2017 was a strong year for global stock markets, and our portfolios were able to follow this trend nicely. Since 1994, the U.S. stock market had the eighth best year with a gain of 21.2%. Our benchmark, a Global 60/40 Stock/Bond portfolio, rose 14.5%. Our Momentum portfolios grew between 10.2% (Conservative) to 20.4% (Aggressive), tracking the overall bull market very well.
Our portfolios are based on stocks, bonds, commodities and real estate but actively allocate to the strongest markets. In 2017, stocks, in particular Emerging Markets and Japan, were the main performance drivers of our multi-asset momentum portfolios. Other asset classes hardly added meaningful returns.
Also in terms of risk, or Standard Deviation, our portfolios were in line with the overall market. Our portfolios’ volatility ranged from 5.4% to 7.5%. Overall, the stock market experienced unusually low volatility. As a consequence, our portfolios had only two slightly negative months. The U.S. stock market finished the first time a year without any monthly negative return — 12 winning months in a row.
As we wrote in our last two recaps (here and here), the market seems to be in the later stage of its current economic cycle. Interest rates and valuation have been our main risk factors for today’s market. Valuations in the stock market are already very high and the Fed started to move off its ultra-low interest policy. How will this affect 2018?
Historically, the average Bull Market lasted 9.0 years, almost exactly the length of the current one. After the last crisis, it took $11 trillion in central bank stimulus to fuel the booming stock market, which is driven by resurgent economic growth and strong corporate profits. Finally, growth is picking up in a synchronized way across multiple regions. In the U.S., one of the largest catalysts was the tax cuts President Trump signed into law. The tax cuts will save corporate America billions over time. The new law also provides incentives that encourage companies to return foreign profits held overseas. According to Moody’s, offshore cash totals a record $1.4 trillion.
With high employment, strong growth momentum, stimulating fiscal policy, and rising asset prices, the bull market appears to be stronger than ever. So what could possibly go wrong? Here are our main concerns for 2018:
1. High Asset Valuations
2. Rising Interest Rates (The end of the grand monetary experiment)
3. Perpetually Increasing Debt
4. Bullish Sentiment
5. Rising Social Inequality
1. High Asset Valuations
Like last year, we worry about high asset valuations. Of course, assets can stay overvalued longer than anybody would expect — sometimes even for years. Nevertheless, high valuations usually appear towards the end of a cycle. Shiller CAPE is currently around 32.6, 94% higher than the historical mean of 16.8. However, CAPE is not a short-term indicator. As Shiller explains:
“The CAPE ratio has successfully explained about a third of the variation in real 10-year stock market returns in United States history since 1881”.
Hence, the current level of CAPE suggests a dim outlook for the U.S. stock market over the next 10 years or so. Prices are not only high in the U.S. P/E multiples across developed equity markets are high as well, with only some exceptions. High prices are not only a phenomenon in the stock market. Other asset classes, such as bonds and real estate, are also hitting new highs. In 2017, the S&P/Case-Shiller U.S. National Home Price Index surpassed its last high from 2007. Again, this does not mean that prices have to revert immediately. In the end, it is about what investors believe is “right”. However, there are two takeaways from this: 1) investors should adjust their long-term return expectations and 2) high valuations make the market more vulnerable when the sentiment starts changing.
2. Rising Interest Rates (or the end of the grand monetary experiment)
One of the most important and reliable indicators for the direction of the market is the interest rate and the monetary policy of a country. Globally, rates have been at record-lows since the last financial crisis. As Austrian Business Cycle Theory explains, a period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. At the beginning of a cycle, low interest rates tend to stimulate borrowing from the banking system — what started in 2008/9. This leads to an increase in capital spending funded by newly issued bank credit. However, economic booms based on artificially low interest rates result in widespread malinvestment. A recession occurs when the credit creation has run its course. Then the money supply contracts causing a curative recession. Eventually this allows resources to be reallocated back to sustainable projects (a timely and painful process). In addition to massive malinvestments, artificially low interest rates also lead to inflation and redistribution of income from saver to borrowers. This does not necessarily impact the market in the short- to mid-run but can have important, long-run implications for an economy.
During the financial crisis, central banks aggressively lowered interest rates and accumulated more than $11 trillion in government, agency and corporate bonds. Nine years later, central banks start to reduce their balance sheets. The big 4 central banks now own 20% to 40% of their respective country’s government bonds. While the end of the grand monetary experiment is near, 2018 could still be a year of net central bank accumulation. When the runoff begins, it is expected to occur over a prolonged period of time. J.P. Morgan summarized nicely, how they believe the runoff could look like. The charts below show:
[a] rolling 12-month central bank flows and how 2018 is still an accumulation year;
[b] a breakdown of flows by central bank, and how only the Fed is projected to be in runoff mode in 2019; and
[c] how prolonged the runoff is expected to be, with central bank balance sheets projected to still be larger in 2022 than in 2017.
