Markets: Growth and Perfection
The fourth quarter culminated a record-setting year for equities when, for the first time ever, both the S&P 500 and MSCI All Country World Equity indices achieved perfection by registering positive total returns every single month. In particular, the final three month stretch was driven by optimism around tax legislation that ultimately passed in late December, ongoing corporate earnings growth, and an improving global economy. Against this backdrop, secular growth stocks shined once again, within a more favorable stock-picking environment triggered by the Federal Reserve’s initial normalization of its quantitative easing (QE)-inflated balance sheet. Fundamental factors, such as high quality and upward estimate revisions, continued to be rewarded, while companies delivering positive surprise also participated during the third quarter earnings reporting season after responding apathetically over the summer. For the last three months and the full year, Growth significantly outpaced Value across the market capitalization spectrum, with Large Cap Growth having the widest annual margin versus Large Cap Value (+30.2% vs. +13.7%), a marked reversal of 2016 when Growth underperformed Value (+7.1% vs. +17.3%). In contrast to the last several years (when correlations were high and monolithic treatment was the norm because of QE), dispersion within and across sectors grew, as investors increasingly differentiated among companies based on their fundamental merits. Adherence to CCI’s time-tested positive momentum & positive surprise investment discipline was paramount to each of our products overcoming 2016’s challenging results and reaping the rewards of secular growth leadership, where returns in 2017 registered within the upper echelon of our respective peer groups.
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Politics: Death and Taxes
Despite considerable time spent to repeal and replace Obamacare healthcare legislation earlier in the year, efforts finally experienced a tortuous death, as bifurcation amongst Republicans prevented agreement on a new framework. During the quarter, the political conversation pivoted to tax reform, where the expected bickering around details, such as tax rate levels, treatment of state and local taxes, child care credits, pass through income, repatriation and interest expense deductions, took center stage. Ultimately, however, the less fractured Grand Old Party constituents delivered an early Christmas present, as they found unification in desperation that enabled passage of the largest tax reductions in over thirty years. The centerpiece of the bill was a dramatic reduction in corporate income tax rates from 35% to 21%, moving the U.S. from among the highest taxed jurisdictions in the world to a solidly below average level. As part of the President’s Make America Great Again campaign, this decrease should provide financial incentives for domestic and foreign companies to increasingly operate onshore.
The benefits of this evolving tax debate were immediate, as market leadership within the quarter shifted from global multinationals to more domestically-focused firms, particularly those with the highest tax rates, which ascended most sharply coincident with the rising odds of legislative passage. Sell-side analysts also scrambled to update their models for the new paradigm, providing a stream of upwardly revised earnings forecasts for the market overall, and especially for companies within the financials, consumer discretionary and industrials sectors. An unexpected response to the tax bill’s approval was the announcement regarding implementation of immediate employee special bonuses, minimum wage hikes and workforce training by several prominent companies (AT&T, Bank America, Comcast, Wells Fargo and Boeing). Democratic officials in high income tax “blue” states that account for a significant portion of the U.S. population are also rumored to be investigating ways to offset the limitations on state and local tax deductions that disproportionately impact their citizens. Shifting individual income tax burdens to employers via deductible corporate payroll taxes, and replacing income taxes with tax deductible charitable contributions to state governments, are some of the novel approaches being considered. These initiatives, along with the more widespread benefits of lowered individual withholding rates, could jumpstart consumer expenditures and provide an accelerant for the U.S. economy.
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Economy: Capitol Save, Capital Spend
In general, capital spending has been in a downward trend for the past several years, consuming a lower portion of free cash flow. This has resulted in an aging infrastructure and industrial equipment that has fueled productivity declines and created sub-optimal economic growth. These productivity decreases have also been a contributing factor to gradually emerging inflationary pressures. The aforementioned corporate tax rate changes just passed could potentially reverse this downward trend in capital expenditures (capex), and eventually generate productivity enhancements that would alleviate some of the inflationary stresses. Corporations have multiple options for the newfound tax savings, including redeploying them for competitive advancement purposes, returning incremental cash flow to shareholders via buybacks or dividends, or allowing the savings to accrue entirely to the bottom line for greater corporate profitability. Another course of action would be to follow the examples of Japan and Spain earlier in the decade, when each country experienced an upward inflection in capex after the passage of corporate tax rate reductions. Several business executive surveys and tabulations of statements made by corporations regarding their intentions pertaining to the incremental tax savings suggest that accelerated capital spending is likely. Additional catalysts for increased capex include more favorable depreciation expense provisions in the tax legislation, banks’ increased willingness to underwrite commercial and industrial loans, ongoing technological advances, and improved relative competitiveness of U.S. locations because of lower tax rates and deregulation. Lastly, prioritizing infrastructure spending on the legislative agenda could serve as a further catalyst. The most obvious beneficiaries of a capital spending renaissance would be Industrials and Technology companies, followed by Materials, Financials and other select companies opportunely positioned for such a recovery.
