Reviews. Commentaries. Opinions.

2017 Yearly Review

2017 Yearly Review

2017 yearly summary & 2018 predictions

2017 was a good year for risk assets. Risky asset returns surpassed expectations and our clients enjoyed excellent risk-adjusted returns. Now our sights are on 2018. We hope you find our comments on Bitcoin, USA Tax Reform and research on expecting a crisis informative and relevant.

Bitcoin- “Millennial’s Fake Gold”[1]

It seems like it is almost impossible to have any professional or social conversation lately, without a mention of Bitcoin. Even at my shul they offered a lecture entitled 'Halacha and Bitcoin... ', not sure if anyone can get more mainstream than that! Opinions are divided between “this is the future” vs. “it’s a fad which will pass”. If you ask anyone who is pro Bitcoin how it works, you will get a bunch of modern words thrown at you (Block chain, Crypto, ICO etc.), whilst you stare back blankly as if you are not seeing the emperor’s amazing suit. The economic definition of a bubble is when the price of something becomes unhinged from its intrinsic value. What is the intrinsic value of Bitcoin? I argue it is very low and too volatile to be regarded as any sort of store of value. Does the fact that some mysterious computer geek says that it is limited in number, and therefore scarce, gives it its intrinsic value? I find the scarcity argument somewhat dubious because the demand is subject to trend and the actual coins are infinitely divisible. If it is (almost) infinitely divisible then how is it limited?

I think this is worth a little history lesson from the first ever recorded bubble called Tulip Mania. Tulip mania was a period, which peaked between November 1636 and May 1637, where the standardized tulip bulb contract price went from approximately 1 to 200 and then back to 1. The mania was many years in the making but peaked during this period. Reportedly, a single flower bulb was selling at the value of a 6 months' income or even a home. This is so similar to Bitcoin. People were purchasing tulip bulbs at higher and higher prices, intending mainly to re-sell them for a profit, having given themselves false sense of comfort that the flower had intrinsic value; because it was a luxurious and coveted item not previously seen in Holland (Tulips were from Turkey). However, such a scheme could not last unless someone was ultimately willing to pay such ever-increasing prices and take possession of the bulbs. In February 1637, tulip traders could no longer find new buyers willing to pay increasingly inflated prices for their tulip bulbs. As this realization set in, the demand for tulips collapsed, and prices plummeted — the speculative bubble burst. Some were left holding contracts to purchase tulips at prices now ten times greater than those on the open market, while others found themselves in possession of bulbs now worth a fraction of the price they had paid. In retrospect, the price rise was a clear example of the 'Greater Fool Theory', which states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems "foolishly" high because one may rationally have the expectation that the item can be resold to a "greater fool" later. Lacking any intrinsic value, like gold, and with so many competing “virtual currencies”, it seems to me that the price rise of Bitcoin is based very heavily on the greater fool theory. The technology behind Bitcoin, however is very interesting and may find some useful value creation in the future. For example, we may finally see more safe and instantaneous technology for money transferring (e.g. Ripple).

To conclude, I believe it is fair to say that Bitcoin and other Crypto “currencies” will remain popular. However, they will be a very risky investment. Luck will play a greater factor than skill. Right now, it seems that Bitcoin specifically is more of a 'digital Tulip' than a digital currency. Because of sudden rise in price and popularity, we should expect to see regulators sit up in their chairs and start to take action. It is hard to imagine the regulations will be supportive of the phenomenon if it continues to grow at this pace. There may one day come a time when Crypto currency investments become part of the alternative asset allocation for mainstream investors, but we do not believe that day is here yet.

USA Tax Reforms

In December, President Trump pushed through congress one of his main electoral promises, which was to reduce taxes and introduce tax reform. The new tax legislation does reduce taxes for most part; however, it does not at all introduce the simplicity that was promised. The tax code is as complex as ever and understanding its impact on the market and on economic growth is not as clear as one may assume. Overall, the tax legislation is positive for equities and for growth, however it is expected to add over a staggering $1.5 trillion to the USA debt burden over 10 years.

