Perspectives & Planning: 2018 Economic & Market Outlook
January 18, 2018
Market & Economy
- U.S. real GDP growth of 2.5% to 3.0%1, while global GDP advances 3.8%2
- Growth balanced across sectors with a fiscal stimulus kicker from tax reform Job gains to average 150,000 per month drive the unemployment rate below 4%1
- Tight labor market fuels consumer confidence and solid consumption
- Robust capital spending as profits surge and hiring difficult Equity markets continue to advance on earnings growth
- Bond returns skimpy as coupon income offset by price decline on modest rate rise
- In addition to geopolitical concerns, monetary policy is a risk should the economy run hotter than expected
The U.S. economy entered 2017 in a sweet spot and exited the year in an even stronger position. Job creation remained strong, surpassing expectations and driving unemployment to a 17‐year low of 4.1%3. With the labor market tight and incomes rising, consumers were spending. Consumption rose nearly 3%4 in 2017 and while gains may not be as robust this year, consumer spending should increase close to 2.5%1. In addition to hiring, businesses also invested in plant and equipment as capital expenditures finally took off. With corporate profits surging, this trend could also persist. Finally, while housing statistics were erratic in 2017, the year ended on a firm note and residential construction should be buoyed by favorable demographics and a severely under supplied market.
Additionally, the recently enacted tax reform, or more accurately tax cut, will likely provide fiscal stimulus to the economy in the range of 0.25% to 0.50%1. The wisdom of the tax plan will no doubt be endlessly debated. However, from a macroeconomic perspective, fiscal stimulus is a function of the size of the budget deficit, which is forecast to increase.
Concern would arise if the wider budget deficit and government financing needs were to lead to higher interest rates. This could then inhibit private investment, an effect referred to by economists as “crowding out”. However, with the 10‐year Treasury note yielding slightly below year end 2016 levels and the Federal Reserve having hiked interest rates at a gradual pace, there has been no discernible impact thus far and financial conditions more broadly remain highly supportive of continued growth.
Rather than fiscal stimulus, consumer spending will be the major driver in achieving healthy growth in 2018, as is usually the case for the U.S. economy. Before slipping in December, consumer confidence hit a 17‐year high in November. The tight labor market should ensure that Americans feel confident about their prospects. It is likely that the unemployment rate could dip below 4% in the year ahead, as we project average job gains of 150,000 per month, which is well in excess of growth in the labor force. Wage gains should continue their gradual ascent with qualified workers in short supply.
Therefore, we are rather optimistic on the outlook for consumer spending. It has been noted that the rise in consumption in the past year has eaten into savings as the savings rate has dropped to just under 3%4. We concede that this could be worrisome. However, prospects for rising incomes coupled with record household net‐worth should ease this concern and spending should continue to increase at a healthy pace.
Capital spending is another area where sustained strength is probable. Businesses will need to invest to offset rising labor costs. Overall business investment increased approximately 4.5% in 20174. Rising oil prices helped boost investment in the energy sector in the past year but other industries also participated. The rate of growth may slip a bit in 2018 if the energy boom fades, but a broad based gain is still expected. Companies may already be seeing a payoff from higher capital spending. Productivity slumped in recent years and even fell 0.1% in 20163. While this data can be volatile, there was improvement in 2017 as third quarter productivity of 3.0% hit its best level since 20143.
Housing should also experience continued improvement, although gains may be somewhat restrained by the impact of tax reform on higher‐end housing. The limitations on the deductibility of real estate taxes and mortgage interest may impede price appreciation and, in some cases, discourage home ownership. This may encourage development of rental properties as real estate businesses (rather than individual owners) receive favorable treatment under the new law. All the same, we expect that home builders will be busier this year given pent up demand and lack of supply from both the Great Recession of 2007‐2009 and the spate of natural disasters in 2017. Our expectation is for housing starts to increase at least 5% from the approximately 1.2 million starts in 20171.
Global growth, while not booming, will show continued improvement in all geographies in 2018. Should global GDP achieve 3.8% growth as expected, it would be the best performance since 2011. While growth could moderate slightly in developed economies, emerging markets continue to build momentum, with particular strength in South and Southeast Asia. Consider that India growing at 7.5%5 annualized is adding over $150 billion dollars to GDP. Even by U.S. standards, that would be considered real money. Resource dependent giants including Russia, Brazil, and Nigeria also returned to growth in 2017 as commodity prices rebounded and further improvement is likely this year. Barring increasing trade tensions, a stronger global economy should be another mild positive for U.S. GDP. Finally, government spending is expected to increase in 2018 and an infrastructure package could be the next major initiative from the Trump administration.
Despite recurring political concerns worldwide, investors managed to focus on improving economic fundamentals in 2017. Global equity markets rallied sharply. Bond markets generated acceptable returns, despite better than expected growth, as inflation remained well contained. The Federal Reserve not only hiked interest rates 0.25% three times but also began to reduce the size of its balance sheet. Despite these more restrictive policies, Fed officials noted that financial conditions remained quite easy as the dollar fell, equities surged, and credit spreads narrowed further.
Returns for major U.S. bond indexes in 2017 exceeded expectations of most forecasters. In 2017 the Bloomberg Barclays Aggregate Index returned 3.5% while the Intermediate Gov’t/Credit Index gained 2.1%. In addition to corporate credit continuing its outperformance, the yield in 2017 curve flattened dramatically as the spread between short and long‐term bonds yields tightened. While the yield on a two‐year Treasury note climbed 0.70% to 1.89% by year‐end in response to Fed rate hikes, the yield on the 10‐year Treasury actually fell 0.04% to 2.41% as inflationary expectations were largely unchanged.