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Topical Theme: Crypto or Klepto
The meteoric rise in cryptocurrencies received intensified media coverage and increased awareness during the quarter, reaching a crescendo when market pundits starting commenting on Bitcoin’s pre- and post-market moves in the same sentences as those addressing the traditional stock indices from Standard and Poor’s and Dow Jones. The number of users with Coinbase accounts (the leading U.S. platform for buying and selling cryptocurrencies) now exceeds those with Charles Schwab (the nation’s largest online brokerage provider). Bitcoin (BTC) is the most popular of these nascent virtual currencies which also includes Ethereum, Ripple, Litecoin and Dash. These cryptocurrencies are considered virtual because they have no physical characteristics and are not backed by central governments, banks or reputable financial institutions. Since its introduction in 2009, Bitcoin has experienced a checkered history, including: several crackdowns and bans from various Asian and Latin American countries (China, Korea, Vietnam and Columbia); characterization as a fraud by financial luminaries such as J.P. Morgan’s Jamie Dimon; corruption, fraud and hacking of several networks; and trading restrictions at financial powerhouses like Bank America.
Daily values for Bitcoin and others have become extremely volatile and reminiscent of other financial bubbles, such as Dutch tulips in the 1600’s, dot-com stocks in the late 1990’s, and housing prices in 2006. BTC more than tripled in the fourth quarter to finish the year with a staggering fourteen fold increase in value. The volatile nature of daily Bitcoin values, as evidenced by the fact that there were more than twenty days in 2017 where BTC experienced a greater than ten percent change in daily prices, creates an environment whereby cryptocurrency users could have their accumulated virtual wealth destroyed at a moment’s notice if this apparent bubble should burst, or kleptomaniacs disguised as hackers again infiltrate the exchange networks.
Despite this volatility and potential financial risk, cryptocurrencies bear watching for their disruptive potential in the emerging growth area of peer-to-peer and electronic payments. While CCI accounts do not hold Bitcoin, the firm has exposure across all portfolios to securities in the mobile/online payment and virtual wallet-type functionality space, so analyzing the evolution of virtual currencies and any potential competitive inroads is essential to our investment process. In addition, the blockchain technology underlying these currencies and serving as a decentralized ledger could revolutionize how various transactions are consummated. Several companies have committed resources to researching how blockchain can enhance security and improve efficiencies around conducting business, and the proliferation of use cases involving this innovative technology could reveal intriguing future investment opportunities.
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Outlook: Spring Forward or Fall Back
Somewhat surprisingly, equity markets typically spring forward after years with strong returns (such as 2017), rather than falling back and consolidating the gains. According to Bank of America, years subsequent to those advancing by twenty percent or more have historically averaged eleven percent increases, and been positive seventy percent of the time since 1928 1 With corporate earnings improving, credit spreads remaining low and relatively stable, global central banks gradually shifting to more normalized monetary policy, and a synchronized global economic recovery, the backdrop for continued success of fundamental stock-picking remains positive. This active management renaissance associated with the unwinding of QE is in its early stages but gaining traction, as a meaningfully greater portion of growth fund managers outperformed (compared to 2016) across the market cap spectrum, according to data from Bank of America.2 Investors will continue to debate the economic effects of tax reform as described earlier, monitor the shape of the yield curve for signs of potential economic pressures on the horizon or changes in inflationary expectations, and make any necessary tactical changes that could impact market leadership. Such rotations are inevitable given the divergent performance in investment styles, market caps, company quality, and other fundamental factors during the quarter and the year. However, we believe secular growth stocks with strong and positively surprising results (such as those sought through CCI’s investment discipline) will continue to be rewarded.
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1 Bank of America, “US Performance Monitor,” January 2, 2018, page 1.
2 Bank of America, “US Mutual Fund Performance Update, ” January 3, 2018, pages 3, 5-6, and Bank America, “US Mutual Fund Performance Update, ” January 5, 2017, pages 4, 6-7.