2017 Q4 Investment Report Commentary
Are you unfazed by the markets’ lofty valuations? Equity markets do not seem too fazed by much of anything. No matter what disaster or uncertainty came our way during 2017, global equity markets (MSCI ACWI) were up in each month of the year. That is a remarkable result and a measure of calm in the face of extreme political drama, international terror, policy changes, North Korea’s nuclear threat, cyberattacks, hurricanes, wildfires, etc.
While acknowledging the many problems in 2017 and the uncertainties ahead, numerous factors are supporting equity markets, including a more business-friendly regulatory environment in the U.S., tax reform, strength in U.S. and global labor markets, and unusually synchronous global growth. Despite tightening labor and capacity, inflation is well contained and the odds of a near-term recession remain low.
Not only were equity markets unusually calm in 2017, they were also unusually profitable. Daintree clients participated in this growth very nicely and most received returns of low double-digits to mid-teens. In our opinion, these are excellent annual returns for a well-diversified portfolio by any historical measure. Moreover, most clients also outperformed on a relative basis compared to their Policy Benchmark (the weighted average return of the asset class indexes).
We highlight the following results for 2017:
• Three of our four asset classes (Equities, Real Assets, and Fixed Income) experienced substantial gains.
• Global equities were the main driver of portfolio returns in 2017, with the MSCI ACWI rising 24%. Daintree’s geographical weightings were favorable since we remained overweight outside the U.S., especially to emerging markets. This tactic paid off since U.S. equity returns were strong, though not as strong as other geographies in 2017:
o U.S. (S&P 500) 22%
o Non-U.S. Developed (MSCI EAFE) 25%
o Emerging Markets (MSCI EM) 37%
• Real Asset returns were in the high single-digit to low double-digits. Heightened geopolitical fears and the declining U.S. dollar drove Gold up 11% to its best return since 2010. International REITs also had a spectacular year, up 25% due to more attractive valuations versus equities, stronger dividend growth, and a competitive commercial real estate market.
• Daintree’s Fixed Income returns for 2017 were low but good relative to the bond market, beating the benchmark. This was largely the result of the market rewarding credit risk over interest rate risk, which matched our tactical weighting.
• Diversifying Strategies were a drag on portfolio returns in 2017. Low returns were not surprising, nor was the gap versus surging equity markets, but the relative underperformance was disappointing. We did take some corrective actions and fired two managers early in the fourth quarter.
Markets May Be Unfazed, But Are We?
When the markets are unfazed, this at least gives reason for pause. The level of market valuations and the risk of a substantial pullback concern both professional and retail investors. Certainly it has helped that earnings expectations remain favorable given economic, regulatory, and tax trends. However, we still think equities, and especially U.S. equities, are expensive. This decreases expected forward returns and increases our discomfort, but we are not reducing equity allocations at this time. The reasons are complex, but we offer here a few high-level observations:
• Given the current macro environment (solid growth, low rates, reasonable leverage, and no clear asset bubbles), we believe that there is low risk of a global recession in the short term.
• If other assets were cheap, we would be quicker to sell equities. (One has to decide what to buy before one can sell.) Unfortunately, fixed income is expensive and so are many other assets–i.e., there is no place to hide.
• We have already reduced equity risk by changing the geographic mix of equities in portfolios. Instead of reducing overall equities, we have reduced U.S. equities in favor of non-U.S., including emerging markets equities, since these are substantially less expensive compared to historical averages. For most clients we also tilt toward quality stocks, which tend to have less downside volatility than the broad market indexes.
• We remain humble about our ability to predict the direction of markets. History shows the inability of investors to time the market and the high opportunity cost of being out of the market. Therefore, we limit the frequency and size of our tactical tilts. We also normally delay tilts until the odds of payback are stacked well in our favor.
• We remain watchful and may choose to act at any time.
Even if 2018 goes well, we do not expect gains to be as robust or as uninterrupted as 2017—be prepared. Portfolio risk management is critical. Daintree builds portfolios that seek to weather various market environments, whether the surprise is to the upside, as it was in 2017, or to the downside.
All information in this document is from sources believed to be reliable and is for informational and educational purposes only. It is not intended to be, and should not be construed as, advice, legal or otherwise. Daintree Advisors LLC (“Daintree”) may not have verified the information for accuracy or completeness, and Daintree assumes no liability for damages resulting from or arising out of the use of such information. You are solely responsible for evaluating the merits and risks of the use of this information. To ensure compliance with IRS requirements, we inform you that any federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this document.