The Next Great Odyssey

Stocks Soared to New Highs in 2017, but Can the Market Rally Continue?

We're now in the second-longest bull market in stocks in history—and there's growing speculation it could be running out of steam. But if the earnings for companies in the S&P 500 expand in 2018, and if interest rates don't rise too much and stay near their historic lows, we think the equity market can continue to advance.

Corporate earnings have been a lot stronger than the market anticipated, and we believe they can remain strong as we move into 2018. The anticipated tax cuts only increase the likelihood that earnings should rise further. In addition, we expect financial conditions to remain attractive allowing for the economic expansion to gather momentum.

Another powerful force supporting further gains is technology. Today we're in a new digital era, and that has launched technology into a leadership position in the stock market. And what we're seeing now is very different than what happened in 2000, when tech stocks were about to fall. The excitement then was about the early hints of what advances in innovation might do. Now, we feel technology's impact constantly—it's woven into our daily lives and it's improving how businesses operate, so technology should help the bull market continue.

We also expect other cyclical sectors, including industrials and materials, to benefit from the strength in the global economy, along with any large-scale infrastructure spending here in the U.S.

How Might Further Interest Rate Increases by the Federal Reserve Affect My Financial Strategy?

Right now, the U.S. economy is still chugging along and is actually getting stronger, the unemployment rate could soon be the lowest it has been in almost 20 years and inflation is expected to pick up. All of that puts pressure on the Fed to continue raising rates to fulfill its dual mandate—to keep prices stable and maintain the economy at full employment.

Yet the Fed controls only short-term interest rates, and longer-term rates are likely to move up by less than a percentage point in the coming year.

But even if rates rise a full percentage point, the increase on payments for mortgages or other consumer lending should be very manageable. At the same time, you may finally be able to earn more on bank deposits and should have the opportunity to reinvest in higher-yielding bonds. For example, you could consider building a laddered portfolio of bonds that mature in sequence over the coming years. As the older bonds come due, you can reinvest the proceeds in new bonds with higher interest rates.

On balance, higher rates aren't something to fear but rather to look forward to, especially if increases come at the measured pace we expect.

Could Rising Geopolitical Tensions Roil the Markets this Year — and How Should I Respond if they do?

Geopolitical events can be disruptive to markets, and some threats, if realized, could generate significant declines in asset prices. What's important to keep in mind here is that markets historically have tended to bounce back quickly, even from major upheavals.

Looking to the coming year, we have to hope that China, which has a strong interest in maintaining stability, will not allow the situation with North Korea to deteriorate. Even without war, per se, a major cyber-attack on the U.S. electric grid, for example, could leave people without access to bank accounts and unable to travel or conduct business.

Rising populism globally could also be a problem. The greatest risk here is advances by fringe political parties that undercut traditional democratic values, such as religious tolerance and belief in the rule of law. The good news is that historically, democratic societies have responded to social discontent before it posed a dire threat to their way of life.

But whatever the future might bring, it's important for investors not to overreact to any given event or crisis. You don't want to disrupt your investment strategy because of an event that might only have a short-term impact. And remember that diversification is the cornerstone of risk management, and can be used to address geopolitical risk just as it can help manage other types of investment risks.

What Areas of the World Offer the Most Promising Opportunities?

We believe both emerging markets and international developed markets, including Europe and Japan, should provide opportunities for investors in 2018. Economic growth in Europe has been surprisingly strong, fueled by a rise in domestic demand, an increase in bank lending and easy monetary policy. Monetary policy is also quite loose in Japan, where unemployment is falling, as it is in Europe, and wages are finally beginning to pick up. All of that means a positive outlook for stocks in those regions.

And because equities in Europe and Japan massively underperformed U.S. stocks during the past decade, valuations in both regions are still quite favorable compared with the U.S.

Emerging market equities have already had a great couple of years, outperforming U.S. markets. But there too, valuations on the whole remain relatively cheap. And we think emerging market economies will continue to benefit from rising global growth and a strong corporate profits picture.

