Recalibrating The Cycle: 2018 Market Outlook

by: Benjamin Lavine, CFA


2017 proved yet again that forecasting "macro regimes" is difficult enough but that predicting how asset classes, styles, risk categories, etc. would behave in that regime is even more difficult.

One would not have expected growth style to outperform value, large caps outperforming small caps, weaker U.S. dollar and a flattening U.S. yield curve in the face of cyclical reflation.

Despite strong global equity performance in 2017, it seems investors are still wedded to the New Normal playbook of low and scarce nominal growth.

Longer term, financial assets have been priced with lower forward expected returns (that’s what happens in a bull market), yet, investors must take on risk in order for the chance to be compensated for that risk with higher returns.

Beneficiaries of late cycle reflation would include "value" style of investing and perhaps hard assets such as commodities. If operating margins have peaked, then factors tied to high quality and profitability could be at risk of underperformance.

2017 Year-End Market Commentary and 2018 Market Outlook

Data Source: Bloomberg

Recalibrating the Cycle

Source: Flickr (Labeled for Reuse)

Note to readers: We have sectioned the 2017 Year-End Market Commentary and 2018 Outlook commentary accordingly:

  1. Big picture outlook and key issues heading into 2018
  2. Summary 2017 year-in-review
  3. Final thoughts and our base case estimate of the path forward
  4. Supplemental charts and exhibits

Predicting the Regime Correctly but Not Necessarily Asset Class Performance

2017 proved yet again that forecasting "macro regimes" is difficult enough, but that predicting how asset classes, styles, risk categories, etc. would behave in the event a particular regime plays out is even more difficult. We first explored the difficulty of forecasting macro regimes in "2Q2016 Market Commentary: A Bifurcated Market" and "How Should Investors Position for this Year's Election? You're Asking the Wrong Question." Forecasting the right regime and predicting how asset classes will behave in that regime mean that failure in predicting either one can end up compounding the poor performance that may follow.

And apart from betting against gold, one would not have expected growth style to outperform value, large caps outperforming small caps, a weaker U.S. dollar, a flattening U.S. yield curve, and record low volatility if one were betting on a surge in cyclical reflation. But this is how 2017 largely played out - signs of cyclical reflation emerging worldwide throughout the year, but investors still pursuing the "New Normal" playbook of chasing scarce growth and yield (Figure 1).

Figure 1 - 2017 Performance of Asset Classes and Styles (Descending Order)

With respect to macro regimes, we posed the following questions at the beginning of 2017 which we believed would determine how market performance would play out.

Can the incoming U.S. administration reverse the New Normal overhang on U.S. business production and how will such a reversal manifest itself?

Answer: To be determined. See #2 below for a more in-depth review. The short answer is that 2018-19 will likely see a cyclical boost from Trump administration initiatives, but New Normal pressures of aging demographics, high debt levels, and global excess capacity will likely weigh on long-term nominal growth. In addition, how the U.S. Federal Reserve enacts its rate hike schedule in anticipation of rising growth expectations will remain a wildcard. The Fed is prone to overshoot on tightening as evidenced by the last three recessions (see the New Neutral for a more detailed write-up.)

Will a new round of inflation be unleashed as the new administration seeks to roll back government policies regulating large swaths of the industrial sector, freeing up pent-up growth, but also unleashing demand that could push up prices?

Answer: Apart from the failure to undo Obamacare, the Trump administration has largely delivered on conservative priorities over the course of the first year, particularly with regard to its regulatory rollbacks. In addition, the Republican Congress pushed through one of its main party platform priorities by passing tax reform legislation designed to make the business tax environment more competitive with the rest of the world. However, it remains to be seen whether we will see a boost in aggregate demand that would be sufficient enough for a sustained upward push in prices.

