Expect the Best, Prepare for... Something Else?
January 3, 2018
By Mike Moreland
Vice President of Investment Services
Welcome to 2018! All of the superlatives have been used to describe 2017, so we won’t try. Looking ahead, we’re enthused about opportunities for economic growth. But, as has been the case for a couple of years now, we’re concerned about valuations. How much of the coming good news is already in asset values?
Following is our Division’s quarterly Economic & Market Commentary. It’s longer than our regular posts, but we believe you’ll find it useful.
We enter the new year with a sense of exhilaration. Stock market records were set in 2017, not only in levels but in consistency and lack of volatility. Risk assets produced great returns, with almost no risk. The U.S. economy picked up steam, ending the year with two consecutive quarters of 3.0%+ GDP growth. Unemployment reached generational lows. While signs of speculative excess started to flash (we’re looking at you, Bitcoin), the economy and financial markets appear on solid footing entering 2018.
That said, it is always prudent to ask, ‘what can go wrong?’ We’re not going to compile a laundry list of what-ifs. Instead, we want to spend a little more time on a longer-term concern – valuations. In and of themselves, valuation considerations do not create risk. Risk rises when there’s a change in the narrative supporting today’s prices. Instead, valuation levels define the opportunity set. Low values show a greater range of opportunity than do higher valuations; in the latter much of the expected reward is already present.
So here’s the take-away for this piece: Economic activity will continue to accelerate. Risk assets will follow, but at a slower pace. Fully-invested, broadly diversified portfolios with a focus on controlling valuation risk will do well again in 2018.
Let the Good Times Roll
We noted above the highlights of a resurgent U.S. economy. And, it could get better. The ink is barely dry on tax reform and across the country, major corporations are announcing expansion plans, pay raises and bonus pools to employees. Personal tax cuts will increase spending power for most consumers. Some Federal Reserve Bank projections point toward 4.0%+ growth for the final quarter – a rate of progress not seen since 2004.
And we’re not alone. The chart on this page, courtesy of State Street Global Advisors, shows economic momentum in the rest of the world. Data from the OECD (Organization for Economic Cooperation and Development) indicate that every major developed nation is moving forward (Goldman Sachs calls this a ‘synchronized expansion’). Some faster, some slower, but all positive for the first time in a decade. Years of accommodative monetary and fiscal policies are flowing through to the real world.
This progress should continue, particularly overseas. Most central banks outside the U.S. remain broadly supportive of growth; negative interest rates are common in Europe and Japan. At home, the Federal Reserve is moving toward a neutral, not restrictive, status. The outlook is good.
Is Some of This Yesterday’s News?
All financial markets are discounting mechanisms. Expectations for profit growth, inflation, and central bank policies mix with income needs and risk tolerance to drive asset prices. Our situation today – high valuations across the board – is, in part, the product of the last decade’s policies. At the same time, all signs point to continued expansion, relative price stability, and controlled interest rates. The unknown is the extent to which this positive outlook is already present in asset values.
Here we rely on history. The accompanying chart from Goldman Sachs Global Investment Research is busy, but telling. Equity valuations are high, Treasury yields and risk premiums are low, and not just in today’s terms. The three components average in the 90th percentile of their ranges of the last century or more. The rewards for taking risk are not what they were a few short years ago. This presents a challenge, at least for the near term.
Valuations Do Matter
The best predictor of future returns is valuation at the starting point. Elevated levels today suggest subdued returns tomorrow. Since the mid-1950s, the twelve-month forward return from price levels like today’s is slightly negative.
We place a low probability on negative equity returns in 2018. Simply, economic momentum should overcome valuation considerations in the new year. At the same time, we will not witness a replay of 2017. Volatility will rise for all asset classes. Returns will be much closer to historic averages. And, at the end of the year, we will see that rewards were well earned.
Diversification will remain the primary component of our management process in 2018. Both equity and fixed income portfolios will stay fully invested, but we will avoid concentrations in asset classes, sectors, and maturity structures. We will emphasize high quality in both fixed income and equity management. Lower-rated assets have a place, but their risk is rising relative to their reward potential. We will also maintain shorter-than-average bond durations. Our goal is to participate in the good times, but protect to downside. This worked in 2017; we expect it to do so again in the new year.
As always, we appreciate your confidence in our services. We work hard to be your most trusted financial advisor. Security National Bank's Wealth Management
team will continue to do so in 2018 and beyond.