  • Personal taxes were reduced by approx. 2% across all ranges and corporate taxes were reduced significantly from 35% to 21%. The corporate tax reduction will have a greater impact on companies whose business is more USA orientated than those that are more international.
  • Inheritance tax threshold for American citizens was doubled to $11m. Most of our readers should note that there was no change in the historically draconian inheritance tax threshold imposed on non-Americans.

Another contentious area was huge cash piles that USA companies were keeping offshore in low tax regimes and avoiding “repatriation tax”. The companies had a choice in the past to leave the cash offshore and only pay USA taxes on a contingency basis if they brought the cash back. The new tax reform imposes lower tax on the money regardless of whether it is repatriated or not. The tax rate depends on when the money was made and the impact is company specific. The bottom line is that the move changes a contingent tax of 35% to a real 8% or 15% tax. Now that CEO’s are free to bring this money back to the USA, it is unclear how that money will be used. Will it be used for share buy backs, dividends, capital expenditure or loan repayments? We suspect that most of the money will be used for loan repayments as the new tax reform has a very severe limitation on the tax deductibility of interest. The view is that even though these tax reductions will increase the deficit, the net effect on the USD is expected to be neutral. It is also interesting to note that the fiscal stimulus of Trump leadership runs contra to the monetary tightening of the FED and it will be interesting to see how this plays out.

Expecting a Crisis

In many meetings with clients over the last 2 years the question “maybe I should wait outside the market until the next crisis?" has been raised. This is a fair question because we have had a very good run on equities, especially in 2017. Except for a painful period in 2011, we have had a solid bull run for nearly 9 years now. This means that it is not unreasonable to expect a “correction” (I do hate that term as it implies that the market is wrong). Goldman Sachs research looked at the S&P index from 1950 to 2016 and tested to see what would happen if an investor “waited” for either a 10%, 20% or 30% crash before entering the market. They found that the “cost of waiting” was far greater that gains made by staying invested over time. They also then narrowed the research to periods when the market valuations were high and found again that the “cost of waiting” (i.e. "lost returns”) was greater than the “staying invested” returns. This gives support to the asset allocation philosophy that Pioneer uses. The more disciplined approach is also supported by other research that says that the gains in stock markets are made on a surprisingly few number of good days. From personal experience, I know of one client who insisted in January 2016 that he was “happy to sit the next crisis out” and sold all his risky assets. In the two years that have passed since then his returns would have built a substantial barrier for the next crisis (should there even be one).

Bull markets do not die of old age. Just because we have had a good run, we need to have some trigger to set off a crisis, especially when we are supported by low interest rates. Economic fundamentals of the world are actually reasonably good and we do not expect a recession in any major market.

There are three types of crises. Firstly, a cyclical crisis which we are sure will happen at some point. Our asset allocation modeling and philosophy will protect us from this. The second type of crisis is an event driven crisis, which is very difficult to predict. If we look at the political events around the world, which are perceived to be market events, we see that most of the political events hardly have any real market impact. An event like 9/11 or a new Korean war could trigger a market crisis in risky assets. Nonetheless, our asset allocation approach will provide considerable protection for this crisis type. At this time we assign low probabilities for those types of events. A spike in inflation is a more realistic concern. The third type of crises is a structural crisis, like 2008 in which the financial sector malfunctioned. For this risk we assign a very low probability at this stage, because the world’s financial system is reasonably strong and well regulated.

Having considered all of the above we remain convinced that investors should remain invested in an asset allocation strategy that fits their current risk tolerance.

Brief Summary of Asset Classes Performance in 2017

  • 2017 was a really excellent year for risky assets. This was led mainly by China and other emerging market stock markets. The world's major markets like USA and Europe also did very well providing gains of over 20% and 10% respectively.
  • A unique feature of 2017 is that many of the gains are from a relatively few number of mega-cap companies like Apple, Amazon, Samsung, Tencent, Ali Baba, Alphabet. 2017 was clearly the year to be invested in technology stocks.
  • The bonds market was relatively robust and gave better than expected positive returns. The biggest surprise of 2017 was the strengthening of the Euro by nearly 15%. I am not aware of a single market commentator who predicted that. Most predicted a weaker euro.