Macro/Market Impact: To be determined. Yes, this answer could be interpreted as a punt into next year and further on into 2019. But the first year administration policy initiatives and priorities will take time for their impact to be felt by the broader economy. There is a lag between the market's expectation of the economic impact from government policy and its eventual impact, and 2018 should provide some clarity on the initiatives undertaken in 2017.

However, U.S. business sentiment continues to trend higher as reflected in manufacturing and services surveys as well as capital spending tracked by regional Federal Reserve surveys (Figure 2). But economists still believe that real GDP will continue to track 2-3% over the next three years (2017 GDP tracking 2.5% based on latest releases). Hardly a prescription for the 3-4% GDP growth aspired to by the Trump administration.

Figure 2 - Business Sentiment Remained Strong Throughout 2017

In addition, the type of economic growth implied by market performance is expected to be like what this country has experienced since the 2008 Financial Crisis: low nominal GDP growth with few signs of inflationary pressures. Except for short bursts of cyclical outperformance since the November election, this implied expectation can be seen in the following:

  1. "Growth" equity style outperforming "Value" - this implies that investors continue to expect earnings growth to be scarce and concentrated in a handful of winners and not be broad-based (which would favor cyclical value stocks). One would expect the opposite should economic growth meaningfully pick up.
  2. Flattening of the 2-10 year U.S. Treasury yield curve suggests fixed income investors are not concerned about long-term inflation and expect the Federal Reserve to be near the end of its current rate hike schedule.
  3. After briefly rising above 2%, inflation expectations, as priced between Treasury Inflation Protected Securities (TIPS) and nominal Treasuries, have dipped below the 2% level that the Fed believes is adequate to sustain economic growth.
  4. In the Supplemental Charts section, we display the year-over-year revenue growth versus operating margins for S&P 500 companies. Since the 2008 financial crisis, S&P companies have grown earnings primarily through higher profitability (i.e. expense controls) as opposed to revenue growth. If cyclical reflation were to emerge, perhaps we will see a reversal of this trend where earnings growth is driven by revenue growth rather than expense controls (and perhaps we see a giveback in margins to offset the top-line growth). If this scenario were to play out, this would serve as a greater tailwind for value stocks that tend to comprise more cyclical and financial companies versus growth stocks which tend to rely more on their profitability characteristics to support their premium valuations.

Will the Fed's goal to normalize monetary policy and preempt cyclical inflationary pressures by pursuing a more aggressive rate hike policy help subdue any macro credit bubbles that could form during a cyclical recovery?

Answer: Apart from cryptocurrency mania that has seen, at one point, a year-to-date return of 1,900% in Bitcoin, one would be hard-pressed to identify any U.S. macro credit bubbles as a result of relatively easy financial conditions (Figure 3) despite the Fed following through on its rate hike tightening schedule. This year the Fed hiked its benchmark rate three times to 1.25-1.50% range and is expected to hike rates three more times in 2018 to 1.75-2.00% range.

Figure 3 - The U.S. Enjoys Relatively Easy Financial Conditions

Macro/Market Impact: Fixed income credit market activity could serve as one signal of any macro credit imbalances. There are growing concerns about the increasing appetite to take on leveraged credit risk based on the popularity of collateralized debt obligation (CDO) issuance (and a willingness for investors to earn narrower spreads) as a result of easy financial conditions.

However, much of this year's debt issuance has simply been the refinancing of existing debt at more favorable borrowing rates rather than in the issuance of new debt. The latter tends to be driven more by speculation than the former. Apart from the energy sell-off from late 2014 to early 2016, there appears to be few signs of systemic risk to the financial system from excess leverage as opposed to what was observed with the telecom debt bubble (2000-2002) and the housing market collapse (2003-2007).

With a more financial industry-friendly regime installed at the Fed given the appointment of Jerome Powell replacing Janet Yellen as Fed Chairperson, the Fed will likely adopt a dovish stance when setting rate policy. Whether it would attempt any preemptive crackdown on excessive "shadow" banking (or financing done outside the regulated financial sphere) remains to be seen. For now, easy financial conditions have, so far, yet to produce a credit bubble that would pose a systemic risk to the financial system (China is another matter - see below).

