Q1 2018: Goldilocks Need Not Fear the Bear in 2018...But Her Respite Will Be More Fitful

2017 In Review

2017 was nearly perfect for risk assets. Buoyant global growth, political stability in Europe, strong earnings momentum, a weak US dollar and a steady policy makers’ hands in China fueled risk assets to extraordinary levels. Most asset classes performed well, with many delivering double-digit returns (see CHART 1). Because the US dollar depreciated by over 10% during the year, non-US investments were especially attractive for US investors.

The events many worried about in early 2017 – including the election of a far-right government in France and aggressive US trade policy – didn’t materialize. The MSCI ACWI closed at record highs 61 times, and the 30-day realized volatility of the S& 500 index hit its lowest level since the early 1960s. Global equities were also boosted by falling inflation and basically flat long-term bond yields even as the economy improved while cryptocurrencies posted huge returns. Finally, 2017 was also a year of extraordinary divergences. In the U.S., the top performing sector, technology (up 38%), outperformed the worst-performing sectors, energy and telecom (down around 5%) by more than 43 percentage points. For emerging markets equities, the divergence was even more start. Four Chinese technology stocks – Alibbab, Baidu, JD.com and Tencent – outperformed the MSCI Emerging Markets index by 59%, 5%, 25%, and 75%, respectively and collectively accounted for 19% of index’s performance. For a report card on the performance of our 2017 calls, please see TABLE 1 on Pages 8-11.

For the seasoned investor, 2017’s extraordinary equity returns should give rise to concerns that positive economic news and earnings have already been discounted therefore are ripe for mean reversion. In the U.S., for example, the economic surprise index rose to a six year high during the last week of 2017 and global indices rose by 40%. According to CFRA, in years with above average new highs and below average volatility, the S&P rose the following year only 55% of the time, with an average gain of 3.1%. Conversely, in years where the dispersion between the best and worst performing sectors was high (such as 2017), the S&P 500 was up only 57% of the time in following year, with an average gain of 1.9%. Therefore, it would be reasonable to ask what additional positive economic or earnings surprises await us in 2018 that have not already been discounted? Relatedly, what risks are being underappreciated as the market plumbs to new heights? On PAGE 4 of this report, we discuss four such risks that, in our opinion, bear close monitoring.