There were many notable, attention-grabbing headlines in the fourth quarter of 2017, including a mid-December Federal Reserve interest rate hike, ongoing improvement in crude oil prices, passage of the highly-anticipated Tax Cuts and Jobs Act, and continued tightening of the U.S. labor market. Across the major asset categories, global equities marched higher, with outsized gains in international markets and domestic large cap. Meanwhile, a flattening yield curve supported long-term Treasury returns. Recent poor momentum in energy infrastructure assets moderated and the sector witnessed impressive gains.
Fed Hikes Rates, Oil Prices Spike, and the Labor Market Tightens Further
The fourth quarter of 2017 was full of market-moving economic events such as the expected increase of the federal funds rate by the Federal Reserve at their mid-December meeting, increases in crude oil spot prices, passage of the tax bill, and tightening across many U.S. labor market variables. In addition, several key U.S. economic fundamental variables witnessed ongoing improvement, including consumer confidence, growth across leading economic indicators, and growth in core capital expenditures. The U.S. economy appears to have gathered momentum before fiscal stimulus even had the chance to feed into the broader economy. If this momentum continues, the economy may witness higher inflation rates once the stimulus begins to officially impact both corporate and individual bottom lines.
The output gap has closed at a time when many other key indicators have tripped “late-cycle” status, including elevated valuations across most risky asset categories, near-peak levels of consumer confidence, a flattening Treasury yield curve, and a recent (modest) slowdown in the pace of monthly job gains.
The passage of the Tax Cuts and Jobs Act is a key wildcard in the persistence of the current economic expansion. The Act is predicted to serve as a near-term tailwind behind domestic economic conditions, and a likely counterbalance will include the deliberate tightening of monetary conditions by the Federal Reserve, including further increases in the federal funds rate and the evolution of the balance sheet wind-down process.
To summarize, the U.S. economy appears to have gathered steam in the fourth quarter 2017, despite the fact that the Fed’s fiscal stimulus has yet to directly impact economic conditions. The risk of “overheating” remains a concern, however, as many key indicators continue to signal a somewhat mature business cycle expansion. While looming fiscal stimulus is likely to keep the current expansion on track, a key macro risk will be the Fed’s deliberate unprecedented tightening of monetary
The U.S. equity markets performed well for the fourth quarter, adding to an already strong year. There were three primary drivers behind the quarter’s strong returns: strong corporate earnings, continued economic growth—including the lowest unemployment level since 2000—and U.S. tax reform. The U.S. is currently experiencing the second-largest bull market in its history, and some speculators believe that the recent tax reform will only add to the run-up.
The fourth quarter followed pace with the rest of 2017, having both continued positive returns and low volatility. Growth outperformed value for the quarter, with tech stocks returning the most out of the sectors. Large-cap outperformed both small- and mid-cap stocks. Moreover, U.S. stocks experienced positive returns for every month of the year—an event that has not occurred since the late 1950s.
In continental Europe, the UK market experienced some of the strongest returns for the quarter. Overall, the rest of Europe’s returns for the quarter were unimpressive, lagging both emerging and frontier markets. The political landscape in Europe has given investors pause, and many are keen to wait and observe events as they unfold. The three primary reasons investors have taken a step back in Europe are the Catalonian independence vote in Spain, the upcoming Italian elections, and the continued uncertainty surrounding Brexit.
There were two major contributors to emerging markets performance for the quarter: Asia and technology. In particular, Chinese and Korean technology companies reported strong earnings that helped the emerging market technology sector’s astounding 60% gains in 2017.
Maintaining the pattern from earlier quarters, the dollar continued to weaken amid increasing inflationary pressures in the U.S., contributing positively to both frontier and emerging markets performance.
Strengthof the U.S. dollar in an environment of low inflation contributed to dollar-denominated emerging market (EM) debt outperforming locally denominated EM debt.
The Federal Reserve raised rates in December, hiking the federal funds rate by 25bps (basis points) in the third rate hike of 2017.
The Federal Reserve’s December rate hike is expected to cost consumers an additional $1.5 billion in credit card debt through 2018, and additional rate hikes are expected to add to these debt levels.
U.S. investment-grade corporate credit outperformed high yield by 70bps for the quarter, with spreads tightening by 8bps to 93bps amid strong demand for investment-grade bonds and elevated valuations in high yield.
Euro zonebond prices rose as the European Central Bank (ECB) announced its intention to extend its bond-buying program through September 2018. While the ECB plans to continue this stimulus, the amountof bond purchases will be reduced from €60 million to €30 million a month.
The U.S. REIT market posted positive returns for both the quarter and the year. Returns were driven by the following top-performing sectors: infrastructure (+35.4%), data centers (+20.6%), manufactured homes (+24.9%), and the industrial sector (+20.6%).
Infrastructure and data center REIT returns were driven by increased demand for mobile and cloud data streaming, whereas industrial REITs saw positive returns from continued demand growth due in part to
ecommerceadvancement and expansion.
Internationally, REITs continued to post positive returns due to favorable supply and demand dynamics.
Oil and natural gas prices rallied throughout the fourth quarter, with OPEC and Russia coming to an agreement regarding production cuts in 2018. A key area to continue to watch is rising total production in the United States, as current production is at 9.6 million barrels a day, just breaking the prior peak of 9.6 million in April 2015.
Natural gas prices spiked at year-end in response to cold weather, with the most severe jumps occurring in the Northeast, where prices increased ten-fold, illustrating the infrastructure weakness in supplying that portion of the country.
Commodities as a whole gained 4.7% during the quarter, with the all metals complex and energy sector contributing to returns. Supply and demand were favorable for all three major commodity sectors during the quarter; however, the metals complex continues to benefit the most due to recent economic growth and optimism for more in 2018.
MASTER LIMITED PARTNERSHIPS
MLP performance continued to become less correlated with the price of crude oil, but
concernof potential negative impacts from debated tax reform—which did not reach the final bill—and tax-loss harvesting at year-end, kept returns in negative territory. The late-year jump in natural gas prices benefited MLPs, but much of the cold weather hit after December 31 and did not support returns for the year.
Strategies that benefit from volatility and dispersion across and within asset classes—such as certain relative value and global macro strategies—generated muted returns for the quarter. Volatility levels continued to hover near record lows throughout the quarter.
Systematic macro strategies generated strong performance to end the year, reversing losses from the prior several quarters. The continuance of bullish trends in equities and commodities, as well as bearish momentum for the U.S.
dollarprovided a fertile trading environment for trend followers.
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All data is as of December 31, 2017 unless otherwise noted.
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