December 22, 2017—As we take stock of 2017, and our expectations of the year ahead, we appreciate the incredible year equity markets have had, and we find evidence that the current momentum can continue. As such, this month we are modestly increasing risk in client portfolios by adding 1% to Developed International equities from cash (within our High-Net-Worth Growth & Income strategy, with other allocations reflecting shifts commensurate with their risk profiles) and adjusting our sector strategy at the margin in favor of the more cyclically-oriented financials sector over health care.
We have held an overweight position in Developed International equities versus our strategic asset allocation benchmark for over a year, and this paid off in 2017. A combination of robust economic growth, easy monetary policy, and a weaker dollar helped generate a total return of over 23% for the MSCI World ex-U.S. Index in U.S. dollar terms during 2017 (through December 21; the S&P 500 Index returned 22% over that same period). Over the past year, the Euro area and Japan (the second- and fourth-largest economies, respectively) have witnessed dramatic improvements in sentiment and economic activity. The Markit Eurozone Manufacturing PMI climbed to 60.6 in December, the strongest reading since the data series began in 1997 (any number above 50 indicates purchasing managers and businesses are seeing expansion in activity). Japanese consumer and business confidence have also improved and the country just registered its 7th quarter of GDP growth in a row—the longest streak in over 20 years.
On top of what we view as very positive economic momentum, we also recognize that non-U.S. economies, both developed and emerging, appear to be earlier in their respective economic cycles with more attractive valuations than the U.S. This is a central theme in our 2018 Capital Markets Forecast. In particular, global inflation remains muted (though, encouragingly, the Euro area and Japan appear to have officially escaped the clutches of deflation for the time being), allowing central banks to remain accommodative while loan growth, labor markets, and sentiment continue to signal early-cycle improvement. We believe non-U.S. developed equity markets have more medium-term upside given this positive economic backdrop, leading to our decision to increase our overweight position in Developed International equities.
Source: J.P. Morgan, MSCI, and IBES
The U.S. tax reform bill has been top of mind for investors, and we view the fiscal stimulus to both individuals and corporations as meaningful. Specifically, we think the tax package is likely to lift real U.S. GDP growth in 2018 from around 2.25% year-over-year to a range of 2.75%-3.0% through a combination of increased personal consumption and corporate investment (e.g., capital expenditures and labor expansion). However, we view the broader market as already pricing in much of the fiscal boost at the asset class level, which has sent U.S. equity valuations to levels not seen since the tech bubble. For example, the tax plan favors small cap stocks over large cap, as small cap stocks have an effective tax rate of around 31% compared to approximately 26% for large cap stocks. However, the Russell 2000 U.S. Small Cap Index has already increased 12% since mid-August versus 9.5% for the S&P 500 (large cap) Index, when Congress shifted attention from health care to tax reform, and over 31% since the November 2016 presidential election.
We are hesitant to chase U.S. equity returns like these, though we are maintaining our neutral allocation to U.S. equities at this time. We see the effects of the Tax Cuts and Jobs Bill on financial markets as being much more nuanced, favoring specific sectors and companies that are reasonably priced and may benefit from a combination of the bill’s elements. For this reason, we have initiated a trade within the U.S. equity sector strategy to reduce health care by 0.35%, with these proceeds added to financials—a sector in which we were already overweight, but have a higher degree of conviction given the passage of tax reform and expected progress on the regulatory front in the new year.
Financials generally have higher tax rates than other sectors within U.S. large cap equities and therefore should be outsized beneficiaries of a 21% corporate tax rate. We expect earnings estimates to rise by an additional 10% on average for 2018 from pre-tax reform levels, with upside potential from increased share buybacks. We also think that tax reform will provide a modest economic boost. Not only will this potentially motivate the Federal Reserve to increase their target rate more quickly, which is helpful to bank margins, but it is also likely to drive loan demand higher and lower credit costs for most banks. Finally, financial firms will have more resources available to invest in technology solutions that will ultimately lower their cost structure, increasing their long-term earnings power.
We are moving the health care sector to a neutral position. The Tax Cuts and Jobs Act repealed the individual mandate that required all individuals to purchase health insurance or face a penalty. As a result, the Congressional Budget Office estimates the number of uninsured individuals would rise by four million in 2018 and increase to 13 million by 2027. This action will likely raise healthcare costs and have the greatest impact on hospitals, as most individuals without insurance use emergency rooms as their primary source of medical care. On a relative basis, the health care sector will also see one of the least net benefits to earnings from the lower corporate tax rate, as the effective tax rate across the sector is approximately 22% versus over 30% for financials. Fundamental headwinds are also building for several industries within the sector, including pharmaceutical and biotechnology industries, as drug prices continue to moderate and competition—from the likes of Amazon and others—heats up and threatens topline growth and margins for the market.
We see continued global economic momentum as evidence that the current bull market is likely to continue, though we have more conviction in the robust early-cycle indicators and relatively more attractive valuations offered by non-U.S. equity markets versus the U.S. We maintain a neutral exposure to U.S. equities but are increasing our overweight to non-U.S. developed markets. Tax reform is likely to provide a boost to U.S. economic growth in 2018, and we are increasing our weight to financials (at the expense of health care) as a result. Our sector strategy remains overweight energy, industrials, and technology, which should also see benefits from faster global growth and capital investment.
For more of our expectations of the year ahead, please see our 2018-2019 Capital markets Forecast: Global Positioning Systems: Recalculating in light of detours, bumps, and blind spots.
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