- Despite the pickup in domestic economic activity, rising short-term rates created one of the flattest yield curves since the financial crisis.
- Many of the discretionary and financial stocks were beneficiaries of tax reform, while retailers were helped by a strong holiday season.
- Expectations for fast-growing and widely owned technology companies are sky high; expensive valuations could result in material downside from small disappointments.
Market Overview and Outlook
The S&P 500 Index climbed 6.6% during the fourth quarter of 2017 on the back of robust economic activity and quick passage of tax reform, bringing full-year returns to 21.8%. Perhaps more noteworthy is that 2017 was the first year in history where the S&P 500 Index generated positive returns in every month. The U.S. 10-year Treasury ended 2017 virtually unchanged from 2016 at roughly 2.4% despite considerable intra-year volatility with a peak north of 2.6% in March and a trough of almost 2.0% in September. Despite the pickup in domestic economic activity, rising short-term rates created one of the flattest yield curves since the financial crisis. We continue to closely monitor the shape of the yield curve, as an inverted curve (where short-term interest rates exceed long-term) has historically led to a recession within relatively short order. During 2017 the U.S. dollar weakened relative to the euro (to $1.20 from $1.05), while oil prices rose from about $54 to $60 — not surprising given that the dollar and commodities often move inversely. In general, commodity markets posted a strong fourth quarter, with copper prices hitting a cycle high in December.
The best-performing sectors of the market in the fourth quarter were consumer discretionary, technology and financials, although every sector generated positive total returns. Many of the discretionary and financial stocks were beneficiaries of tax reform, while retailers were helped by a strong holiday season. Technology stocks, especially those with “cloud” exposure, again showed powerful earnings-per-share growth. Utilities, health care and real estate lagged the market. The yield-friendly utility and real estate sectors were hurt by the climb in long-term interest rates from late September as well as uncertainty stemming from tax reform. Health care continued to suffer from relatively weak earnings growth, the result of crowded drug categories and pricing pressure. During December, market leadership shifted — albeit slightly — away from the high-flying tech companies to cyclicals and year-to-date laggards such as energy.
U.S. economic activity was consistently strong in the fourth quarter, with GDP growth likely to exceed 3% and unemployment sustainable in the low 4% range. We believe current levels of employment point to an increase in wage inflation in 2018. The four-week moving average of jobless claims was 238,000 in December, a historic low. Many employee bonus packages and wage increases were announced by large companies after the passage of tax reform in late December — Bank of America, PNC Financial, BB&T, Comcast, AT&T, Fifth Third Bank, Wells Fargo and Boeing, just to name a few.
"The U.S. consumer is doing well, with confidence recently the highest since 2000."
The U.S. consumer is doing well, with confidence of 122 in December (and of almost 130 in November, the highest since 2000) and housing showing steady gains throughout the year. November single-family housing starts and permits were up 10% to just under 1.3 million. New home sales also climbed 10% to a 10-year high, and housing appears poised for further gains in 2018. After a mid-year dip, auto sales rebounded after the Texas and Florida hurricanes and held ground near 18 million SAAR despite the fading of storm-induced replacement demand.
While tax reform has some very positive aspects, there are also elements that reflect weaknesses within the U.S. political system. The reduction in the corporate tax rate from the third highest in the world to a competitive 21% and the implementation of a territorial system will lower economic incentives to move U.S. production and intellectual property offshore. Also, lowering the amount of interest expense that corporations can deduct should result in a healthier U.S. economy through lower usage of leverage. That said, tax reform is estimated to increase the budget deficit by $150 billion per annum. Also, the bill showed that Congress remains beholden to special interests by doing almost nothing to eliminate corporate givebacks (e.g., sugar subsidies and carried interest) and it was highly partisan in eliminating state and local tax deductions. By combining corporate and individual tax changes in one bill, the Republican party leaves itself open to claims that corporate tax cuts were funded by individual increases.
Utility securities fell sharply in December, hurt by the post-September climb in long-term interest rates and the California wildfires. That said, absolute valuations remain elevated and fundamentals are mixed. Energy infrastructure companies, which also performed poorly in the second half of 2017 despite improving fundamentals (higher oil prices and oil/gas production), are a more attractive asset class in our opinion. Health care is a mixed bag, as sub-sectors with strong fundamentals — HMOs, devices and tools — carry rich valuations, while cheaper large cap biotech and pharmaceutical firms appear to have subpar growth prospects. Expectations for fast-growing technology companies are sky high and the stocks are widely owned; expensive valuations could result in material downside from small disappointments. The oil sector is intriguing after a year of significant underperformance despite rising commodity prices. President Trump, Senate Majority Leader McConnell and many Democrats have expressed interest in passing an infrastructure bill in 2018. The cement and aggregates companies, which lagged in 2017, offer attractive upside should the potential for legislation gain traction.
Our outlook has remained relatively consistent over the past 18 months: we are enthusiastic about fundamentals but concerned about risk. The U.S. economy is strong and recession risk appears low, with the Leading Economic Index (LEI) hitting a peak in November (historically, recessions come no sooner than 18 months after a LEI peak). From a technical standpoint, the market also looks healthy, with excellent breadth and tight BAA credit spreads. There is a whiff of speculative fever in the air, as evidenced by the dramatic move in Bitcoin prices. Valuation remains the greatest risk we see in today’s market. Our strategy of owning large, high-quality stocks is well-suited for today’s market, offering good upside participation if the economy remains robust and preserving capital if unexpected risks occur.
The ClearBridge Appreciation Strategy had a positive return during the fourth quarter of 2017, outperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in 11 of the sectors in which it was invested during the fourth quarter (out of 11 sectors total). The main contributors to the Strategy’s performance were the information technology (IT), financials, and consumer discretionary sectors.
In relative terms, the Strategy outperformed its benchmark impacted primarily by stock selection. Stock selection in the IT sector contributed the most to relative performance. An underweight to the utilities sector also added to relative performance. Conversely, the Strategy’s cash position detracted from relative performance during the quarter.
On an individual stock basis, the biggest contributors to absolute returns during the fourth quarter included positions in Microsoft, Home Depot, JPMorgan Chase, Wal-Mart and UnitedHealth Group. The greatest detractors from absolute returns were positions in Merck, Celgene, CVS, Amgen and Regeneron Pharmaceuticals.
During the quarter, we established a position in Vulcan Materials in the materials sector and Lennar in the consumer discretionary sector. The Strategy closed positions in Intel in the IT sector, BioMarin Pharmaceutical and Regeneron Pharmaceuticals in the health care sector, Toll Brothers in the consumer discretionary sector, General Electric in the industrials sector and Brighthouse Financial in the financials sector, a small holding inherited following its spin-off from existing holding MetLife.