Investors enjoyed a second consecutive calendar year of strong capital market gains, with global equity markets continuing the bull market. Contributing factors included stronger economic data, accelerating earnings growth, and relatively loose monetary policy despite the Fed’s move toward increasing policy rates and tapering asset purchases. The domestic political climate remained contentious in 2017. Even with control of the executive and legislative branches, Republican lawmakers suffered a series of setbacks in their efforts to repeal the Affordable Care Act. After an arduous process, the GOP passed a tax reform package along party lines and delivered it to President Trump’s desk by the third week of December as his first year in office came to a close. Despite an uncertain political climate, the year was marked by subdued equity market volatility. For the first time since 2007, the CBOE Market Volatility Index (VIX) dipped into single digits.
In the absence of a fiscal stimulus-led bump, the U.S. economy continued to deliver positive, albeit modest, growth during the year. Even as the unemployment rate fell, wage pressure was contained and overall inflation levels remained under the Federal Reserve’s 2% target. However, this did not dissuade the Fed from continuing to gradually raise rates, with three policy rate hikes during the year. After carefully guiding markets about its intentions, the Fed also put into motion its plan to reduce the size of its balance sheet.
The Fed’s actions had mixed impacts on currencies and interest rates. Although policy rate hikes are normally positive for a currency, the U.S. dollar (USD) fell approximately 10% against a basket of developed market currencies. Weakness in the dollar stemmed in part from a degree of market skepticism that the three hikes projected for 2018 will actually occur. Also, following rate hikes by the Bank of England and a tapering in monthly purchases by the European Central Bank, more investors believe that global monetary policy will be tighter. The chart below compares changes in developed and emerging markets (EM) currencies to fluctuations in the USD. The greenback weakened against all major developed market currencies. The pattern was mixed among EM currencies, with the dollar weakening against 23 currencies tracked, but appreciating against a small subset that included the Argentine peso, Nigerian naira, and the Turkish lira.
Historically, Fed tightening cycles have led to flatter yield curves, and this cycle has been no different through 2017. The yields for three- and six-month Treasury bills rose 90 bps to 1.4% and 1.5%, respectively, and the yield for the one-year Treasury note rose 68 bps to 1.9%. Conversely, the yield of the 10-year Treasury fell 3 bps to 2.4% and the yield on the 30-year Treasury dropped 33 bps to 2.7%. However, by historical standards, the degree of flatness in the U.S. yield curve was not at an extreme level.
Demand for long-term U.S. Treasuries remained high as U.S. Treasury yields were attractive relative to other large developed market yields. Also, demand from large buyers such as pension funds, banks, and insurance companies remained strong. Lastly, the level of inflation and expectations going forward remained low, which contained yields at the longer end. In this environment, long Treasuries gained 8.5% over the one-year period compared to 1.1% in the intermediate part of the curve and 0.4% for short-dated Treasuries. Investment-grade credit curves benefited from a flattening as well, with long-dated corporates rising 12.8%—more than double the 5.6% gain in corporates maturing in the next five to 10 years. Corporate debt investors also benefited from tightening credit spreads, particularly for lower quality credits.
The growing appetite for risk was apparent in other asset classes as well. Emerging markets set the pace for global equity returns, returning 37.3% for the year and outperforming their U.S. and developed non-U.S. counterparts. While returns were strong broadly, market leadership was narrow, with IT names driving the rally. As a whole, the sector gained 60.6% for the year and accounted for roughly 40% of the MSCI EM Index’s gains. Leadership within the sector was even more concentrated within Chinese internet names, with Alibaba (+96.4%) and Tencent (+114.0%) posting significant gains. From a country perspective, many large Asian EMs fared well, including China (+54.1%), Korea (+47.3%), and India (+38.8%). European stocks also enjoyed a strong run on the back of the economic recovery in the euro area. Major European economies France (+28.8%), Italy (+28.4%), and Germany (+27.7%) benefited after economic growth estimates in the euro area were revised upward to 2.4%, which would mark the region’s strongest year since 2007.
The U.S. equity market continued to advance, with the Russell 3000 Index gaining 21.1% for the year. It was the first time in the Index’s history (incepted in 1979) that it posted gains in all 12 months of a calendar year. Similar to EM equity, IT was the Index’s best performer, advancing 36.9%. All FAANG stocks (Facebook, Apple, Amazon, Netflix, and Alphabet/Google) posted gains exceeding 30%, led by Amazon (+56%) and Netflix (+55%). However, gains were broad-based, as nine of the 11 economic sectors recorded gains, with materials, health care, consumer discretionary, industrials, and financials all gaining more than 20%.
Hedge funds gained 8.5% in 2017. Through December 2017, the HFRI Fund Weighted Composite Index had 14 consecutive months of positive performance. From March 2016 through December 2017, there was only one month of negative performance. According to Morgan Stanley, alpha generation by hedged equity managers was on pace to reach its highest level through July (over 9%), but alpha levels were modest in the second half of the year.
