During 2017, the market experienced an unusual year with the gains for equities being the strongest since 2013. The most unusual part of the year for equities was the lack of volatility as the S&P 500 did not experience a single drop of more than 3%, which is extremely rare.
The reason for the low volatility was due to the synchronized global growth that outperformed expectations. There were very few disappointments and many of the concerns at the beginning of the year did not occur. Interest rates stayed low, China did not experience a hard landing, and the US didn’t implement trade restrictions that could have impacted the global growth story.
For 2018, expectations are high for the global economy. Tax reform in the US is expected to provide some additional growth in the US as well a significant earnings and cash flow boost to US firms. Despite what you may hear, we feel that equity markets are reasonably valued and have not seen irrational risk taking by investing. Equities can continue to perform well if interest rates rise slowly, inflation remains below 3%, and economic growth remains at reasonable levels.
We believe accelerating inflation and interest rates are the biggest risk to the market for 2018 and we are watching there closely as the yield curve has flattened. Should interest rates rise or the yield curve invert (i.e. long rates become lower than short rates), bonds may become more attractive investments relative to equities, causing equity valuations to contract. Additionally, an inverted yield curve has usually led to recessions.
Additionally, we continue to watch investor behaviors. At this point, we have not seen irrational exuberance (Bitcoin and other cryptocurrencies not withstanding). This gives us confidence that we still have room for valuations to expand before the next bear market.