The fourth quarter of 2017 put the crowning touch on a year which saw risk assets deliver outstanding results.  Once again US stocks finished the quarter close to an all-time high … broadly-diversified international stocks fell off the torrid pace of earlier quarters, but remained sufficiently positive to claim the title of best-performing asset class for the full year.  The S&P 500 rose 6.2% during the quarter, while international stock markets produced a 3.8% advance.

Similar to the first nine months of the year, defensive assets in the fourth quarter again delivered a much more subdued performance than stocks.  Both fixed income markets and Real Estate Investment Trusts (REIT’s) were essentially flat, as investors continued to flock to asset classes that benefit from steadily improving corporate profits and historically low interest rates.

As we have pointed out in recent quarterly reports, stock markets appear increasingly vulnerable to a correction as they approach the nine-year anniversary of the current bull market.  Price/earnings ratios have extended above historical norms, leading us to believe that US stock markets are “priced to perfection” – fully reflecting positive expectations for interest rates, inflation, economic growth and corporate profits.  And while all of those factors appear to justify an optimistic assessment, any unexpected disappointment could trigger a market pullback.  On this basis we believe that the odds favor a market correction within the next 12 to 18 months.

However, we do not anticipate an imminent end to the bull market.  For that to occur the US economy would need to be heading towards recession, which seems highly unlikely given the positive backdrop of a synchronized expansion among the world’s major economies.  Combine this with the dramatic drop in US corporate taxes and persistently low interest rates, and the foreseeable future offers the promise of continued economic growth.

What might threaten this sanguine forecast for 2018?  We have identified the following risks, in decreasing order of probability: an external geopolitical shock, such as armed conflict on the Korean peninsula or heightened hostilities in the Middle East; an acceleration in the pace of short-term interest rate hikes orchestrated by the Federal Reserve; or an unanticipated spike in the rate of inflation driven by pent up wage demands.  In our view all of these negative catalysts have a low probability over the next twelve months.

Nevertheless, it would be very unrealistic to expect investment markets to again deliver the kind of outsized performance enjoyed by portfolios in 2017.  Our prediction for 2018 is that stock markets will generate moderately positive returns, falling somewhat short of historical averages.  Meanwhile we expect fixed income and Real Estate Investment Trusts to “tread water”, as interest payments and dividend distributions are offset by gradually rising interest rates.

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