Heading into 2018, 3D expects cyclical reflationary trends to prevail over the "New Normal" secular disinflationary trends although the magnitude and when the cycle turns may depend on the following:

Monetary policy under a new Federal Reserve Board, chaired by Jerome Powell, and how the Fed will continue its rate tightening campaign so as to stay ahead of the inflation curve but not overtighten rates that would push the economy into recession. Debate (and political reception) of Trump administration initiatives to boost the economy, primarily the impact from tax reform legislation. China's ability to engineer "higher quality" GDP growth by unwinding its excess leverage without causing a systemic meltdown of its financial system.

As we've mentioned previously, #1 has already been addressed with our 2018 Outlook Preview article, "The New Neutral." #2 and #3 follow below.

#2: Will the Republican Tax Reform Legislation Produce Feast or Famine? Answer: Probably Neither but Still Net Positive to the U.S. Economy

Philosophically, one's view on the Republican tax reform legislation largely comes down to whether one holds a Keynesian vs. supply-side view of economics - both have their merits and shortcomings.

Keynesianism adopts a more liberal (egalitarian) view of economics but is inclined to focus too much on aggregate demand and tends to overlook the big picture of economics, namely the modeling of human behavior in the face of scarcity. The supply-side view focuses on the importance of incentives that can drive the "dynamic" aspects of modeling economic growth (as opposed to a static revenue model that largely ignores the Laffer Curve). However, this view also forgets that the world has no desire to return to serfdom (or at least the Gilded Age of Big Trusts and Bankers).

We at 3D don't adopt an official view of which economic model to favor (trust us, you wouldn't find a consensus), but we lean towards 1) "incentives matter" and 2) capital is a scarce resource (although in a year that saw a 1,900% return on Bitcoin, high market valuations, and minimal compensation for credit risk, capital would appear to be in abundance), so investors need to be compensated for taking on risk.

There is little doubt that tax reform legislation will produce its share of winners (corporations, off-shore repatriation) and losers (professionals services organized as pass-throughs, high income earners in high tax states, heavily indebted firms), but the doubling of the standard deduction and expansion of the child tax credit likely mean that most Americans will see a tax break. This gives tax legislation more of a progressive veneer so as to, presumably, make it more palatable to the American public.

But, the tax reform legislation's main purpose was to make U.S. business (and the cost of investing in the U.S.) more competitive with the rest of the world. And the rest of the world is starting to take notice.

The above-linked WSJ opinion piece references a study released by German economists at the Center for European Economic Research (ZEW) on the expected impact of how U.S. corporate tax reform will lower the cost of capital hurdles associated with investing in the U.S. versus the rest of the world:

"The study estimates the cost of capital-the pretax return that an investment needs to earn to be worth making-and finds America had priced itself out of the market. In the ZEW model, U.S. firms needed a return of around 7.6% for an investment to be profitable under pre-reform tax law, compared to an EU average of 6%, and 5.7% in low-tax Ireland.

The U.S. reform changes all this. America's statutory and effective corporate rates will both be near the EU average, essentially even with Britain and the Netherlands and well below France (a 39% headline rate) and Germany (31%). The U.S. cost of capital similarly falls to around 6%, which is also the EU average." (Underline emphasis from 3D).

So, it would appear that the tax legislation should lower the cost of capital of investing in the U.S., which should be bullish for financial assets as investors would require even smaller risk premiums in the form of higher market valuations and lower credit spreads.

Now trying to answer which economic model (Keynesian vs. Supply-Side) produces a more prosperous (and stable) economic outcome bound by a social contract between the "haves" and "less-than-haves" is about as challenging as trying to answer:

Whether (and which) risk assets will outperform under the new U.S. tax regime, and whether the larger (looming) forces of global disinflation (as we've written several times this past year - more recently in "The New Neutral") will overwhelm the cyclical boost expected from corporate tax reform?