Increased concentration and portfolio conviction was a common theme across long/short equity managers, as evidenced by the elevated gross exposure over the course of the year. However, net exposure remained modest as managers maintained a sense of caution amid a market with relatively high valuations, but low volatility. From a performance standpoint, 2017 was a bifurcated year as alpha for equity managers was highly positive in the first 10 months, then trailed off significantly in November and December. Performance for long/short equity managers was positive overall, but fell short of expectations as the average manager captured roughly half of the equity market’s gains—largely in line with net exposures. Technology was a bright spot as selection was generally strong, and managers focused on the sector largely outperformed at a meaningful level. However, technology became a hindrance late in the year as momentum supporting the larger, higher quality names rolled over. This relative underperformance coincided with a rally in the consumer sectors—areas that were consistent targets of short sellers. Hedge funds were forced to adjust to rising consumer confidence and better-than-expected holiday sales, leading to rapid covering of popular short targets in the traditional retail industry. In a sign that reflects how great of a consensus the short retail trade had become, ProShares launched the Decline of the Retail Store ETF (ticker: EMTY) on November 14th. Through year-end, the ETF fell more than 14%.
Hedge fund performance was more muted outside of equity strategies, as the pace of merger and acquisition activity slowed and opportunities for credit managers remained limited. Uncertainty related to tax policy and the impact of changes in leadership at the Federal Trade Commission and Department of Justice contributed to the slowdown in merger activity. In addition to creating uncertainty about which deals will get approved, the timeline for review of announced deals was longer than managers expected. This was most evident in the politicized AT&T/Time Warner deal, which experienced delays and significant spread-widening late in the year. Qualcomm’s purchase of NXP Semiconductors, which was announced in October 2016, did not close before 2017 came to an end, and the deal was further complicated by Broadcom’s offer to purchase Qualcomm.
Within the credit component of flexible capital, the major theme was a lack of new distressed opportunities. Many recent bankruptcies have involved lower quality retailers, many of which have entered liquidation and not provided opportunities for distressed investors to get heavily involved. One of the largest contributors to returns was Caesars Entertainment, which restructured its debt load and went public in 2017, creating gains for both senior and junior creditors. However, this was weighed against losses for many investors involved in Puerto Rico, where hurricane devastation delayed any chance of a settlement with creditors. Security selection within Puerto Rico was highly important as performance varied considerably based on the type of claim. The dearth of new distressed opportunities prompted many investors to increase allocations to various forms of private and illiquid credit in an attempt to enhance returns.
Real asset segments produced mixed returns, with diversified commodities (+1.7%) and natural resource equities (+1.2%) lagging, while global REITs delivered the strongest returns (+11.4%). Global REITs were driven by Europe (+29.1% in USD) and Asia (+23.4% in USD), which benefited from generally improving fundamentals, strong global capital flows as investors continued to seek real estate’s attractive relative yields, and a weaker U.S. dollar, which boosted USD returns. The highly diverse U.S. market (+3.9%) was held back amid: (i) investor concerns around the growing impact of e-commerce on brick and mortar retail real estate; (ii) emerging pockets of weakness, including a surge of new supply in certain multifamily and office markets; and (iii) sentiment that the U.S. is in the later stages of its current cycle.
While diversified commodities finished the year up 1.7%, crude oil advanced by double digits for the second straight year (+12.4%, WTI) closing above the $60 a barrel mark for the first time in two and a half years. The advance was driven by stronger-than-expected global demand, declining domestic inventories, and the decision of the Organization of the Petroleum Exporting Countries to extend production cuts through the end of 2018. Despite rising oil prices and a recovery in energy company earnings, energy equities underperformed (−1.0%, S&P Energy) as the sector remained out of favor for much of the year. At year-end, energy equities represented less than 6.1% of the S&P 500—the lowest percentage in more than a decade. Further, a consistent stream of headlines around potential governmental carbon regulation and the projected growth in electric vehicles contributed to the sector being out of favor. Investors worried that higher electric vehicles adoption rates over the longer term may reduce internal combustion engine vehicle demand, and by extension, begin to meaningfully lower crude oil demand. Currently, electric vehicles represent less than 1.0% of the vehicle market due to a number of challenges, including high overall costs (particularly related to batteries), range and storage limitations, and a lack of necessary support infrastructure.
Amid this backdrop, the traditional 70/30 portfolio—70% domestic equities (S&P 500)/30% fixed income (Bloomberg Barclays Aggregate)—gained 16.1% in 2017. This mix modestly outpaced the 15.9% gain of a more broadly diversified portfolio, which incorporates non-U.S. developed and EM equities, private equity, real assets, hedge funds, and non-U.S. bonds. Diversified portfolios were aided by EM equity exposure relative to domestic, as well as non-U.S. bond exposure within the fixed income structure. While year-end marks are not yet available, early indications are that private capital investments will be additive for diversified structures in aggregate. Positive results from natural resources and commodities were modest after strong gains in 2016. However, elsewhere within the marketable real assets segment, global REITs posted double-digit gains during the calendar year.
There are several areas we will be watching in 2018. Jay Powell will become chair of the Federal Reserve in February, and while it seems likely that he will continue the trajectory of Janet Yellen, only time will tell. We will also be monitoring whether the flattening of the U.S. yield curve that occurred in 2017 continues into 2018. For the past several years, credit markets have been very receptive to new issuance and corporate refinancing activity, which has kept levels of distress and default at a minimum. We will be closely watching how credit markets develop in the coming months. The tax plan passed in December is likely to have a meaningful impact on corporate performance in the new year. In addition to analyzing the obvious earnings impact, we will be monitoring its effect on corporate actions and boardroom behavior. With this key agenda item resolved, the next policies addressed will be very important. If the infrastructure plan is indeed the next major policy effort by the Trump administration, it could potentially impact the very muted level of inflation that continues to be discounted by the market.
It seems highly likely that there will be more equity market volatility in 2018 than we observed in 2017. We will be working closely with our clients to prepare their investment programs for the inevitable increase in volatility and manage through whatever environment ultimately transpires.