We suspect that fixed income returns will be stingier in 2018. We anticipate that the Fed will raise Federal Funds rates another three times this year. There will be new supply for private investors to absorb from both the wider deficit and the Fed’s plan to allow increasing amounts of securities to roll off its balance sheet over the course of the year. Inflation is likely to edge higher as well. In short, we anticipate modestly higher yields across the curve and expect to find the 10‐year Treasury note yielding in the range of 2.5% to 3.0% at year‐end 2018.
Given the long‐term outperformance of corporate credit, further upside is probably limited and we would endeavor to upgrade portfolio quality. We hold a similar view concerning the municipal bond market which also outperformed in 2017 with a gain of 5.4%5. While the tax advantage of municipal debt has been preserved, the long‐term impact of tax reform on the finances of many jurisdictions may be unhelpful.
Equities remain our most favored asset class yet again in 2018 but not without caveats. Realistically, it is highly unlikely that the S&P 500 Index’s 2017 return of 22% will be matched or exceeded. As the disclaimer states, past performance is no guarantee of future results. Valuation has climbed and the index now sports a forward price/earnings multiple (P/E) of 18.4x estimated earnings of $145 per share1. This compares to a long‐term average forward P/E of 16.0x and 17.0x at the start of last year. However, fundamentals are favorable with earnings growth expected in the low double digits. While earnings estimates are typically overly optimistic at the beginning of the year, one could argue that 2018 earnings estimates should be achievable given that the lower corporate tax rate alone should boost S&P 500 earnings by 5%. While year‐end market strength may have borrowed returns from 2018, one can still make a reasonable argument for high single digit equity gains.
2017 was the third best year for the S&P 500 in the past decade. Performance was impressive, but the lack of volatility was more remarkable. There were only 9 trading sessions during 2017 where the index moved by 1% in either direction. Furthermore, 2017 was the first year on record where the S&P 500 posted a positive total return in each and every month of the year. Volatility will probably return to some degree this year. The Federal Reserve is likely to be joined by other central banks in moving to “normalize” monetary policy. In all likelihood, the European Central Bank will end its policy of quantitative easing in the fall and the Bank of Japan will probably reduce its asset purchases and, perhaps, target higher bond yields as well. With growth accelerating, an inflation scare could spark a temporary retreat.
International stock performance surpassed that of domestic shares as the EAFE Index, the developed market benchmark, returned 25% and the MSCI Emerging Market Index advanced a stunning 37%. These returns were enhanced by a sagging U.S. dollar which fell 7%. Over the course of 2017, we steadily boosted exposure to international developed markets based on the surprising improvement in economic data. We continue to view foreign equities favorably given that many of these countries are in an earlier stage of economic expansion relative to the U.S. While the direction of the U.S. dollar is difficult to predict, it is less likely that the U.S. dollar will run up sharply as in 2015 and 2016 since many overseas economies are back on their feet.
As always, there is a plethora of political and geopolitical risks. In the U.S., Congress seems to lurch from one stopgap government funding resolution or last minute debt ceiling increase to another. In addition, a change in control of Congress in the mid‐term elections could weaken the business friendly Trump administration and rattle investors. The ongoing Russia related investigations and possible re‐emergence of trade as a front burner issue also present serious concerns.
Overseas, the landscape remains perilous. In the Middle East, the Sunni/Shiite divide exacerbates the struggle between Saudi Arabia and Iran for dominance. Both of these would‐be regional hegemons are simultaneously struggling with domestic political unrest. Although the world is more than adequately supplied with oil, disruption cannot be entirely ruled out. In the Far East, attention is focused on a nuclear armed North Korea, while China, on the basis of dubious historical claims, continues to expand its presence in the South China Sea.
In Europe, it appeared that after the success of a centrist reformer in the French election, the political air would clear. Instead, negotiations over Brexit dragged on and a secessionist movement in Catalonia found new life. German Prime Minister Merkel is struggling to form a coalition while Italian elections also loom. For now, investors have regained confidence in the durability of the Euro and are impressed with Mario Draghi’s stewardship of the ECB.
Absent any major conflagration, the U.S. and global economies should enjoy a solid performance this year. A strong economy, however, is not a guarantee of rising markets. For financial markets, the major non‐political risk will be coping with tighter monetary policy. The Fed is determined to normalize interest rates, and while investors to date have not been perturbed by the Fed’s progress in that regard, any indication that the Fed will quicken its pace could cause turmoil. As we alluded earlier, a byproduct of interest rate normalization is likely to be a return to more normal levels of volatility.
With all major economies enjoying growth and inflation benign, we view the probability of recession in 2018 as quite low. The types of imbalances that led to the last recession are not in evidence. 2019 may be a different story with the U.S. bull market and economic expansion superannuated at 10 years and central banks globally more likely to tighten in unison. In the meantime, we intend to maintain a portfolio tilt favoring stocks that benefit from rising growth. We will be alert to shifts in the economic environment, particularly concerning inflation and interest rates.
- Washington Trust Wealth Management
- Morgan Stanley
- U.S. Bureau of Labor Statistics
- U.S. Bureau of Economic Analysis
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large‐cap U.S. stock‐market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
Investing entails risk, including the possible loss of principal. Past performance does not guarantee future results. This information does not take into account any investor’s particular investment
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The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.