Within emerging markets, Indian equities look particularly promising. And we expect the Indian economy to grow faster than other emerging markets and much faster than developed ones. Analysts at BofA Merrill Lynch Global Research believe that rapid growth should propel India past the United Kingdom, Germany and Japan to become the world's third-largest economy— after the U.S. and China—by 2028.¹

What are the Most Important Steps Investors Should Take in 2018?

In terms of how to allocate assets, we continue to expect equities to outperform fixed income amid ongoing U.S. and global expansions, improving corporate profits and inflation that remains subdued. Although we remain positive about U.S. equities, we also emphasize international stocks, given their more attractive valuations and better earnings prospects.

Within equities, we suggest a strong, solid mix between growth and value stocks, and a particular emphasis on dividend growth stocks—that is, equities whose dividends are likely to grow rather than just those that have the highest current yields. Dividend growth is our number one theme for long-term investors.

For fixed income, we prefer high quality, investment-grade corporate bonds over Treasuries, although a small allocation to Treasuries, which offer liquidity and relative safety, is still advisable.

The best thing for anyone to do in 2018 is to maintain discipline as an investor. It's important not to overreact to volatility caused by concerns over geopolitical risk, China's growth story or anything that may come out of the headlines about Washington policy. Stay the course, diversify, rebalance during market volatility and take a goals-based approach that's focused less on market performance and more on achieving your personal objectives.

CIO Asset Class Views

• We continue to expect equities to outperform fixed income: We expect equities to remain in an uptrend as the U.S. and global expansions gradually continue, corporate profits improve and inflation gradually picks up. Earnings Revision Ratios (ERRs) are currently rising for most regions and cyclical sectors, suggesting further gains for global equities. In most regions, relative valuations for equities currently remain attractive versus fixed income. Despite higher absolute valuations, we remain overweight U.S. equities. However, we emphasize international equities, such as those of Europe, Japan and emerging markets, given their more attractive valuations and better earnings prospects, in our view. We also believe investors should consider increasing less correlated investments and commit to an increased level of tax-efficiency and rebalancing.
• We are overweight U.S. equities: We maintain our positive view on U.S. equities on the basis of anticipated improving economic growth both in the U.S. and globally, still attractive relative valuations versus bonds and rising corporate profits. We believe above-trend growth in GDP, rising inflation, strong capex recovery and improving productivity trends augur well for another year of solid corporate earnings, with tax reform potentially providing additional upside in 2018. For the S&P 500, our current target range for earnings per share (EPS) for 2018 is $139 to $149, with the lower end assuming no tax cuts and the higher end assuming net recurring benefits from tax reform.
• We are overweight emerging market equities: We expect emerging markets to potentially benefit from continued cyclical improvement in global economic activity and improving corporate profits. In our view, valuations for emerging markets overall are moderate, particularly relative to global equities. We continue to favor emerging Asia over other regions for its faster growth rates, stronger fundamentals and higher exposure to consumer-driven sectors. India remains our preferred market given local support from internal reforms and relative insulation from risks to global trade. On a structural basis, we continue to expect strength in demand from emerging market consumers, as incomes and spending power have room to increase over the longer term. Key risks include a spike in inflation and interest rates in the U.S. and protectionist trade policies.
• We are overweight international developed equities: In Europe, corporate earnings appear to be making a strong comeback, driven by an improvement in the global cycle, rising domestic demand and bank lending. And while U.S. companies have surpassed the pre-financial crisis peak in earnings, European Union (EU) earnings are still lagging meaningfully, suggesting more potential upside for them along with margins and return on equity. Similarly, fundamentals for Japan have improved, with real GDP growth in positive territory for the past six consecutive quarters and earnings revision ratios among the strongest globally.
• We are overweight international developed equities: In Europe, corporate earnings appear to be making a strong comeback, driven by an improvement in the global cycle, rising domestic demand and bank lending. And while U.S. companies have surpassed the pre-financial crisis peak in earnings, European Union (EU) earnings are still lagging meaningfully, suggesting more potential upside for them along with margins and return on equity. Similarly, fundamentals for Japan have improved, with real GDP growth in positive territory for the past six consecutive quarters and earnings revision ratios among the strongest globally.
• We are underweight fixed income: We believe neutral-to slightly- short duration is warranted, balancing expectations for higher short-term rates over time and periods of flight to-quality given U.S. political and geo-political headwinds. We continue to prefer credit over Treasurys, with an emphasis on investment grade corporates—particularly banks— and municipals, although the relative value of credit has moderated and Muni-to-Treasury ratios are currently less compelling than they were earlier in the year. We believe Treasurys offer liquidity and relative safety and that a small allocation is still preferred, particularly on the basis of the spread to inflation and the spread to other developed market sovereigns, as the yields are at the higher end of the post-crisis range. We believe active management can potentially help improve risk-adjusted returns in a rising-rate environment. We believe that a barbell strategy of owning bonds or bond funds with both longer and shorter maturities could potentially outperform a bulleted strategy in a rising yield environment.