And the answers to the above questions are yes/yes and no/no (most likely influenced by your political viewpoints), or it all depends on one's time horizon in gauging "success," and whether the political temperament will cement the new tax law just as Obamacare has been cemented into how healthcare is consumed in this country (removal of the individual mandate "tax" aside).

With respect to the short term, we believe the following may emerge as key drivers of market volatility and to what extent the business cycle will be extended:

Political atmosphere (or as Jim Grant from Grant's Interest Rate Observer has branded our current president "The Avatar of Tail Risk"); the outcome of the 2018 mid-term elections; clarity of Fed rate hikes (largely dependent on whether the U.S. can generate higher, sustainable GDP growth to support higher rates); how China manages its debt imbalances without engineering a major capital flight risk like what the global market experienced from August 2015 through February 2016. More on China below.

Whether the legislation produces imbalances, bad incentives and poor capital allocation remains to be seen, but its goal is to incentivize domestic business formation and investments, so those objectives will serve as the yardsticks to determine the success or failure of tax reform.

With respect to the longer term, one cannot ignore the larger New Normal demographics at play, but one would also be hard-pressed to see recession on the horizon, short of an overly aggressive Fed (again we refer you to "The New Neutral"). Business cycles do not last forever and there will be a downturn at some point (the last three partly caused by an overly aggressive Fed), but investors should not be swayed by the short-term headlines (nor their political biases).

Longer-term, financial assets have been priced with lower forward expected returns (that's what happens in a bull market). Yet, investors must take on risk in order for the chance to be compensated for that risk with higher returns (the probabilities increasing with time), whatever the short-term concerns.

Regardless of the short-term risks facing investors in 2018, we at 3D aspire to stay on top of market developments as our long-term focus does not mean burying our heads in the sand, oblivious to what is driving the market environment. Our general bias is not to trade in reaction to market-moving events but to be conscious of the risks embedded in our model portfolios and whether we are being properly compensated for taking on those risks given the macro environment.

#3: China and the Tightwire Act of Managing Debt Imbalances While Maintaining Growth

For an up-to-date (and less sanguine) picture of the challenges facing China as it seeks to tamper down debt imbalances that have built up over the last two decades, we refer readers to UC San Diego (and fellow Triton) associate professor Victor Shih who authored "Factions and Finance in China - Elite Conflict and Inflation" (hat tip to Grant's Interest Rate Observer which conducted a podcast with professor Shih on 12/11/2017). More recently, Professor Shih has been warning about the growing debt imbalances that have formed over the massive economic push seen over the last two decades (see "Financial Instability in China: Possible Pathways and Their Likelihood").

Here are some highlights of the report:

  • Total credit as a % of China GDP has grown to 329% through May of this year from 295% back in 2015 with much of the increase occurring outside traditional banking channels.
  • What makes this debt load unsustainable over the long term is the cost (interest expense) of servicing that debt versus economic output. Total interest payments have exceeded incremental increase in nominal GDP since 2012, which means…
  • In the absence of large scale defaults, China's debt service burden is being financed with yet even more debt. The correction to this debt imbalance may not necessarily come from the collapse in off-bank (shadow bank) financing.
  • According to Shih, "…despite explosive growth, shadow banking assets remain a modest share of total banking assets, and both the central banks and commercial banks continue to support shadow banking with interbank loans."
  • As long as central financial support is maintained, an unwinding of shadow banking, in of itself, would not be sufficient for a widescale correction in China's debt imbalance (this assumes we don't see a repeat of policy errors that led to long periods of insufficient liquidity that occurred in 2013 and 2014).
  • A more pressing concern for China is the dwindling of its foreign exchange reserves as a % of money supply (M2), increasing the impact from "capital flight" as "households move money out of a country, depleting a country's foreign exchange reserve and forcing a dramatic maxi-devaluation of the currency [which in turn] could…trigger severe inflation, high interest rates, and substantial asset depreciation. Based on this measure, the ratio has dropped from 20% of money supply (55% of household saving deposits) in 2014 to 10% (30% of household saving deposits) in July 2017.
  • As Shih warns, "if households and firms were to move just 10% of money supply overseas, China's FX reserves would basically be depleted." Despite draconian capital controls, Chinese savings continue to flow out of the country through several mechanisms: 1) Exporters receiving foreign payments in Hong Kong, 2) importers exaggerating imports to remit more money overseas, and 3) payments for services to overseas counterparties (i.e. travel, medical care, education).
  • In total, $50-70 billion per month has flowed out of China since the implementation of capital controls, and now $100 billion of monthly outflows remain possible. Should this happen for a few months and not be arrested with further capital controls and/or massive devaluation of the RMB, "it may lead to a crisis of confidence in the RMB, which further accelerates outflows."
  • China has also made itself more dependent on external financing, the withdrawal of which would accelerate a capital flight resulting in "sizeable devaluation and defaults on external debt." In contrast to how China addressed the 2015 and 2016 currency crises: "Without additional external funding, it would be very hard for the PBOC alone to stop politically connected insiders from moving sizable amounts of funds out of China."
  • Shih concludes the report by stating: "As Russia discovered in 2013, maxi-devaluation, followed by an aggressive interest rate hike, may be the only effective way of preserving the foreign exchange reserve, presumably still the highest priority for China's FX policy."

Now all this represents a tail risk and hardly a healthy prognosis for continuing outperformance of emerging markets, let alone worldwide risky financial assets. Still, this represents a tail risk but a tail risk with a long fuse. We've written about how the great China debt unwind could unfold in prior articles (see "2nd Quarter 2017 Market Commentary"). Using the market top of Japan's Nikkei Market Index in the late 1980s as a historical parallel, we thought it was more likely that the unwinding of China's debt burden can be "contained" just as the collapse of Japan's equity and real estate bubbles had been contained, resulting in three decades of deflation for Japan, but not inhibiting the rest of the world from moving on. Perhaps our outlook on China's inevitable debt correction is too sanguine.

Heading into 2018, investors need to question if they are being properly compensated for taking on emerging market risk, be it highly leveraged equity, sovereign debt, or local currency. The long-run growth story for emerging markets remains intact, but we may see some hiccups come 2018, especially with a tightening U.S. Federal Reserve serving as the backdrop.

2017 Year in Review: It Was a Momentum Market

1Q2017 - Investor Hopes for a Cyclical Boost Deflated by Political Realities

3D came into 2017 with a hopeful, albeit slightly cautionary, outlook on global market risk, much of which we argued would be influenced by "expectations of what the Trump administration and the Republican Congress can deliver versus what has been promised in the areas of corporate and personal tax reform, infrastructure spending, and regulatory relief." Trump supporters would at least argue that this administration delivered on the first and third items, with infrastructure spending expected to be part of administration's agenda for 2018.

Yet, the year began with "fits-and-starts" as the new administration tried to find its footing and that high expectations of small cap/value equity outperformance and a steepening U.S. yield curve were quickly deflated by the end of the first quarter. Rather than building on the strong performance at the end of 2016, global markets ended the first quarter on a whimper as investors' high expectations for fiscal stimulus and regulatory relief hit the hard reality of Washington D.C. political machinations. Recall that in March, the Republicans' first attempt at passing their own healthcare legislation failed which led investors to question whether the Republicans would be able to pass other key pieces of legislation such as tax reform.

With respect to long-term Treasuries, the end of 2016 saw a record net short position built up in 10-Year Treasury futures as we cautioned that sentiment for the "Trump Trade" had become near-term overcrowded. The 10-Year U.S. Treasury yield ended the year nearly where it began but with some oscillation between high and low expectations for cyclical reflation. In mid-March the 10-Year Treasury peaked around 2.6% before dropping to as low 2% in August before rebounding to finish the year around where it started (2.4%).

