BETTER GROWTH, NEW TAX LAW DRIVE STRONG FINISH TO THE YEAR

  • Data point to a U.S. economy that has picked up some speed. Real gross domestic product (GDP) growth increased at an annual rate of 3.2% in the third quarter, representing the second consecutive quarter over 3.0%, and exceeding the 2.2% average for the economic expansion. Measures of economic surprises relative to expectations rose to decade highs. As of year-end, Bloomberg economists’ consensus forecast for fourth quarter GDP stood at 2.7%, while leading economic indicators pointed to continued solid growth as 2018 began, potentially supported by the new tax law.

    Consumer-oriented reports were mostly positive in the quarter, including the strongest increase in holiday retail sales since 2011. Although consumer spending in the third quarter only rose at a 2.2% annualized rate, measures of consumer confidence remain high and job growth has been steady; the hurricane-related dip in jobs created in September was followed by a strong rebound in October. Business investment picked up in the third quarter, increasing at a solid 10.8% annualized pace, while manufacturing surveys remained strong and near expansion highs. As 2017 ended, guidance from the Federal Reserve (Fed) was for three interest rate hikes in 2018 as labor markets continued to tighten incrementally amid signs of budding inflation pressures.

  • U.S. stocks returned 6.6% during the fourth quarter, which is the ninth straight quarterly gain and best since the fourth quarter of 2015. Solid U.S. economic and earnings growth, improving overseas economies, and monetary policy support helped drive gains, while optimism that the new tax law would stimulate growth and corporate profits supported higher stock valuations. Growth beat value for the fourth straight quarter on strength in the technology and consumer discretionary sectors. Broadly, cyclical sectors outpaced defensives, as healthcare, real estate, telecommunications, and utilities lagged. Small caps trailed large caps in the quarter despite more potential benefit from lower corporate tax rates; large caps benefited from U.S. dollar weakness, improving overseas growth, and repatriation of overseas cash at low tax rates, which was part of the new tax law. Emerging markets (EM) outperformed U.S. and developed international equities in the quarter based on the MSCI benchmarks, benefiting from U.S. dollar weakness, improving economic growth overseas, and commodities gains. The S&P 500 Index returned 21.8% in 2017, while the MSCI EM Index topped major regions with a 37.8% return for the year.
  • Tax reform progress and ultimate passage during the quarter dominated headlines, sending expectations for future Fed rate hikes higher. With longer-term Treasury yields more muted, the Treasury yield curve flattened again over the quarter, and made for a positive month for all major fixed income sectors.

    The Bloomberg Barclays Aggregate Bond Index returned 0.4%, outperforming Treasuries, which returned 0.1% (Bloomberg Barclays U.S.

    Treasury Index). Richening valuations helped investment-grade corporates outperform the broader market, returning 1.2% (Bloomberg Barclays U.S. Corporate Index) during the quarter. Economically sensitive, lower credit quality sectors continued higher, with high yield returning 0.5% (Bloomberg Barclays High Yield Index), bank loans returning 0.9% (S&P/ LSTA US Leveraged Loan Index), and EM debt returning 0.5% (Bloomberg Barclays EM USD Aggregate Index).

    Municipal bonds were impacted by tax reform, as headlines about the potential for some areas of the market to lose tax benefits led to a lateyear surge in issuance. The Bloomberg Barclays Municipal Bond Index posted a quarterly return of 0.8% as market participants chose to look past heightened December issuance, and instead focus on the possibility of reform leading to lower supply in the municipal market in the future.

