By Mohamed A. El-Erian
(Bloomberg View) --Many of the assessments of the 2017 financial markets understandably focused on the impressively favorable outcomes delivered by stocks and other risk assets. Yet it is also worth considering what didn't happen -- in particular, nine events, which, by not taking place, contributed to make the last 12 months exceptional for many investors, big and small.
Superlatives have been and should be used to describe stock-market performance in 2017. Rewarding overall returns, including gains of 25 percent for the Dow Jones Industrial Average and 19 percent for the S&P 500, came wrapped in extremely low volatility. The VIX, the most widely followed measure of market volatility, registered nine of its 10 lowest levels last year.
The series of record highs during the year -- 71 for the Dow alone -- was accompanied by very few episodes of market retracement. And the rare times these occurred, they were comfortably limited in size, duration and scope.
Overall, the Dow rose nine months in a row, the longest streak since 1959; the S&P delivered positive returns every month of the year. The powerful performance of stocks was not limited to the U.S. A few international markets did better, including an almost 40 percent return on Hong Kong stocks, and the MSCI ACWI (excluding the U.S.) index returned a solid 24 percent.
Adding to the good news for investors, the cost of risk mitigation associated with the traditional 60/40 stock/bond investment portfolio was de minimus, and even non-existent with a diversified fixed-income approach. In another unusual twist, both stocks and bonds delivered positive returns.
The yield on the 10-year U.S. government bonds ended the year at 2.41 percent, or four basis points lower than at the start of the year. Given the surge in global stocks, that is certainly not the performance that would be expected for the “risk-free asset” based on history. Moreover, the U.S. government bond market traded in a relatively narrow range all year, with the 10-year spending around 80 percent of the time in a band of just 30 basis points.
Yes, there is a long and impressive list of things that went extremely well for investors in 2017, as markets responded favorably to the trifecta of:
- A synchronized pickup in global growth, turbocharged in the U.S. by progress on pro-growth measures,
- Strong corporate profitability, and
- Ample liquidity, particularly on account of central bank policies and the redeployment of corporate cash back into the market via higher dividends and buybacks.
Yet as long and consequential as the list of 2017 superlatives is, it is also worth looking at what didn’t happen -- especially if the goal is to look ahead to 2018. In this regard, nine issues are worth mentioning:
- Lack of a Fed policy mistake. Confounding critics again, the Federal Reserve took important steps in normalizing monetary policy without disrupting markets and/or derailing economic growth. These actions included several interest-rate hikes and laying out a timetable for reducing the balance sheet. And while the Fed was helped to some extent by the extremely loose non-conventional measures that continue to be implemented by other central banks, particularly the Bank of Japan and the European Central Bank, credit is due to U.S. policy makers’ careful planning and measured policy response, including in skillfully nudging markets on at least two major occasions to price more realistically its short-term interest rate intentions.
- No durable disruptions to trade. Belying the fears of some, the Trump administration did not disengage from the North American Free Trade Agreement, declare China a currency manipulator, or cancel free-trade pacts with countries such as South Korea. It did exit the Trans-Pacific Partnership negotiations, but this agreement was still a work in progress and had not had any notable impact on trade. Instead of disengaging from existing trade agreements, the U.S. nudged its partners to pursue fairer international trade practices, reinforcing rather than undermining the pro-growth policies it pursued elsewhere.
- No spike in inflation. Despite the sharp decline in the unemployment rate and a year of impressive net job creation, neither wage growth nor the inflation rate took a meaningful leg up. This lack of price pressure perplexed many economists, went against what history would predict, powered a market response with the notion of “Goldilocks” growth, and contained market concerns about excessive Fed policy tightening.
- No selloff in U.S. government bonds. The lack of inflationary pressure was one of the factors helping to explain a government bond market that defied expectations again. The persistence of low and stable yields reinforced the general market risk-taking appetite, underpinned by the notion that, with the Bank of Japan and the ECB remaining ultra-dovish, the central banking community would remain investors’ BFF.
- No dollar appreciation. After the notable appreciation into the start of 2017 and the resulting cautionary statements by President Donald Trump about excessive currency strength, the dollar remained relatively weak for most of the year even though the Fed raised rates, the U.S. adopted pro-growth measures, the economic expansion broadened, and the tax bill encourages the repatriation of corporate profits held abroad. In addition to lowering trade tensions, this removed a headwind to U.S. growth and reinforced the feel-good factor concerning corporate profits.
- No bitcoin regulatory crackdown. Despite some worrying that the historic surge in bitcoin prices was a bubble that would end up bursting and hurt most small investors, there was very little regulatory backlash against a phenomenon that some also believe is empowering illegal activities. This reinforced a more general view that the regulatory pendulum has now swung solidly, heralding a period of general deregulation.
- No contagion from Puerto Rico or Venezuela. Although both Puerto Rico and Venezuela missed contractual payments on their bonds, neither event created contagion in the municipal and emerging-market segments, let alone more broadly. Investors treated both events as isolated and as constituting no threat of adverse spillover.
- No geopolitical shock for markets. North Korea continued its brazen threats of nuclear attack throughout most of 2017, including on New Year’s Eve. Yet markets continued to ignore the risk almost all year, betting -- correctly -- that provocative words would remain just that and not translate into actions that would disrupt markets during the year.
- No OPEC disintegration. Despite the pressure earlier in the year of low oil prices, Qatar-related tensions within the Gulf Cooperation Council, and various Iran-Saudi proxy wars, the operational discipline of the OPEC cartel was not eroded. If anything, it strengthened during the year. That, together with effective cooperation with Russia and other non-OPEC producers, allowed oil prices to withstand competitive pressures from shale and end the year at levels not seen since December 2014. This gave an important boost to energy stocks, reversing their large underperformance during the first half of 2017.
The failure of these nine threats to materialize contributed to 2017’s strong annual performance for risk assets. Together, they turbocharged a rally powered by improving economic prospects, strong corporate profitability and ample liquidity. After closing the books on a great year, investors now need to assess the durability of this unusual combination of things that did and did not happen.
Happy New Year and best wishes for a happy, healthy and successful 2018.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."
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