With 2017 largely in the rear-view mirror, we can say that it has been a year of history in the making, putting it in the category of the mid-1960s and mid-1990s. We continue to see “all-time” highs in equity markets (not unusual in bull markets), and we remain at or near historical lows for the volatility market. In November, the S&P 500 Index broke its previous record for the number of days without a 3% pull-back (over one or multiple days). As for low volatility in terms of pullbacks, 2017 ranks with 1995, 1965, and 1964, according to brokerage firm LPL.
These are very impressive results but also very unexpected. If you would have asked any market expert at the beginning of the year, few if any would have predicted this kind of market performance. While the historical highs and lows are noteworthy, there are other developments which were widely “expected” at the beginning of the year. Global economic growth was in an upswing at the beginning of the year and was expected to continue through 2017. Confidence in Europe was confirmed as national elections rejected xenophobic candidates in favor of largely pro-European leaders. Brexit talks have proceeded in an up and down fashion, with both sides making declarations that contradict each other, and the thorniest issues being pushed off into the future. Some market observers feared that US trade policy under the Trump administration might turn protectionist and disrupt global growth, while others expected a variety of pro-growth policies to boost growth. The closest we have come to seeing any major economic policy enacted is a Republic-supported plan to cut taxes, which may be passed in some form prior to this note reaching your hands. With a deal so close, the market is pricing in the positive impact on stock values, since large corporations would be among the biggest beneficiaries of this plan. With all these things considered, we still believe that equity markets are favorable, that bond markets are stable, and that any correction would represent more of a buying opportunity than much of a larger concern.
One issue that was thought to be a potential concern for markets was whether President Trump would reappoint Janet Yellen as the Federal Reserve’s Chairwoman. He chose to replace her with a colleague of hers from the Federal Reserve’s Board of Governors, Jerome “Jay” Powell. In the end, this announcement did not cause markets too much concern, as Powell has voted in agreement with Chair Yellen since his joining the Board in 2012 and is expected to follow the path she has laid out. As a former investment banker, he has supported the idea of giving banks more freedom in their investment decisions.
As we think about the future, one place to look is interest rates, especially the difference between 2-year lending rates and 10-year lending rates. This difference between short-term rates and longer-term rates is called a “yield curve”, because interest rates (or yields) tend to rise the farther into the future one looks, creating an upward rising curve. Looking at this curve can give us a glimpse of what investors in aggregate are expecting. And interestingly, at the time of this writing the curve is fairly flat, with the difference between the 2-year and 10-year US government bond yield being a mere 0.53%. This suggests that investors don’t expect much growth or inflation over the next 10 years. The problem with this measure currently is that central banks around the globe have “muddied the waters” by artificially pushing down long term rates. With that caveat in mind, we still pay attention to the yield curve, especially looking for an “inverted” curve where short-term rates are higher than long-term rates, making the curve “fall” instead of rise. We believe it would take some aggressive and very unexpected moves from the Fed and from inflation for the yield curve to invert. It’s hard to see something like that happening any time soon.
We look toward the remainder of the year with optimism. It will be interesting to see how the last month of 2017 plays out from the perspective of volatility. As we stated previously, volatility is at an historical low. Is there enough “stuff” out there to cause volatility to pick up and the markets to correct? We are not sure. We don’t necessarily believe that increases in market volatility will be a bad thing. It just may be later in January that conditions for corrections and volatility become more apparent