2017 was a particularly strong year, with broad growth and low inflation creating an almost perfect environment for equity investors. But we are beginning to see signs that we are in the sixth or seventh inning of the current economic cycle.
Technology was a significant part of the 2017 growth story. As of mid-December, Bitcoin had reached 17,000, an increase of over 1,600% since January 1. China, which is transforming into one of the most innovative countries in the world, had one of the most interesting runs we have seen for a while.
There were other less obvious but notable areas of strong price action: Salvator Mundi, a painting of Christ by Leonardo da Vinci, sold for $450 million, and Paul Newman's Rolex Daytona was the most expensive watch ever sold at auction at about $18 million.
Reasons for Optimism
Because that kind of price action normally occurs further into a cycle, it is difficult not to think that we are near the end of something. But when we look at some of the themes dominating the markets in 2017, we are clearly at the beginning in many ways.
Technology is one, particularly artificial intelligence, which is disrupting existing business models, placing new demands on infrastructure, and even breaking down societal institutions.
Another is the rise of innovation in China. China is transitioning into an innovative, digitally led economy. The number of technology graduates, ample venture-capital funding, and tax credits all support Chinese innovation. Yet, China is under-represented in global equity indices relative to its economic influence, leading us to believe that China's weight in global benchmarks—and thus its relevance to investors—will increase materially.
We are trying to understand these forces and use that understanding to position our portfolios. The synchronized global recovery is well understood, and global growth remains firm. For us, though, it is important to determine the nature of the cycle and how far we are into it. There are signs—including the sale of Leonardo da Vinci's Salvator Mundi and Paul Newman's Rolex Daytona—that we are in the sixth or seventh inning of the current economic cycle.
Potential Risks
The low-volatility regimes we have experienced in the equity and fixed-income markets carry potential risks. When change comes, it will likely be difficult, because we have been shielded from natural cyclical behavior—from negative economic and market forces—for some time.
Sudden inflationary pressures and wage growth acceleration would alter investor return expectations, driving bond yields and volatility materially higher, while potentially triggering equity-leadership rotation both across and within sectors. Financials would be expected to benefit from higher rates, but increased caution would be warranted for financially leveraged companies. We want to be mindful of that.
Our Outlook
Returning to some of the themes I mentioned earlier—technology and the rise of innovation in China—I am optimistic. Despite the growing likelihood of a cyclical slowdown within the technology sector, we believe that strong secular growth will continue.
From a geographic perspective, we believe that emerging markets continue to offer attractive investment opportunities in 2018. In particular, there are abundant opportunities to invest in China's growth, but we are mindful of the significant share-price gains in 2017 from the perspective of near-term momentum reversal risk.
Simon Fennell
Portfolio Manager
William Blair
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