- Bull Market in U.S. Equities Likely to Continue
- U.S. Economy on a Roll, but There Are Caveats
- Positive Year Expected for Fixed Income Markets
- High Yield Municipal Bonds Moving the Needle
From the Desk of
GARRETT D'ALESSANDRO, CFA, CAIA, AIF®
Equities had an outstanding year in 2017. Returns were high across the U.S., Europe, and Asia (see chart), while volatility remained at record lows. Equities in particular registered some of the best performances in recent memory as the top 30 global stock markets all posted gains, most of them in double digits. Corporate and government bonds around the world enjoyed moderate returns, as did many commodities.
As we go forward in 2018, most of the positive developments that drive financial markets remain in place, including improving global growth, benign inflation, low interest rates and strong corporate profits. While future stock returns will likely be moderate, there are worthwhile gains ahead in equity markets and select credit opportunities in fixed income. This year will likely have more volatility as well as more moderate returns. Given current valuations levels, if history is a reliable guide, equities are likely to generate lower overall annual returns during the next several years.
On the positive side, the world economy looks set for its best back-to-back years of growth in more than a decade, and there are few obvious clouds on the horizon (see chart). A rise in corporate profits has helped revive capital investment, while strong labor markets and relatively low inflation are fueling consumer spending. This has lifted confidence, creating a positive feedback loop where the pickup in global GDP and better financial conditions are further boosting spending and investment. Meanwhile, inflation shows some signs of moderate acceleration and, while central banks have thus far been patient as they seek to normalize monetary policy, the Federal Reserve has said it will raise interest rates 3-4 times in 2018.
In the U.S., the expansion is on track to soon become the second-longest in post-war history and, despite its advanced age, fundamentals remain good (see chart). The unemployment rate has reached its lowest level in 17 years, confidence is high, and business surveys support continued economic expansion. We expect recently passed tax cuts to provide an additional modest boost to GDP growth over the next several quarters.
Investors – as they should be – are clearly focused on this positive outlook. After three years of modest growth, the upturn in the world economy has fueled an impressive recovery in corporate profits, which should help extend the long-run bull market for another year. What's been remarkable about the recent rally is how low volatility has been (see chart). While many investors expected more turbulence last year due to Washington politics, European elections, or conflict with North Korea, the market has largely shrugged off all negative news. Indeed, 2017 was the first calendar year without a single negative month in the history of the S&P 500. However, we expect more volatility ahead.
From the perspective of the past year, with broad global economic growth, solid corporate fundamentals and attractive financial conditions, these low levels of volatility appear justified. However, the expectations bar is now set quite high and growing market enthusiasm means that equities are fully valued. This suggests that future returns will be lower and also subjects investors to potential shocks and unexpected shifts in policy going forward. At 14 months and counting, we are in the longest period in S&P 500 history without a correction of 3% or more, but we do expect a correction in 2018.
Given all of this, our advice for investors is to stay invested while lowering expectations and preparing for choppier markets. Global economic growth will likely continue to lift earnings and power the bull market higher. However, we appear to be entering the later stages of the market cycle, and investors should remain disciplined. The final stages of a bull market can be rewarding, but last year's impressive gains are unlikely to be repeated, and investors should expect more moderate returns in 2018.
Read the next article in the series: U.S. Economy on a Roll, but There Are Caveats
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