During the first quarter, small cap value underperformed and "momentum" style of investing took off with investors gravitating towards growth technology stocks. The U.S. dollar also weakened as investors began to rotate more funds to international markets with emerging markets leading all major regions. In addition, investors started to take down the price of "insurance" or selling volatility as implied measures of equity volatility such as the S&P VIX began to drop to reflect the lower volatility environment that was to characterize much of 2017.

2Q2017 - Reaching the Macro Inflection Point

Heading into the second quarter, it appeared the market narrative had settled into a calm, defensive market characterized by low volatility and low rates. But then the final week of the second quarter saw the U.S. dollar weaken and global bond yields rise over hawkish central bank comments and U.S. small cap value, which had lagged up until the last week of the quarter, rallied sharply over brighter prospects for healthcare and tax reform legislation. The U.S. dollar continued its year-to-date weakness against major currencies as the world started to catch up to the normalized rate path communicated by the U.S. Federal Reserve from last year.

The conflicting signals seen in equity, bond, and volatility markets implied that we were reaching an inflection point on the macro development front. All seemed to be pointing to a slowdown but in varying degrees as there were fewer signs of inflationary-led cyclical growth spurts. But if investors were concerned about a slowdown, they weren't taking out insurance against a market decline as shorting the VIX gained even more popularity as market volatility levels continued to drop.

The second quarter saw "momentum" style of investing surge above other styles as it became clear that investors were moving away from the cyclical Trump trade of small cap and value investing in favor of "success" whether captured by scarce growth or profitability.

Oil prices also oscillated between $40 and $55 as investors tried to reconcile conflicting signals between high inventory levels and a slowdown in U.S. North American production within the backdrop of growing worldwide demand, in part due to a recovering global economy. There was a minor sell-off in high yield energy fixed income, but that abated as oil prices stabilized.

We wrapped up our first half thoughts with this note: "If energy prices stabilize at current levels and some progress is made in D.C. concerning health care and tax reform, then the focus should shift towards how earnings will track for the remainder of the year." Despite D.C. headlines influencing day-to-day market reactions, the underlying global earnings story had become supportive of further market advances as analysts were projecting ~10% earnings growth and 5% revenue growth for S&P 500 companies for 2017.

3Q2017 - A Volatility Sandwich

The third quarter started somewhat quietly but then market volatility spiked in August over rising tensions with North Korea and the powerful hurricanes that would hit the Gulf Coast (Harvey) and Florida (Irma). In addition, President Trump's reaction to the Charlottesville protests and the public outcry that ensued threatened to derail the Republican agenda and almost led to some high-profile departures, such as Gary Cohn.

However, similar to what happened at the end of the second quarter, U.S. small caps surged ahead versus large caps right at the end of the third quarter when it appeared the damage from Irma would not be quite as extensive. Following the Fed's reaffirmation of its near-term outlook on growth and inflation (recent inflation declines considered transitory i.e. mobile plan pricing), the Trump administration and congressional leaders released their blueprint for tax reform with the goal of lowering the corporate tax burden (to make it more competitive globally) and simplify the tax code. In addition, the Republicans made a second attempt to write new healthcare legislation, although this effort would later fail.

As volatility spiked throughout August and early September, investors flocked to safe-haven assets such as U.S. Treasuries pushing the 10-year yield to a YTD low of 2.04%. Despite the damage Irma caused much of Florida, damages came in below estimates which resulted in a relief rally led by financials (insurance stocks). Treasury yields began to rise as investors saw the green light to exit the safety trade. Following hawkish comments from the Federal Reserve, the sell-off in Treasuries accelerated as the 10-year Treasury yield spike to 2.33% at quarter-end.

With the earnings picture firming up for S&P companies and prospects of tax reform on the horizon, investors pushed up the forward earnings valuation of the S&P 500 to over 18-19x projected next 12 months' earnings. After a brief hiccup in August, equities entered the fourth quarter with strong momentum.

