U.S. equities markets have rallied to very strong gains in 2017. The 20.5 percent total return (including dividends) of the S&P 500 index through November was notable in that not only has the index delivered positive total return in each quarter of the year, but also in each of the first 11 months. Should the S&P 500 hold or extend its gains through December, 2017 will represent the strongest year for equities since 2013, and the ninth consecutive year of gains since the large decline in 2008.
In our view, one of the big surprises of the 2017 investment year has been the strength of the rally in U.S. equities. To begin the year, very few market forecasts anticipated even double-digit S&P 500 returns, let alone returns exceeding 20 percent! Our initial 2017 forecast published in December of last year was for a 7 percent total return. We attribute the year’s strong gains to four powerful factors that have driven strong investor confidence and demand for equities. Those factors are 1) stronger than expected earnings growth, 2) U.S. GDP growth that has accelerated from a lackluster 2016, 3) improving global economic activity, and 4) continued low interest rates compared to historical levels. As 2017 approaches year-end, each of those factors remains firmly intact, and should provide support for continued investor confidence to begin 2018.
Looking back at the year we have identified nine investment surprises that went against consensus. In addition, as we formulate our 2018 forecasts, we have listed several potential surprises for 2018.
2017 Surprises
1. Equity markets rallied globally. This was not just a U.S. rally as major markets across Europe, emerging markets, Japan, China and Latin America all have increased in double-digits.
2. Market volatility has been historically low. In 2017, the largest peak-to-trough pullback in the S&P 500 was 1.7 percent in mid-August. Since the beginning of 2009, there have been 10 periods of market pull-backs of at least 5.5 percent (more than one per year) with an average decline of 10.8 percent. Many investors expected higher volatility after the election of President Trump.
3. Growth stocks have far outpaced value stocks in 2017. 2017 has been the strongest year for growth vs. value since 2009. This surprised many investors as value stocks ended 2016 on a roll after surging following the November Presidential election.
4. Technology stocks have led the market rally. The tech sector has far outpaced other industry groups while also beating the market the past three years. In 2017 through early December, the S&P 500 Technology sector gained 37.0 percent, well above the #2 sector’s (Health Care) 20.9 percent gain.
5. Through November, no major legislation has been passed by the U.S. Congress. Despite gaining control of both the Federal Government’s Legislative and Executive branches in November 2016, Republicans have been unsuccessful agreeing to major legislation. After years of Washington gridlock, hopes were high. Hopes remain high for tax reform before year-end.
6. Geopolitical tensions, natural disasters and terror attacks have not derailed investor confidence.
7. Oil prices have trended higher in 2017 for the second consecutive year. While oil prices have been volatile in 2017, West Texas (WTI) oil, trading at $58 per barrel is on track for a 7 percent increase in 2017, following a 45 percent gain in 2016; this despite a much larger than expected increase in U.S. production.
8. The U.S. dollar has declined in value in 2017. After steady appreciation since mid-2014, the U.S. Dollar Index (DXY) has declined 9 percent this year. This was unexpected given rising interest rate expectations; but as a result has made U.S. exports more affordable abroad.
9. The yield curve has flattened. The spread between the 2-year and 10-year U.S. Treasury yields has narrowed to multi-year lows. In early December, the spread of 50 basis points compared to 122 basis points at the end of 2016. Long-term rates are lower in December despite stronger than expected economic growth in the U.S.
2018 Predictions
1. The S&P 500 will experience its first 10 percent correction since February 2016. While it is difficult to predict the timing of a pullback, investors should expect a period of market weakness in 2018. Weakness could be sparked by profit taking, disappointing earnings growth, or Fed tightening. Despite expectations for a pullback, the bull market, in our view, remains intact.
2. Strong earnings and GDP growth will drive the S&P 500 index above 2,800. S&P 500 earnings growth has exceeded expectations in each quarter in 2017, and GDP growth has been above 3 percent since Q1. With tax reform on the cusp of becoming law, there remains upside to both earnings estimates and GDP forecasts in 2018.
3. Value stocks will outperform growth stocks as the financials and energy sectors rally. Financials and energy are the two largest sector components of the Russell 1000 index, and have lagged the broader market in 2017. The prospect for reduced regulation and global expansion should help both sectors in 2018, leading the value index higher.
4. The GOP will pass tax reform, giving President Trump an important policy victory. This will build political support for an infrastructure spending bill by mid-year. The tax reform bill will represent the first major legislation passed by President Trump and a GOP-led congress. This will give the President some momentum to begin 2018, which will lead to an early 2018 introduction of an infrastructure bill that could be passed by congress by the middle of the year.
5. The Republicans will lose control of the House, but gain seats in the Senate in the 2018 mid-term elections. Late 2017 senate and state elections suggests that the 2018 mid-term elections could favor the democrats as voter turnouts have been higher than expected. This places the House of Representatives republican majority (currently 46 seats at 239 vs. 193) in jeopardy as all seats will be contest. We view the Senate republican majority as more secure as just one third of seats are up for reelection. The democrats must defend 23 seats, while republicans will defend just eight.
James Ragan is the director of wealth management Research at D.A. Davidson & Co.