, we are taking steps to position your portfolios more defensively. As an example, we have replaced some of your taxable bond investments with a government securities fund to provide a better counterbalance to equity market volatility. We will selectively continue to take additional risk off of the table in 2018; while also participating in what we expect to be another positive year for risk assets. We remain committed to constructing thoughtful portfolios, built with institutional quality research and decades of market experience, to give our clients the very best chance at reaching their long-term goals.
If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.
Your O’Brien Wealth Partners LLC Investment Team