4Q2017 - Tax Reform Legislation and Robust Holiday Spending Make for a Holiday Full of Mirth and Cheer

The fourth quarter ended with merry cheer or fetid eggnog, depending on your political views, but U.S. shoppers were feeling especially festive this year as Mastercard (NYSE:MA) reported north of $800 billion in seasonal spending ("more than ever before"). Holiday spending rose 4.9%, the fastest year-over-year growth since 2011. (NASDAQ:AMZN) also reported that it topped its worldwide holidays sales record this year. Beaten-up retail stocks also caught a bid following reports of strong holiday shopping that lifted all retail boats (and not just Amazon).

This quarter also witnessed the spectacular assent of cryptocurrencies, especially Bitcoin which rose from $1,000 at the beginning of the year to a peak of $19,000 and then dropping to $12,000. With one coin costing such an exorbitant amount, the high price defeats the purpose of using for actual transactions, say buying a pizza. In addition, 2018 can expect to see a flood of cryptocurrencies and transactional systems built off of blockchain technology, consisting of cryptographic keys and shared ledgers.

Global investors were in a festive mood as global equity markets (MSCI ACWI) rallied 5.5% led by Japan and emerging markets with Europe lagging major regions. The S&P 500 rallied 6.6% led by smaller caps and value stocks, primarily due to the prospects of these two segments benefiting more from tax reform legislation.

Commodities performed well (up 9.9%) as oil prices rallied to the $60/barrel range from upper $40/barrel. For the first time since 2014, global demand is exceeding global supply on a trailing 12-month basis (see Supplemental Charts at the end of the report).

Yield-sensitive sectors like REITs and utilities were laggards as were High Dividend and Low Volatility factor strategies. The 10-Year Treasury yield rose ~0.10% from the beginning of the quarter following passage of tax reform legislation and increased confidence that the Federal Reserve would tighten short-term rates further in 2018 and 2019.

High yield credit spreads widened, albeit off two-year narrow levels, while investment grade spreads remained flat. The tax legislation capped how much interest expense could be deducted by corporate tax payers, which could put more pressure on highly leveraged borrowers.

2018: The Path Forward

With healthcare and tax reform legislative initiatives behind us, headlines out of D.C. may not be as market moving, barring any major bombshells that could negatively impact the Trump administration or another round of sabre rattling between the U.S. and North Korea.

Much of the outlook we shared in last year's commentary applies to this upcoming year as well but with the caveats (Fed, China, political reception of new tax regime) mentioned above. This is what we wrote last year:

"As we head into the year, our global macro barometers exhibit strong momentum providing a bullish backdrop for continued outperformance of cyclical risk. Despite region-specific risks such as populist candidates prevailing in 2017 European elections, geopolitical conflicts, and potential restrictions on global trade stemming from Trump administration policies, the macro backdrop and relative valuations should be supportive of global diversification rather than investing in single markets. And with yields having backed up globally, dividend-based strategies look more appealing from a valuation standpoint. As investors chase cyclical risk and potential credit imbalances start to form, one may want to improve the quality of the equity portfolio without sacrificing broad market risk."

Indeed, much of this did play out, even with populism a lingering political threat in Europe (witness this year's German elections). With respect to the path forward, we expect some cyclical boost from the tax legislation. The larger debate is whether that boost will be enough to raise the real sustainable GDP growth rate in order to give the Federal Reserve enough cover to raise rates so as not to tip the economy back into recession. Both the Fed and the markets are signaling three rate hikes in the coming year to a range of 1.75-2.00% for the Fed Funds Rate.

Overall, narrow market risk premiums, whether equity valuations or credit spreads, reflect a tightly-coiled market susceptible to any hint of trouble (geopolitical, inflation/deflation, Trump). Those shorting volatility in 2017 have been handsomely rewarded for underwriting the risk of a market meltdown. However, as we stated above, the macro backdrop remains largely supportive of risk taking, but it is a matter of identifying those areas of the market with more attractive risk premiums.