In a Reuters poll, Wall Street’s banks see the Fed raising borrowing costs three times in 2018. Is this already the contracting money supply the Austrian Business Cycle Theory refers to? The question is not if but when. Currently the yield curve is still upward sloping and not inverting. While central banks are working on a “soft landing”, wage inflation could eventually force the Fed and ECB to eliminate negative real policy rates, creating a modest headwind for growth and valuations by 2019.
3. Perpetually Increasing Debt
Similar to high asset valuations, the fear of continued fiscal deficits and perpetually increasing debt has been around but ignored by the market for years. Household debt and debt service have both declined since 2008 (from 130% of disposable income to 107%). Corporate debt is at an all-time high relative to cash flow and equity. What is more surprising and concerning: Even before the passage of a tax bill, the U.S. budget deficit has been rising. This is odd for a time in the cycle when it would typically be shrinking given improving growth and more economic activity. How will the U.S. budget deficit look like during a recession? For the market, this means that the safety net of fiscal stimulation during the next downturn is shrinking since a government with massive debts can spend less in the future.
4. Bullish Sentiment
Listening to financial analysts and investors around, most of them seem to be aligned in their opinion that we are in the last innings of the bull market. The general opinion appears that growth could slow down in 2018. However, there is no real alternative to stocks, which forces everybody to agree that the rally continues. Sentiment data confirm that unified view. Compared to their history, most sentiment indicators, including volatility and optimism, are at the high end of their historical ranges. In 2017, the VIX fell to a record-low below 10. It has been ranging lower than its lows in 1994/5 and 2006/7. For a lot of analysts this means that good news is already priced in and may constrain the upside to high single digits. Let us not forget: When everybody agrees, there is suddenly room for grey or black swans.
5. Rising Social Inequality and Populism
High valuations, bullish sentiment and potentially further rising interest rates are one large concern. However, rising social inequality and therefore the rise of populism is a much larger concern, which could negatively influence the markets. According to Ray Dalio, founder of Bridgewater Associates, populism is at its highest level since the late 1930s. For Dalio, populism may even be a bigger deal than monetary and fiscal policy. To illustrate this point, Dalio created the Developed World Populism Index, which measures the vote of share of populist/ anti-establishment parties. The index increased dramatically during the last years and is now at the highest level since the 1930s.
But what happened? Aren’t we in the ninth year of a bull market? Why is there such a large disconnect between the real and financial worlds? The total market capitalization of all global stocks has rocketed to $80 trillion and is heading steadily toward $100 trillion worldwide.
However, after almost nine years of economic growth, nearly half U.S. men ages 18–34 live with their parents — the highest level since the Great Depression. 78% of the U.S. population lives paycheck to paycheck, with essentially zero savings. The richest 10% of America owns 75% of the nation’s wealth, also the highest level since the 1930s. In contrast to this, for most Americans, real wages have been stagnant or falling for decades. It seems to be a paradox.
The current situation has many social and political implementations. Often, free markets and capitalism are blamed for rising inequality. The rich are getting richer while poor are getting poorer. Many voices demand governments to step in and fix the problem with more taxes, regulations and subsidies. Growing pain is driving the anger, the radical politics, and the growing racism in our society. Dalio’s Developed World Populism Index is one way to measure the current situation. However, the fundamental problem is that extreme inequality in a society is created by the government and its monetary policy, not by the free market. About one year ago, Peter Oppenheimer, chief global equity strategist at Goldman Sachs, showed a chart that illustrates how this disconnect between the real and financial worlds has worked. The chart is an exceptional illustration of disinflation in the real world and inflation in asset prices — which is nothing else than a redistribution of income.
Since the business cycle is a monetary phenomenon, inflation in asset prices is driven by the policy of the central banks. Although the goal was to stabilize the economy after the financial crisis in 2007/8, unintended consequences of low interest combined with other factors like globalization, created a massive redistribution of income towards the richest 10%. Asset prices have been soaring while prices in the real economy — most importantly wages — have had a hard time keeping up.
In addition to stagnating wages, millions of people cannot feel the bull market in stocks because they have little to no money in the market or a job, which is linked to rising asset prices. In the U.S., just 18.7% of taxpayers own stocks directly. Roughly half of Americans participate in the market through an employee-sponsored retirement plan, according to a Pew analysis of Census Bureau data. That gap is another contributor to record-high wealth inequality in America.
Even after nine years of growth, the overall economic situation remains solid. Global stock markets are reaching new highs while high asset valuations and increasing debt levels seem to be ignored by the market. In the U.S., the Fed is working on a soft landing. If there is no surprise of a sudden increase in inflation (e.g. triggered by rising wages), the Fed is expected to act less aggressive. As long as the yield curve is not inverted, the party can continue. Other central banks, like the ECB, seem to be trapped to continue their stimulus even longer. However, the sentiment is quite bullish. The question is how much good news has already been priced in? Consensus in the financial markets often leads to negative surprises. A large concern is the rise in inequality and its political implications. More regulations, transfer payments and government interventions under the umbrella of ‘social justice’ could seriously harm the power of free markets in the long run. For investors, there are not many alternatives to global stocks. However, when the tide changes, investors could benefit from protective portfolio insurances like real assets and precious metals. Until then, we ride the last waves of the global bull market. Party on!