2017 Annual Market Review
Economic Overview: Solid economic data gave markets little to be concerned about
As we reflect on the year gone by, 2017 proved to be another year of surprisingly strong investment returns across the board. The last quarter provided positive returns and equity markets are now in their ninth year of a bull market. No major risks materialised in 2017, so market volatility continued to be low throughout the year.
Economically, the year can generally be characterised by good GDP growth and modest inflation in most places. The US economy keeps improving, now at a 2.3% annual GDP growth rate. Inflation still hovers at the 2% mark.
The biggest news in the final quarter came towards year end as new US tax laws were passed. From 1 January 2018, US corporate tax decreased substantially from 35% to 21%. While that change may improve company profits, it may possibly also increase the US deficit substantially and push the US debt burden to higher levels. Federal Reserve Chair Janet Yellen delivered another quarter- point interest rate increase, raising the Fed funds target up to 1.5% in December; she will be handing over the US central bank baton to Jay Powell in February.
In Europe, German elections, Brexit negotiations and the Catalan independence referendum passed without causing market turmoil. The Bank of England (BoE) decided in early November to raise interest rates to 0.5%, the first time we have seen an increase in over a decade. Inflation pressures persist, as the latest reading is at 3.1%, above the BoE target. Annual GDP growth slid to 1.7% from 2.0% last year, the weakest reading in nearly 5 years.
Across the channel, things look rosier with annual GDP growth of 2.6% for the Eurozone and inflation of just 1.8%. Interest rates remain at the all-time low.
The Japanese economy is growing nicely at an annual rate of 2.1% for the GDP. Inflation at 0.6% is something positive from a Japanese point of few, given the Bank of Japan (BoJ) has been fighting to get it into positive territory. Unemployment is now down to 2.7%, the lowest level since 1993. Still, the BoJ is maintaining its 10-year bond yield target around zero.
Over in China, President Xi Jinping was re-elected for another five-year term at the end of October. Annual GDP growth has been relatively stable, just below 7%, which is within the range targeted in the five-year plan that was adopted in 2016 by the National People’s Congress. Inflation is also under control at just below 2%. The benchmark lending rate remains at 4.35%, the lowest level in over 20 years.
Fixed Income: Strong returns as investors continue hunt for yield
It has been, perhaps surprisingly forsome, a good calendar year across the fixed income spectrum. Emerging market bond returns narrowly beat returns from global high yield bonds with a 1.2% rally in the fourth quarter: The JPM EMBI index in USD returned 10.26% for the year, the ICE BoAML Global High Yield Index 10.20%. More risk averse investors also had a reason to smile as US investment grade credit bonds (Markit iBoxx USD Liquid Investment Grade index) achieved a return of 7.35% in 2017. Even investors in global government bonds (CITI WGBI index), with currency risk hedged, saw their assets increase by 2.1%.
Yield levels are still low and unattractive for investors, if they are sticking with only developed market government bonds. US investors were rewarded with 2.4%, if they bought 10-year bonds at the end of the year. For 2 years, it is only 1.9%. Still, investors in other countries can only dream of those yields. UK investors receive a yield of 1.2% for 10-year gilts, Euro investors a meagre 0.5% in comparison.
Currencies: The US dollar rally has reversed
After much strength last year, the US dollar weakened versus most other currencies, developed as well as emerging. It depreciated 3.4% against the Yen, but losses were higher against the Pound and the Euro, with 8.7% and 12.2% respectively.
Equity: Robust rallies as liquidity floods markets
Looking across to the equity side, the return picture looks equally bright. All markets were up in the fourth quarter and returns for the full year reached double digit levels. In local currency terms, most broad local stock markets returned between 20% and 30%. Including currency impact, returns looked even better for US investors. In aggregate, the MSCI All Country World Index (ACWI) rose by 19.8% for the year, or 24% in USD terms.
Commodities and REITs: Hints of inflation lift sector
REITs also produced a positive return in 2017. The S&P Global REIT index returned 8.6% for the year, boosted by a gain of 3.3% in the final quarter. Commodities also ended up in positive territory: The broad Bloomberg Commodity index gained 1.7% in 2017. The biggest driver was the gold price. It rose 12.7% over the last 12 months.
Emerging Markets (EM): Patience paid off
It has not always been easy to be an emerging markets investor in recent years. But 2017 was a whopper year. EM bond markets had another year in the double digits, and EM equity markets crossed the 30% mark. Even the currency environment was supportive, boosting returns further for both camps.
Risk Premia: Bond risk premia continue to deliver but equity style premia suffer
In short: Taking risk was rewarded across asset classes, causing most risk premia to be positive again.
As cash has not returned even 1% for US investors, adding just a bit of duration risk increased results by 0.3%. In times of loose monetary policy, the duration premium was positive in every one of the last five years. The same astonishing consistency holds true for the credit premium. Over the last five years, investors were rewarded for taking this additional risk versus government bonds by an extra annual return of 1.2% per annum. Taking on currency risk and extending the universe into emerging market bonds, considerably increases return volatility. But again, this decision was rewarded this year, as the global fixed income risk premium in USD terms finished an astonishing 10.6% above government bonds.
If we turn our attention to asset classes that traditionally do well in periods of high inflation, the picture has been less consistent and positive over the recent years of low inflation. But 2017 again has delivered improvements. Both commodities and REITs have finished in positive territory, beating inflation by 1.7% and 8.6%, respectively.
Fund manager performance – on average bad, but not for MASECO’s client
We had a look at the reports produced by S&P Dow Jones Indices again that are produced to share the results of their methodology to analyse the performance of active managers based in the US and Europe. Depending on the market cap category, only 55% to 60% of US-based managers outperformed their respective domestic S&P index for the most recent one-year period. Still, those recent positive results have not improved the longer term picture a lot: 82% to 94% of managers underperformed over the most recent five-year period. For those who hope that the picture looks any prettier for active funds covering international equities, the facts are equally disappointing.
Percentage of International Equity Funds Outperformed by Benchmarks
Did fixed income managers save the day for active management? In some areas like municipals results are positive over five years, but moving out to 10 years, consistently across all areas of fixed income more managers underperform than outperform.
Percentage of Fixed Income Funds Outperformed by Benchmarks
I spare the audience additional details from the SPIVA report for European managers. In summary, the active fund management community in Europe cannot produce better results than their US peers.
When we try to understand how the managers that we picked for our clients compare to one another, we focus on active managers only. We include funds that are still in our core USD, EUR or GBP model portfolios at the end of 2017 and have been in those same model portfolio a year ago or since inception of our firm.
Our clientele was invested across 30 different active funds (not double-counting different share classes), and 16 – or 53% – have outperformed. However, from the 20 funds that have been in model portfolios from day one at MASECO, 16 outperformed. In other words, fund selection over the longest period we can assess has been a value additive proposition 75% of the time. I am curious to see next year’s one-year figures given we have added a few new strategies in 2017.
Source of data:
Morningstar for index data, FT.com for foreign exchange and yield data, Trading Economics for economic data, all as of 31st December 2017; SPIVA US and Europe Mid-Year 2017 Scorecards
Risk Warnings and Important Information
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