Solid December caps strong year for markets
U.S. financial markets were strong throughout 2017 and capped off the year with even more gains in December. All three major indices were up for the month and the quarter. In December, the Dow Jones Industrial Average led the way with a return of 1.92 percent. The S&P 500 Index gained 1.11 percent, and the Nasdaq Composite trailed with a gain of 0.48 percent. For the quarter, the Dow also led the way, up 10.96 percent. Again, it was trailed by the S&P 500 at 6.64 percent and the Nasdaq at 6.55 percent. For the year, however, the Nasdaq claimed the top spot with an impressive gain of 29.64 percent. It was followed by the Dow, up 28.11 percent, and the S&P 500, up 21.83 percent. All three indices remained supported technically at year-end, trading well above their 200-day moving averages.
This positive performance was driven largely by improving earnings growth. According to FactSet, as of year-end, the estimated fourth-quarter earnings growth for the S&P 500 was 10.9 percent, with all 11 sectors projected to grow from third-quarter levels. If we get this level of growth—and analysts have made much smaller downward revisions than usual—it would mark the highest level of annual earnings growth for the S&P 500 since 2011. As fundamental performance ultimately drives long-term returns, this would be a boon for investors.
International markets also had a successful year. The MSCI EAFE Index, which tracks developed markets, gained 1.61 percent for December, 4.23 percent for the fourth quarter, and 25.03 percent for the year. The more volatile MSCI Emerging Markets Index returned 3.64 percent for the month, 7.50 percent for the quarter, and a whopping 37.75 percent for the year. Like U.S. markets, international markets closed the year with strong technical support, trading well above their trend lines.
Fixed income had a more volatile year than equities, as early outperformance was offset by rising rates. The Federal Reserve (Fed) increased the federal funds rate three times in 2017. Although these rate hikes are indicative of the Fed’s confidence in the ongoing economic expansion, rising rates can hit fixed income markets—and that is exactly what we saw. Markets currently anticipate two to three rate hikes in 2018, which could have similar effects.
Despite the rate hikes, the Bloomberg Barclays Aggregate Bond Index gained 0.46 percent in December, bringing the quarterly return back to 0.39 percent and capping the annual return at 3.54 percent. The Bloomberg Barclays U.S. Corporate High Yield Index had similar returns of 0.30 percent and 0.47 percent for the month and quarter; however, a stronger start to the year left the index with an annual return of 7.50 percent.
Consumers drive economic growth
The economic news in December was good pretty much across the board, but the best news came from the ever-important consumer. Shoppers helped the year end with a bang, as high confidence translated into much better-than-expected spending heading into the holiday season. Retail sales, which had lagged confidence all year, surprised to the upside, with headline and core sales both increasing by 0.8 percent over October’s figures. On an annualized basis, retail spending growth now sits at 5.8 percent, the highest level since 2012 (see Figure 1). This recovery in spending has been a long time coming, and seeing it is a positive sign.
Figure 1. Retail Sales Annualized Change (2017—2017)
The housing industry also had a strong month. Here, again, improvements in industry sentiment were matched by additional investment. Homebuilder confidence rose during the month to an eight-month high, as strong consumer demand and rising prices continued to offset the high costs of labor and materials. The supply of new and existing housing stock remains near historic lows. This, coupled with strong demand, has kept the industry confident.
Consumer demand came in much better than expected, with existing home sales growing at 6.2 percent, against expectations for a decline of similar proportions. On an annualized basis, the level of new home sales is the highest it has been since October 2007. Builders have started to react to low supply levels, with both housing starts and building permits increasing by more than double their expected growth rates for the month. As long as consumer demand remains strong, builders are expected to continue to invest in new construction, which will be positive for the economy.
With consumer, business, and housing spending all increasing, faster growth is quite possible for the second half of the year. In fact, the second estimate of third-quarter gross domestic product growth came in at 3.3 percent, up from the initial estimate of 3 percent. If this level holds, it will mark the first two consecutive quarters of growth above 3 percent that we've seen since 2014.
The rest of the world is growing as well. European growth continues to improve, with several countries growing faster than the U.S. Meanwhile, growth in China remains solid, and even Japan has started to improve. This is the first synchronized global growth cycle we have seen since the crisis, which could help all countries around the world.
Political risks remain elevated
With the economic news good, the major source of risk remains political. In Europe, the inconclusive German election and stalled coalition talks rattled European markets mid-month and still have the potential to create more uncertainty. The ongoing Brexit process in the U.K. is also creating concern. Looking to Asia, North Korean nuclear tests continue to destabilize the region.
The immediate political risks, however, are here in the U.S. The two major stories highlighting the rest of the year are tax reform and the debt ceiling. If tax reform passes, it could be positive for the markets. But that passage is uncertain—and that uncertainty could create volatility.
Of more concern is the potential government shutdown in early December. The current debt ceiling agreement expires on December 8. Without a new agreement between Republican and Democratic lawmakers, the government will shut down. Although the most likely outcome remains some sort of agreement, a shutdown—with all the uncertainty and turmoil that implies—remains a very real possibility.
Markets remain strong
The good thing about the political risks, however, is that the economy is in good shape to weather them. With the combination of economic growth, earnings growth, and high confidence likely to lead to faster growth for the second half, any political disruption will be cushioned by the strong economy. This, combined with the potential for passage of a business-friendly tax bill, signals that we may see faster growth over the next couple of quarters than we have for some time.
If not, market volatility is very possible. But even then, any short-term shocks should be offset by the strong economic and corporate fundamentals. As always, a well-diversified portfolio matched to your risk tolerance remains the best way to meet your financial goals over the long term.
Co-authored by Brad McMillan, senior vice president, chief investment officer, and Sam Millette, fixed income analyst, at Commonwealth Financial Network®.
All information according to Bloomberg, unless stated otherwise.
Disclosure:Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Barclays Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg Barclays government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.