  • The HFRX Systematic Diversified CTA Index led all quarterly alternative investment returns with a gain of 7.1%. Long equity exposure continued to drive portfolio gains, as the upward trend in global markets persisted. The HFRX Market Neutral Index was the main laggard, as the category declined 1.0%. Many strategies within the category have a long bias to value stocks, while being short growth firms, an approach that was a broad headwind to overall returns this year.
  • Commodities rose 4.7% during the fourth quarter, bringing the 2017 gain to 1.7%. Oil helped drive the quarterly gain, as WTI crude jumped 16% amid improving global demand, overseas supply disruptions, OPEC and Russia extending their production cut agreement, and increasing geopolitical risk in key oil-producing countries. Natural gas ended the quarter down nearly 12% despite a December cold wave throughout much of the middle and eastern parts of the United States. Strong global manufacturing activity drove double-digit gains in industrial metals, led by copper and nickel, while U.S. dollar weakness helped precious metals produce modest gains despite the market’s apparent preference for riskier investments. Agriculture commodities fell, led down by grains, partly offset by strength in cotton, sugar, and livestock.

A LOOK FORWARD

The return of the business cycle, as discussed in our Outlook 2018, remains our major theme for the year. With the Fed pulling back on its monetary policy support, we believe that fiscal policy and earnings will emerge as key drivers. We also believe the combination of improved personal consumption and capital spending from the tax legislation could add anywhere from 0.25 – 0.50% to our original 2018 forecast of 2.5% in U.S. real GDP growth in 2018.

The reduction of the corporate tax rate combined with businesses’ ability to fully expense their capital expenditures for the next five years are likely powerful tailwinds for profits. We look for business investment and further gains in corporate earnings per share (EPS) to power the economy and equity markets. Our recently raised 2018 operating earnings forecast for S&P 500 companies is $147.50. Assuming a trailing 12-month price-to-earnings ratio (PE) of 19 – 20, we believe the S&P 500 would be fairly valued in the range of 2,850 – 2,900 by year-end 2018.

Given our outlook for the economy, Fed policy, and the potential for fiscal stimulus, as well as our expectations for a gradual pickup in interest rates across the yield curve, we expect flat to lowsingle-digit returns for the Bloomberg Barclays U.S. Aggregate Bond Index in 2018. Moderate GDP growth and rising inflation may lead to gradually higher interest rates, limiting bond returns. We expect the 10-year Treasury yield to end 2018 in the 2.75 – 3.25% range.

Click here to download a PDF of this report.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

All performance reference is historical and is no guarantee of future results.

All indexes are unmanaged and cannot be invested into directly. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

General Stock & Debt Equity Risks

Stock investing may involve risk including loss of principal.

Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards

Investing in emerging markets may accentuate these risks.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

Long/short equity funds are subject to normal alternative investment risks, including potentially higher fees; while there is additional management risk, as the manager is attempting to accurately anticipate the likely movement of both their long and short holdings. There is also the risk of “beta-mismatch,” in which long positions could lose more than short positions during falling markets.

Distressed Debt is an investment in companies in or near bankruptcy. The investment is often made to gain control of the company with the goal of either improving the operations of the company or disposing of assets. The risks associated with distressed investing arise from several factors including: limited diversification, the use of leverage, limited liquidity, and the possibility that investors may be required to accept cash or securities with a value less than their original investment and/or may be required to accept payment over an extended period of time.

Definitions

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments, and exports less imports that occur within a defined territory.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

Small cap is a term used to classify companies with a relatively small market capitalization. The definition of small cap can vary, but it is generally a company with a market capitalization of between $300 million and $2 billion. The prices of small cap stocks are generally more volatile than large cap stocks.

Index Definitions

The Bloomberg Barclays U.S. High Yield Loan Index tracks the market for dollar-denominated floating-rate leveraged loans. Instead of individual securities, the U.S. High-Yield Loan Index is composed of loan tranches that may contain multiple contracts at the borrower level.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency).

The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market.

The Bloomberg Barclays U.S. Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include T-bills (due to the maturity constraint), zero coupon bonds (strips), or Treasury Inflation-Protected Securities (TIPS).

The Bloomberg Commodity Index is calculated on an excess return basis and composed of futures contracts on 22 physical commodities. It reflects the return of underlying commodity futures price movements.

The Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by Any Government Agency | Not a Bank/Credit Union Deposit

For Client Use | Tracking #1-686297 (Exp. 05/18)