Politics and monetary concerns—in the form of the U.S. fiscal agenda and Federal Reserve policy—are still key focal points for the market. We believe tax reform is generally positive for investors, although there are offsetting factors. In our view, while there are changes for the municipal bond sector, the key fact is that the tax exemption remains and is still extremely beneficial to investors with high tax rates. For corporate bonds, lower tax rates are beneficial overall, but the partial elimination of the deductibility of corporate interest expenses could potentially be a credit negative for the high yield sector. In terms of the Federal Reserve, the administration chose an existing Governor, Jerome Powell, to succeed Janet Yellen as chair, which was received well by the market. It also selected Marvin Goodfriend to be a governor, who is slightly hawkish in this environment. There are still three open governor spots, and the New York Fed president (who acts as vice chair of the Federal Open Market Committee) has announced his retirement. That means there are still an additional four new voting members who could join the committee in the next year, so the "changing of the guard" occurring at the Federal Reserve still needs to be watched closely.

• We are currently underweight corporate high yield: In our view, valuations are rich, especially for lower-rated credit tiers. Within high yield, an allocation to leveraged loans may be prudent due to the floating-rate coupon, secured status and minimal yield give-up to unsecured bonds. Allocations should be with an active manager favoring higher-quality securities, in our opinion. Current valuations lead us to be cautious on allocations to index-based solutions in high-yield, as we prefer to be "up-in-quality" at this point in the cycle. While spreads could stay at current levels or grind tighter—especially if the economy continues to perform as we expect—the incremental rate risk and signs of excessive optimism (refinancing waves, Collateralized Loan Obligation activity) signal the risk-reward is unfavorable.
• We favor a strategic allocation to hedge funds: We believe the environment for active management, and hence hedge funds, will remain favorable heading into 2018 and we continue to prefer a diversified approach when investing in this heterogeneous asset class. We maintain a moderately positive view on equity long/short strategies.
• We favor a strategic allocation to private equity: We view private equity strategies as long-term potential portfolio return enhancers with unique access to specialized deals unavailable to most investors. We believe it is prudent for investors to plan a disciplined multi-year commitment strategy that builds portfolio diversity among different managers, styles, geographies and, importantly, vintages.
• We favor a strategic allocation to private real estate: In our view, general economic conditions are good for commercial real estate going into 2018; and while not all U.S. property sectors and markets are synchronized in the current and mature real estate cycle, we believe there are continuing positive signs that the markets for rentable space are generally in balance across the country, with a few property type and market exceptions.
• We remain neutral in commodities: Commodity prices have strengthened with the synchronized global expansion, but are contained, in our view, by the supply overhang from over-investment in the last cycle. Our estimated range for oil prices in 2018 is $55 to $65.
• The dollar: In our view, while rising U.S. rates should support the greenback going forward, capital flows that favored the U.S. during the deflation-scare years are currently reversing to take advantage of improvements in emerging markets and the rest of the world, offsetting much of the dollar's support from higher U.S. rates. On balance, we expect a steady or mildly depreciating dollar over the next year.