Fiscal year 2017 began with lingering uncertainty caused by a rising tide of populism, notably the Brexit referendum vote that closed out fiscal year 2016. Rooted in global trade-related economic inequality, a desire to control borders, and national security concerns, populism helped Donald Trump win the U.S. presidential election in November and was a dominant factor during a busy election calendar in Europe. Despite a series of unexpected events during the fiscal year, volatility in the equity markets remained subdued, and the strong performance generated by a typical diversified portfolio was largely driven by robust global equity returns. While equities remained resilient, other asset classes were impacted by swings in sentiment about the macro environment.
Immediately following the surprise election of Trump, a reflationary trade took hold, which drove up inflation expectations and interest rates. The Federal Reserve’s forward guidance called for three rate hikes during the year, but many believed stimulus-driven inflation increased the probability of more hikes or some other monetary policy offset. Short-term Treasury yields were range-bound until markets started to price in a December 2016 rate hike—only the second increase in 10 years—followed by a another hike in March 2017. Meanwhile, as a higher inflation premium was built into the term structure, the 10-year Treasury yield rose sharply after the election and reached a peak of 2.62% on March 13th.
In the second half of the fiscal year, investors’ confidence in the Trump administration’s ability to lead a series of pro-growth measures through Congress waned, and inflation expectations subsequently moderated. Front-end rates held their steady upward trajectory for the remainder of the year, as Fed rhetoric suggested policy normalization would continue. As economic data started to soften and both Congress and the administration suffered a series of policy setbacks, inflation expectations waned further and the 10-year trended lower, eventually reaching 2.31% on June 30th.
Through the first half of the fiscal year, the U.S. dollar (USD) continued to rally. Investors believed the diverging paths of various central bank policy rates would continue—views that were fortified following Trump’s election win. The USD hit a near-term peak on January 3rd with a cumulative rise of 7.6% from the start of the fiscal year, before beginning a descent that ended with a cumulative loss of 0.4% for fiscal year 2017. Had the Japanese yen (−8.7%) and British pound (−2.8%) not weakened during the fiscal year, the downdraft in the Dollar Spot Index would have been much more extreme.
The shift in sentiment is partly attributable to the same factors that led to a moderation in Treasury yields, most notably a lack of progress on the administration’s campaign promises, falling inflation expectations, and Congressional setbacks on health care reform. The House GOP health care bill passed along partisan lines, but Senate leadership was unable to generate enough support to bring its bill to the floor before its recess just after fiscal year 2017 ended. The bills in both chambers included various tax relief measures that needed to be enacted before more comprehensive tax reform could be addressed. Adding to the uncertainty of health care and tax reform, details on the administration’s infrastructure plans remained scarce. Some investors were skeptical that the administration’s plan to fund infrastructure projects through public-private partnerships would garner enough interest. Many also felt that, unless cuts were made elsewhere, it would be a challenge to gain support for increased spending from deficit hawks in Congress.
Concurrent with these events, data shows that the U.S. economy began to soften while economics in the U.K. and Europe strengthened. In light of stronger underlying data, some members of the Bank of England and the European Central Bank (ECB) became hawkish, and reports emerged that the ECB may potentially taper its quantitative easing program later this year. These factors—a possible shift from central bank policy divergence to convergence, skepticism regarding the government’s ability to pass fiscal stimulus, and softness in U.S. economic trends—put downward pressure on the USD, which, in turn, served as a tailwind for international developed and emerging markets equities.
For the first time since fiscal year 2008, non-U.S. equities (both emerging and developed markets) outperformed the S&P 500 Index in fiscal year 2017, both in local terms and on an unhedged USD basis. Throughout the year, a number of headwinds that weighed on international markets in fiscal year 2016 reversed course, as populist candidates fared poorly during elections in 2017 and currency headwinds abated. The shift was most pronounced in 2017, when non-U.S. equities made significant gains over domestic equities. Although developed non-U.S. equities entered fiscal year 2017 mired in uncertainty due to the Brexit vote, European markets went on to recoup those losses as the economy proved to be resilient.
Within emerging markets, a recovery in energy and industrial metal prices contributed to a rally at the start of the year in a number of commodity-sensitive countries like Brazil, Russia, and Peru. Stable macro data in China also benefited the equity markets of its trade partners. However, the asset class began experiencing weakness in the months leading up to the November election, and fluctuated for several months after. A rally started as calendar year 2016 came to a close, but market drivers differed from those of the first six months of the fiscal year. Political environments grew more contentious and commodity prices weakened, causing large markets like Brazil and Russia to lag. Conversely, tech-heavy economies like South Korea, Taiwan, and China rallied in light of a 45% gain in the emerging markets tech sector. Lastly, Mexico, which tended to move inversely with Trump’s protectionist agenda and underperformed in the first half of the year, rallied sharply in 2017 and delivered a 23.5% gain for the fiscal year.
