2017 proved to be an excellent year for performance across most asset classes around the globe. U.S. and international equity markets posted their strongest returns since 2013 with U.S equities gaining 21.8% (S&P 500) and international equities rising by 25.0% (MSCI EAFE Index). In the context of a relatively low interest rate environment, bonds also performed well with U.S. fixed income rising by 2.0%-3.5%, depending on the index.
Perhaps most surprising in 2017 was the incredibly low volatility experienced in U.S. equities. At no point during the year did U.S. stocks suffer even a 3% decline. Typically, the S&P 500 averages three separate 5% corrections and one 10% correction annually. How could this have occurred given constant political battering, three separate Federal Funds rate increases, debates on healthcare and tax policy, increasing acts of terrorism, a defiant North Korea and several large natural disasters? The straightforward answer is that what markets really care about are corporate earnings and jobs.
As highlighted in this very Outlook letter early in 2017, corporate earnings growth was quite strong in 2017. In fact, while final figures are still to be reported, it looks as if the S&P 500 produced earnings growth of 11% during the year. In addition, the economy continued to add new jobs in each month of 2017, extending the streak of rising employment to an impressive 87 consecutive months. These two factors combined with improving global growth were largely responsible for U.S. equity market performance in 2017.
As mentioned, international equities posted very strong returns and modestly outperformed U.S. equities for only the second time this decade. Despite some disruptions (North Korea, Brexit and Catalonia to name a few), international equities rightfully focused on improving economies.
During the year, U.S. economic growth has continued to chug along at a solid pace and has recently accelerated to 3.2% as of the 3rd quarter of 2017. At the same time, inflation has remained under control with the most recent Core Consumer Price Index at a modest 1.7%. Improving economic growth coupled with the goal of removing extraordinary monetary policy stimulus stemming from the Financial Crisis prompted the Federal Reserve to raise the Fed Funds rate three times (0.75%) in 2017 to its current target of 1.25%-1.50%. That said, when compared to the beginning of the year, longer-term interest rates as measured by the 10-year U.S. Treasury bond yield barely budged, declining by a grand total of 4 basis points (0.04%) to 2.41%. Subdued inflation and a low global bond yield environment where Japanese 10-year bonds yield 0.05% and German 10-year bonds yield 0.42% have kept a lid on U.S. yields.
One area of caution that has emerged is the shape of the yield curve. That is to say, the difference between yields on a 10-year U.S. Treasury bond and a 2-year U.S. Treasury bond. Typically, a 10-year bond provides a higher interest rate (or yield) than does a 2-year bond because investors demand better rates of return the longer the timeframe they invest. Every once in a while, that relationship goes awry and 2-year bond yields rise above 10-year bond yields. This is called inversion. Unfortunately, a yield curve inversion tends to be a powerful indicator of upcoming recession. We have lived through three recessions over the past 30 years. A few quarters before each of the three recessions the yield curve inverted. Perhaps just as important, with one miniscule exception, the yield curve has offered no false positives. In other words, each time that the yield curve has inverted over the last three decades, a recession has followed.
At the beginning of 2017, the difference (or spread) between the 10-year U.S. Treasury bond yield and the 2-year U.S. Treasury bond yield was 127 basis points (1.27%), that spread declined to 53 basis points (0.53%) by the end of 2017. As described above, the tightening of the spread has been related to the 0.75% increase in the Federal Funds rate impacting 2-year bond yields while 10-year yields barely budged. At this point, the yield curve has not inverted and is therefore not yet a red flag. We will monitor this important metric in 2018 and will discuss the yield curve further in our 2018 Market Outlook.
To summarize, 2017 will go down as a splendid year for asset and portfolio returns. Performance was quite strong across the board with remarkably low volatility despite the usual myriad distractions. In terms of where markets may be heading, please see our 2018 Market Outlook.