Rate volatility should remain subdued, barring any inflationary surprises. But fixed income investors could be spooked by an outbreak in inflation and whether the Fed is falling behind the inflationary curve. This could lead to a panic sell-off in longer-term bonds. In this scenario, investors would want to underweight duration (interest rate sensitivity) and convexity (prepayment risk or the risk that your short-duration assets turns into a long-duration assets).

Beneficiaries of late cycle reflation would include "value" style of investing and perhaps hard assets such as commodities. What strategies that could be at risk are ones that focus on high quality and profitability given a mix of premium valuations and record high margins potentially at risk due to rising input costs. Small caps should also perform well in late cycle reflation, but their performance could be tempered by high valuations.

And at some point, the late cycle turns into a downward cycle. One could point to Fed rate hikes as the rudimentary cause for the last three downturns, but there were other major factors at play such as excess credit bubbles that exasperated the slowdowns. However, a lot will depend on how GDP growth (and inflation) is tracking as the Fed raises rates throughout the year. Will we see the Fed raise rates well above the theoretical neutral real rate necessary to maintain economic growth without causing inflation? If so, then a more defensive positioning in equity and fixed income could be warranted.

Parting Thoughts

As we've done for the last two year-end commentaries, we concluded the 2017 year-end market commentary with this parting excerpt from the 2015 year-end market commentary on diversification that bears worth repeating:

"Diversification" is a [expletive deleted] poor surrogate for knowledge, control and price consciousness."

Marty Whitman, founder of 3rd Avenue Management (cited in Barron's earlier this year).

Mr. Whitman is partly right in this statement (the irony of this statement is not missed on those who followed the collapse of the 3rd Avenue Focused Credit Fund and the subsequent drama surrounding its closure including the abrupt firing of the firm's CEO). With all due respect, we disagree with the word choice "poor surrogate"; instead we would rephrase Mr. Whitman's statement as follows:

"Investors diversify because they don't possess full knowledge, control, and price consciousness."

Diversification can be a humbling exercise for professional investors who take it as a point of pride to deliver their primary value proposition, which is to beat the market. Diversification is an admission that even the most knowledgeable investors don't possess enough information, skill, and insight to invest an entire amount into a few securities. Even an investment concept such as "price consciousness" (or value) needs to be tempered with other well documented risk-premia such as price momentum, quality, and low volatility. We at 3D Asset Management proudly proclaim global diversification as one of our primary philosophical tenets. We diversify because we don't pretend to hold enough knowledge to warrant the type of concentrated strategies adopted by other active managers who lay claim to possessing this special kind of insight. As such, we don't concentrate our clients' assets into one or two themes. Rather, we build our ETF portfolios to provide broad diversification across market regions, sectors, and fundamental factors (alternative betas) to extract long-term risk premia while being conscious of the price we are paying within the context of the current market environment. Diversification, like compounded returns, is a gift from the market to investors that should be freely received rather than rejected out of hubris.

4Q and Year-to-Date 2017: Charts and Exhibits

This section provides charts and exhibits covering market performance and macroeconomic conditions. All data comes from Bloomberg unless noted otherwise.

QTD Ending 12/31/2017

YTD Ending 12/31/2017

Other Key Charts

High Yield and Investment Grade Credit Spreads

Global Energy Supply and Demand

U.S. Domestic Drilling and Employment

2- vs. 10-Year Treasury Spread and 5-Yr/5-Yr Forward Inflation Expectations

Primary Global Sovereign 10-Year Yields

Industrial Metals and Oil

U.S. Dollar Spot Index and Against Euro and Yen

Global Equity Valuations (Price / 1-Yr Forward Earnings)

S&P Operating Margins and Rolling 1-Year Revenue Growth


The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as January 2, 2018 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm's Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing or visiting 3D's website at

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.