Moving from a Gallop to a Grind

January 10, 2018  | by Ryan Driscoll, Michael Strauss

Market Commentary

Summary

  • The S&P 500 Index surged almost 875 points from late January 2016 through the end of 2017 and then another 75+ points in the first six days of 2018. This “gallop” higher represented more than a two percentage point per month average increase. And, for the first time ever, the S&P 500 Index posted 12 consecutive monthly total return gains in 2017.

  • An improvement in economic activity, a rebound in corporate profits, steady and predictable normalization by the Fed, a reduction in regulations, and, most recently, a much-anticipated cut in corporate tax rates were all catalysts to this rally.

  • Even with the strong start to 2018, the stock market may transition from a gallop to a grind higher as “good news” may have a smaller impact on returns, especially if signs develop that inflation may be poised to move higher and the Fed shifts to a more hawkish tilt.

 

The Economy and Earnings Drive Returns

The U.S. economy, in line with our long term view, has clearly moved into a stronger growth mode as the domestic economy expanded at around a three percent pace in the final nine months of 2017. The short-term stimulus from the tax cut package is likely to produce continued solid growth in 2018.  On the earnings front, corporate profits expanded at close to a double-digit year-over-year pace in 2017, and, with the added help from lower corporate tax rates, after tax corporate profits and, most importantly, corporate cash flow should increase to the mid to upper teens in 2018. 

 

Markets React to Stronger Growth Expectations

Interestingly, the stock market’s initial reaction to the passage of the tax package was muted. A significant portion of this good news may have already been priced into the capital markets as equities rallied about 10 percentage points from mid-August to late-December in anticipation. Portfolio rebalancing at year-end, particularly by pension funds, also served to limit the upside response from domestic equities. As the calendar flipped to 2018, so did some asset allocation models as the New Year brought a surge in equity prices, at the expense of U.S. Treasuries, as witnessed by the latest back-up in 10-year Treasury yields to 2.55 percent.

The rise in U.S. Treasury yields appears to partially reflect increased market expectations for unintended consequences of the tax plan, including higher budget deficits and growth potentially leading to higher inflation.  The result may be a realization among investors that more aggressive monetary policy normalization could be on tap.  In mid-December the domestic Treasury market was priced to reflect less than two Fed rate hikes for the upcoming year, versus the Fed’s interest rate “Dot plot” which showed most FOMC members forecasting three rate hikes. Moreover, it is generally anticipated that the Fed’s planned reduction in the size of its balance sheet will act like an additional rate hike.  At the same time, both Japanese and European officials are likely to temper the amount of stimulus they are providing to the capital markets. Likewise, the stronger economic growth may signal a bottoming in input costs and, with signs pointing to stronger business capital expenditures as well as higher wage and benefit costs, inflation is likely to accelerate modestly in 2018.

 

Signs to Watch

In the upcoming year we will watch factors that impact these conditions carefully. Our concern is that the smooth sailing we have seen the last two years may face turbulence ahead. The result could be a shift from a galloping equity market to a grinding equity market, whereby total returns moderate to be in-line with our five-year projections for mid- to upper-single digit gains. Strong near-term earnings and cash flows from tax cuts are likely to be partially offset by a modest compression in the price to earnings ratio. 

As we first showed two years ago and reiterate in the chart below, equity returns in a rising interest rate environment, defined as periods when the Fed is tightening monetary policy, have generally been positive. Since 1958, we have had 15 such periods and gains have been recorded in 13 of the 15 periods, including the current one.  However, with equity returns since the start of the latest tightening cycle in December 2015 running at close to a 20 percent annual pace, or more than seven percentage points per year above the norm, some reversion to the mean is likely in the year ahead.

 

CH1-EquityReturns

Authors

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Michael Strauss is Chief Economist at Commonfund. Michael has over 30 years of institutional financial services and investment experience. Previously, he held positions as a top-ranked chief economist and financial market strategist with Sanwa Securities, Yamaichi International (America) Inc., and UBS Securities. Michael received the Market News Forecaster Award as the most accurate "Wall Street" economist for 1997 and has been a speaker on CNN and CNBC and, over the years, has been quoted by Reuters, Dow Jones Capital Markets, The New York Times, The Wall Street Journal, and Barrons. He has been a faculty member at the Treasury Institute for Higher Education (TIHE), the Tax Institute for Colleges and Universities (TIFCU), and the National Association of College and University Business Officers (NACUBO) Conference. He holds a B.S. degree with distinction from Cornell University and an M.B.A. with distinction from New York University.
Michael H. Strauss
Chief Economist
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Ryan Driscoll is responsible for trading and investment analysis at Commonfund Asset Management Company. Prior to joining Commonfund, Ryan worked at Sailfish Capital Partners, a multi-strategy fixed income fund, where he served on the Emerging Markets team. Prior to that, he was on the fixed income team at Grantham, Mayo, Van Otterloo & Co. and was an equity/fixed income trader at Loring, Wolcott and Coolidge, in Boston. Ryan received his B.S. in Finance and M.S. in Global Financial Analysis (with Distinction) from Bentley College. He is a CFA Charterholder and is a member of the Boston Securities Analyst Society and CFA Institute
Ryan Driscoll
Director, CFA
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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.