On the whole, 2017 saw strong performance across nearly all asset classes around the globe. Led by the emerging markets, stocks posted another year of gains with extremely low volatility. Here in the US the S&P 500 returned 21.83%, but were outpaced by stocks abroad. The MSCI EAFE index tracking international stocks in developed markets returned 25.03% on the year, with its counterpart in the emerging markets returning 37.28%.
This is typical for the latter stages of an economic cycle. International stocks tend to be more cyclical and sensitive to inflation. During strong markets and periods of strong global growth, these securities do very well.
Fixed Income in 2017
For bonds, corporate issues and preferred stocks performed very well in 2017. Thanks to the strong economic conditions, declining defaults, and easy monetary policy, most corporate bonds saw rising prices. Looking into 2018, we see it as unlikely that corporate bonds will continue posting the same level of price gains. Given the trajectory of interest rates and current credit spreads, their 2017 performance would be difficult to replicate.
That doesn’t mean corporate bonds shouldn’t be in your portfolio though. We’d just expect future returns to be driven by income payments, not price gains.
Like investment grade corporate bonds, high yield bonds also posted strong gains in 2017. We also think it’s unlikely they’ll post similary performance this year. One way to determine how expensive bonds are is to measure their yield against a risk free US government security. This difference is known as a bond “spread”. A bond’s additional yield on top of a comparable risk free security constitutes the risk that the issuer defaults, and is not able to repay lenders.
When the yield spread of bonds as a group is high they’re considered cheap, since you can collect a higher yield for taking a similar amount of risk. When spreads are low they’re considered expensive. You take the same amount of risk, but don’t capture as much yield.
Currently spreads on high yield bonds are low. The average spread for the Bloomberg Barclays US Corporate High Yield Bond Index is 5.5% over the last 20 years. The index spread currently sits at 3.4%, which is very close to its all-time low of 3.2% in June of 2014. In other words, like many other asset classes high yield bonds are expensive right now.
What's Ahead for 2018
Looking ahead, the prolonged period of growth since our last recession will come to an end some time. When we review the causes of the last three recessions, all were caused by bursting bubbles. The crisis in 2008-09 was triggered by the housing bubble. The dot com collapse caused the recession in the early 2000s, and the recession in the early ‘90s was caused by the savings and loans crisis and implosion of the Soviet Union.
Whatever the cause of our next recession, there’s a good chance it’ll end up resembling recessions of the ‘60s, ‘70s, and ‘80s moreso than a bubble bursting. Recessions during these periods followed overheated business cycles. Concerned about inflation, central banks across the world hiked interest rates and tightened policy, freezing the economy in its path. There could always be a bubble we haven’t identified yet, of course. But given the long, steady climb of this economic cycle central banks may need to intervene before anything “pops”.