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Multi Asset

Lessons from 2017

January 2018

Luca Paolini, Chief Strategist

Corporate earnings can sometimes top expectations and central banks don't always practise what they preach.

Profits rather than animal spirits fuel rally

For the first time since 2010, corporate profits surpassed expectations, with companies represented in the MSCI ACWI index delivering a 15 per cent yearly rise in earnings compared with forecasts for a 13 per cent gain. Corporate profit growth was responsible for more than 60 per cent of the index’s 25 per cent return in 2017, double the contribution attributable to the expansion in stocks’ price-earnings ratios.
earnings beating expectations for first time in 6 years
earnings surprises
Source: Thomson Reuters Datastream, Pictet Asset Management; data covering period 01.01.1995-01.01.2018 

Selling too early can be costly

Warren Buffett, among others, contends that equities tend to perform better during the latter stages of a bull market. The experiences of 2017 back that up. Global equities delivered 12 consecutive months of gains – a first – while the realised volatility of the S and P 500 index hit a record low of just 3.5 per cent during the year. What is more, the peak to trough fall in the S and P 500 was 2.8 per cent, far shallower than the average bull market correction of 5-7 per cent.

Rich pickings for active investors

For much of the period since the 2008 debt crisis, regional equity markets and individual stocks moved up and down more or less in lockstep. But in 2017 that trend came to an abrupt end. Take the S and P 500. Here, the correlation between the returns of individual stocks and the return of the index fell to a record low of 0.27 in December. Similar trading patterns unfolded across other country indices, industry sectors and currencies. In such an environment, strategies such as stock picking and tactical asset allocation delivered handsome rewards for shrewd investors.
era of highly correlated asset performance comes to an abrupt end

Correlations of stocks in the S and P 500 to the index

correlations
Source: Thomson Reuters Datastream, Pictet Asset Management; data covering period 20.10.1998-26.12.2017 

Without inflation, bonds won't sell off

Strong economic growth and higher US interest rates are preconditions for a rise in bond yields, but they alone are clearly not sufficient: the JPMorgan index of global government bonds ended 2017 yielding just 1.4 per cent, almost exactly the same as at the beginning of the year. The missing link is inflation. Inflation remained much lower than expected in 2017, not only in the US, but also in Japan and the euro zone. Without a rise in prices and wages, bond yields will hold firm, not least because tighter pension regulations and an ageing investor base have raised demand for fixed income securities. 
range-bound inflation keeps a lid on global bond yields
bonds
Source: Thomson Reuters Datastream; data covering period 27.12.2011-02.01.2018 

Equities on fire, but bonds won popularity contest

Although returns from stocks have outpaced those of bonds by some 20 percentage points in 2017, fixed income securities have been the year’s most sought-after investment. According to data from EPFR, investment inflows into bond funds reached USD350 billion last year, topping the USD300 billion that headed into stocks.

Consensus can be badly wrong

Most investors and economists went into 2017 believing the US dollar would add to its already hefty gains. They reckoned, not irrationally, that healthy US economic growth, President Donald Trump’s protectionist streak and US interest rate hikes would combine to push the greenback higher. What they failed to see, however, was that much of the rest of the world was in good economic shape too. A revival in the economic fortunes of the emerging world and Europe proved pivotal in pushing an overvalued dollar lower, resulting in the US currency’s biggest  yearly trade-weighted decline since 2007 (of some 7 per cent).

Valuations don't matter over the short term

Although equities and bonds remain expensive by many yardsticks – US stocks’ market cap, for instance, is at its highest ever level relative to the country’s GDP – lofty valuations are rarely a barrier to market gains over the short run. Investing on the basis of mean reversion is only effective over the long term.
us equities look expensive

Ratio of market value of US equities to the country's GDP

market cap
Thomson Reuters Datastream; data covers period 31.01.1986-01.01.2018 

What counts is what central banks do, not what they say

Throughout 2017, the world’s major central banks have been at pains to point out that the era of exceptionally loose monetary policy is coming to an end. Their rhetoric contradicts the facts, however. This year, the volume of net liquidity injections1 by these central banks amounted to USD2.5 trillion, double the amount of 2016. Also, real interest rates have barely budged. Among other things, the Fed itself says, this has left US financial conditions at their most expansionary since 1993. 

Political risks are tricky to price

There were plenty of political landmines for investors to worry about in 2017, including North Korea’s sabre-rattling, Trump’s unpredictability and Brexit. The returns delivered by the major stock and bond indices would suggest that such concerns were cast aside. On deeper inspection, however, the picture is more nuanced. Political upheaval had a part to play in the decline of the Turkish lira, the fall in the Qatari stocks and the lacklustre performance of the Spanish IBEX stock index.