The fourth quarter marked the end to a very stable and impressive year for stocks. U.S. stock indices posted strong gains in the fourth quarter, driven by better-than-expected earnings and lower corporate tax rates starting in 2018. Investors exhibited a preference for growth stocks based on strong economic and earnings growth, and they outperformed value stocks across asset classes. Large-cap stocks slightly outperformed small- and mid-cap stocks as the U.S. dollar’s weakness helped enhance foreign sales and earnings. International developed market stocks took a breather after a great first nine months of 2017 and underperformed domestic stocks by about 2.0% in the quarter.
The Federal Reserve continued its rate hike campaign with a 0.25% bump in the Federal Funds rate in December. Although shorter-term interest rates rose, longer-term rates declined slightly as demand for the bonds remained robust. Bonds provided only modest returns in the quarter as rates in general rose.
Equity markets across the globe provided above-average returns in 2017. Given this strong performance, it is unlikely that stocks, particularly in the U.S., will provide similar returns in 2018. U.S. equity prices increased faster than earnings in 2017, and equity index valuations finished the year elevated compared to longer-term averages. Investors have likely incorporated the strong economic data into their equity valuations, and stocks would likely need positive earnings surprises in order to provide double-digit returns in 2018. If economic growth surprises to the upside, it is likely the Federal Reserve will be forced to increase interest rates more aggressively to dampen growth and the prospect of rising inflation. A more aggressive Fed would likely weaken investor enthusiasm for equities and negatively impact returns.