U.S. equity markets rose 17.9% during the fiscal year. U.S. stocks started the year on solid footing, benefiting from a post-Brexit risk rally. Following the November elections, gains were extended due to optimism around the prospects for the reflation trade. During the first half of the fiscal year, small cap stocks outpaced their large cap counterparts and growth outperformed value. Sectors such as financials, technology, and industrials outperformed defensive, high dividend sectors like REITs, utilities, and consumer staples. As the reflation trade unwound and investors questioned the impact of regulatory reforms, market leadership shifted in 2017, with large caps outperforming small caps. Despite this change, technology (+35.2%) and financials (+33.7%) still finished the year as the top-performing sectors.
Technology stocks and banks (notably Bank of America and JPMorgan Chase) were the top individual contributors to broad market gains. The FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google/Alphabet) became a larger percentage of the market, accounting for more than 8% of the market cap of the Russell 3000 Index. These stocks delivered outsized returns during the period: Netflix (+69%), Apple (+54%), Amazon (+38%), Google/Alphabet (+36%), and Facebook (+35%).
U.S. equities ended the fiscal year on an extraordinary run, registering gains in 19 of 20 quarters. Meanwhile, volatility remained near historic lows, with the VIX dipping into single digits early in May. Investors may be overly complacent, particularly against the backdrop of elevated valuations, the Federal Reserve tightening cycle, and the potential for geopolitical tail risks.
Fiscal year 2017 continued a recent trend of strong performance for a traditional portfolio of stocks and bonds relative to a more broadly diversified portfolio. A representative diversified asset mix generated strong absolute results, gaining 11.6%. However, it modestly trailed the 12.2% return of the 70% domestic equities/30% fixed income portfolio and the 12.1% return of the global 70/30 index. Allocations to non-U.S. developed equity (+20.3%) and emerging markets equity (+23.7%) were the strongest contributors during fiscal year 2017 in light of positive local market returns and currency gains. Private equity (+8.9% based on December 31, 2016 marks) had a neutral impact on returns. Capital was actively deployed, but deal multiples were near an all-time high, which restrained results. IPO activity grew, with 13 private equity-backed debuts during the first quarter of 2017—the most since mid-2015. Hedge funds produced positive returns for the period with a 7.6% gain in the HFRI Fund Weighted Composite Index. Equity hedge, event-driven, and distressed/restructuring indexes each captured more than 70% of the upside in the equity market over the year. The post-election equity rally in late-2016 was led by value-oriented defensive companies, while growth-oriented sectors traded down. This was a challenging period for many long/short managers focused on growth-oriented companies, but created an opportunity for managers to add to high conviction positions as they traded down. In 2017, managers reported a better market environment for hedge funds on both the long and short sides of the portfolios. Fundamentals seemed to matter once again, as earnings season saw stocks that missed trading down and vice versa.
When the equity market traded down, investors were reminded of hedge funds’ relative and absolute potential to preserve capital. In October 2016, the S&P 500 fell 1.8%, while equity hedge lost 0.8%, event-driven added 0.1%, and distressed gained 1.3%. Detractors for the fiscal year included sovereign-related debt, owing to its longer duration posture and a lack of a credit spread cushion to help absorb rising rates. Long Treasuries fell 7.2% and underperformed the 0.3% decline of the Bloomberg Barclays Aggregate Index. Similarly, the 5.0% drop of the Citigroup Non-U.S. World Government Bond Index trailed the 3.2% decline of the Bloomberg Barclays Global Aggregate Index. Within marketable real assets, REITs (+1.1%) delivered positive absolute returns but weak relative returns, and natural resource equities (−2.6%) fell along with lower energy prices. However, non-marketable real assets did provide some protection to weakness in the public markets, with a 17.6% gain in private energy and a 6.9% rise in private real estate (both based upon December 2016 marks).
Outlook
Equity bull markets, particularly extended ones, tend to increase the risk appetite of investors, both on the retail and institutional sides. This is not a new phenomenon—as markets cycle, investors’ position on risk will cycle with them. Market cycles can be long or short, and the associated change in risk appetite can vary from slow and steady to sharp and dramatic. The one constant is that the market will always cycle and investor behavior will always cycle with it. Activity over the last fiscal year is no different, as valuations have ticked higher while the VIX has ticked lower. Meanwhile, credit spreads are shrinking and defensive strategy asset flows are declining. At least at the margin, each of these factors are symptomatic of increased risk appetite.
We have never been comfortable predicting short-term moves in the capital markets or ringing the bell to signal the beginning of the next market cycle. However, we are comfortable reaffirming our position that developing a thoughtful investment strategy and remaining disciplined to it increases the likelihood of long-term success. While maintaining a diversified portfolio with assets other than U.S. equities was challenging in recent fiscal years, there are signs that the next market cycle may be nearing. For example, central bank policies are no longer pushing in the same direction, which is a major difference from years past. Also, inflation expectations, while muted, are at least reacting to policy shifts—unlike in recent years, when they barely moved regardless of these changes. And the opportunity set for many hedge fund strategies seems to be improving. Default activity remains low, but overall corporate activity, such as mergers and spin-offs, and stock-level dispersion have increased in recent periods.
While we have not and will not ring the bell, we note the numerous signs of an increased risk appetite by investors. Historically, this has preceded difficult periods in the equity markets and a more favorable environment for a broadly diversified portfolio. We believe building a portfolio that respects the threat of risk even during extended bull markets and avoids chasing various market cycles is key to long-term success.