Whilst there was a lot of political noise, including heightened North Korean risk, Brexit threats and increased Middle Eastern instability, none of it had any major impact on the market.

Outlook for 2018

Following a very good 2017 it is difficult to think 2018 will repeat those results. We expect positive returns on risk assets as there is a broad based global economic growth, however we do not expect to be rewarded as well as we were in 2017. We do expect short-term interest rates to rise. The Tax Reform described above gives further push to USA equities. We are positive on European equities and emerging market equities, knowing full well the risks.

Notwithstanding special event risk, unexpected inflation seems like our highest probability risk. This could trigger a quick turnaround in risk appetite. Oil prices above $80 would also be a cause for concern.

Currencies remain a big question for 2018 and whilst we are happy to increased amounts of USD exposure in a shekel portfolio, we would limit the non-base currency risk of a global portfolio. One argument is to expect the USD to strengthen because of the short-term gains of the growth and tax cuts coupled with higher and higher short-term rates. The counter view is that the long-term thesis for the USD is weaker given the high debt and higher inflation target of the fed. I personally am of the view that we will see a marginally stronger USD in 2018.

Israel at a glance

  • Israeli economy in 2017 grew by 3.2%, which is a good result. Unemployment is also a very low 3.7%. It is the first year since 2009 that the number of listed companies on the Tel Aviv Stock exchange grew with 20 new listings. All of these are very positive.
  • Ironically, most of the strengthening of the shekel was off the back of weak USD rather than shekel strengthening.
  • The Israeli stock market did not keep up with developed markets around the world and recorded a modest gain of 2.65% (TA 35). This index was heavily drawn down by the losses of Teva, Bezek and Delek. Were it not for these names the index would have more closely resembled European main index gains.
  • On the property market side, we have seen a slowdown of new deals as some buyers are waiting to see the effect of Kachlon’s property schemes. Even though the government is going to assist to provide around 140, 000 subsidized apartments to qualifying buyers, we do not believe that the total Israeli apartment property market will fall materially. Kachlon’s intention was purely political and he wanted to help his voter base. If he is too successful and prices of property really fall, then he would have made many property owners very unhappy.

Looking forward at 2018 our views are cautiously optimistic. We do not expect major rate increases in Israel.

[1] courtesy of Vitaly Katsenelson

The review is not a substitute for personal Investment marketing, which takes into account the particular circumstances and special needs of each person. The views expressed in this Review should be considered as market comment for the short term for information purposes only. As such the views herein may be subject to frequent change, are indicative only and no reliance should be placed thereon. This Review does not constitute legal, tax or accounting advice, or any investment recommendation, or any offer to buy or sell financial instruments of any kind, and does not take into account the investment objectives or needs of specific investors. Although this Review has been produced with all reasonable care, based on sources believed to be reliable, reflecting opinions at the time of its writing and subject to change at any time without prior notice, neither Pioneer Wealth Management nor any other entity or segment within the Pioneer International Group makes any representations or warranties as to the accuracy or completeness hereof and accepts no liability for any loss or damage which may arise from its use. The writer and the company are unaware of any conflict of interest at the time of publishing the above commentary.


About the Author

Mike Ellis

Mike Ellis

Director and Chief Investment Officer

Mike Ellis, originally from South Africa, joined Pioneer in March 2000 after working in the Private Banking & Trust industry in the UK. At Pioneer he was the group CFO for the better part of the last decade. Today Mike serves as a director and is the CIO.

Mike is a Chartered Accountant, a CFA charter holder and received his MBA from Tel Aviv University & Kellogg Business School. Mike is also an Oxford University Alumni having participated in the Said Business School's Global Investment Risk Management Program. In addition, Mike is a licensed Portfolio manager by the Israel Securities Authority.

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