Since 2017 was one of the best years in recent history in terms of economic growth, corporate performance, and equity-market performance, it is natural to ask where we go from here.
Risk assets led the markets in 2017. Emerging markets—which received oxygen from a weak U.S. dollar—performed the strongest, returning 34.2% year to date as of November 29, 2017. China drove emerging markets’ performance with a return of 50.2%, but was followed by Poland (49.0%), Korea (46.1%), Peru (39.2%), India (38.1%), and Hungary (32.3%).
Underpinning strong equity-market performance in 2017 was a broadening of growth in both developed and emerging markets, which we have not seen in more than a decade. And as growth broadened, it also strengthened. Year-over-year growth in industrial production volumes, a proxy for growth, ranged from 3% in the United States to 8% in Brazil.
Underpinning strong equity-market performance in 2017 was a broadening of growth in both developed and emerging markets, which we have not seen in more than a decade.
When global growth drives expansion, it shows up in corporate earnings. In 2017, returns were driven predominantly by corporate earnings growth (versus valuation, or, in professional parlance, multiple expansion), as the chart below illustrates.
That is not to say we did not see any multiple expansion. Delving deeper into the sectoral composition of returns, we did indeed see it, in Europe and the United States, where the economic expansion cycle is further along. There, valuations have moved up, as we would expect in response to stronger growth performance.
Looking ahead, we believe the trade-off between interest rates and growth will likely be marginally less favorable. Comparing the global manufacturing purchasing managers index (PMI), which is a proxy for economic growth, to the 10-year U.S. Treasury yield, as we do in the chart below, we see that a measurable gap has opened.
In other words, the fixed-income markets have not appreciated the magnitude and breadth of economic growth. Either growth must decelerate or interest rates must rise.
The fixed-income markets have not appreciated the magnitude and breadth of economic growth. Either growth must decelerate or interest rates must rise.
We do not believe that a deceleration in growth is imminent, but interest rates are likely to begin rising in the United States, so it is worth thinking about the impact.
In 2017 there were three periods of rising interest rates, as the chart below illustrates. During those periods, we saw a rotation in the market away from growth and toward more value. That is not surprising; what is interesting is that these moves toward value have not been long-lasting. Once market participants and companies adjusted to higher interest rates, growth resumed.
In other words, economic growth ultimately prevailed in terms of return generation. We expect that to be the case in 2018 given the marginally less favorable trade-off between interest rates and growth.
Past performance is no guarantee of future results. Indices are unmanaged, do not incur fees and expenses, and cannot be invested in directly.
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