Market Commentary: 4Q 2017

The bull market continued for another year. The summary below shows that just about everything gained in 2017, causing market indices to repeatedly soar to new heights. Larger-cap U.S. stocks gained 6.6% for the quarter and ended the year with a 21.7% total return. This was the ninth consecutive year of positive returns for the index—tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis. Foreign stock returns were even stronger than the U.S. market, with developed international markets gaining 25% and emerging market stocks up 37.3% for the year.

 The broad driver of the market’s rise for the year was rebounding corporate earnings growth. Ned Davis Research analysis shows that, over the last 12 months, the United States saw earnings grow by 14%, Europe saw earnings grow by 25% and the U.K. local-currency earnings grew by 35%. Support for this jump in earnings resulted from solid economic data, synchronized global growth, modest inflation, and accommodative monetary policy. U.S. stocks got an additional catalyst in the fourth quarter with the passage of the Republican tax plan.

 Here are the broad index returns through the Fourth Quarter of 2017*:

U.S. Large Cap Stocks 21.7% Emerging Market Stocks 37.3%
U.S. Small Cap Stocks 14.7% Commodities 1.7%
U.S. Real Estate 5.1% U.S. Aggregate Bonds 3.5%
Overseas Stocks 25.0% International Bonds 10.5%

Economic Outlook

As noted above, U.S. stocks were up for the year, driven in part by expectations of a historic corporate tax cut. It is likely that much of the benefit of tax decreases is already priced in based on consensus earnings estimates for the S&P 500. So, what do lower corporate tax rates mean for long-term earnings assumptions for the United States? The answer is not straightforward, as there are many variables to consider.

Politically, the tax cut was designed to provide an incentive for companies to hire and spend more. Some companies will increase hiring and boost pay as a token gesture but ultimately the pressure from shareholders will lead many companies to return much of the excess cash flow from tax savings to shareholders or capital owners, not employees.

U.S. Corporate earnings will probably see a boost in the short term (consensus seems to be around 10% in aggregate) with more benefit provided to smaller companies. Over the long term, however, the incremental margin benefit from lower taxes will likely be “competed” away. In the new tax plan, there’s an additional tax incentive for companies to pursue capital expenditures. This could increase economic activity and boost overall profits but may also result in an increase in inflation.

 Political uncertainties notwithstanding, Europe continues its economic recovery. It is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20% in 2017. Emerging markets are experiencing a rebound in corporate earnings growth, and, importantly, are becoming less dependent on commodity-oriented sectors as technology and consumer sectors have assumed greater importance. Both overseas stocks and emerging market stocks appear poised to do well in the coming months.