2018 Market Outlook by Joseph Karl, CFA
Posted on January 31, 2018
Greater confidence in future economic growth defined 2017. Interest rates and inflation remained low, while all major U.S. equity indexes ended the year with double-digit gains. In addition, Congress successfully passed a law in December that represents the most significant changes to the tax code in 30 years. With these factors in mind, we at Provenance Wealth Advisors (PWA) remain optimistic in our outlook for 2018. We believe that the U.S. and global economies will continue to gather momentum and strengthen further, and stocks will likely continue to produce attractive returns that outperform bonds and cash.
Despite this enthusiasm, it is imperative that investors remember to position their portfolios based on their individual goals and objectives before considering the market outlook. This is especially important today, given the length of the market rally and the optimism already priced into markets. Given that investment portfolios become more sensitive to market declines when they are being relied upon for income, investors who are currently or are relatively close to relying on their portfolios, need to be mindful of the potential risks.
Following is PWA’s Economic and Market Outlook for 2018.
The U.S. currently has the lowest unemployment rate since 2000, and its economic expansion is eight months away from tying the longest in the nation’s history. While there have been many improvements since the great financial crisis, we simply aren’t hitting on all cylinders yet. Therefore, we continue to believe the economy has further room to expand and will likely continue to strengthen through 2018.
Hot off the press, the tax reform bill passed last month helps to reduce the tax burden for individuals and corporations beginning in 2018. While we believe that the Tax Cuts and Jobs Act (TCJA) will be net neutral to slightly positive on balance for the economy, we are mindful that the U.S. did not become the world’s leading economy due to great tax policy.
If corporations do not invest their newfound tax savings in research and development, new capital and equipment, the TCJA may not achieve its intended goals. Moreover, economic growth may be unchanged. The same holds true if businesses do not increase their workforce and raise wages and households do not spend their tax savings. In these scenarios, the tax bill will merely increase the country’s national debt and leave the U.S. in a more unhealthy financial position that before the TCJA. Moreover, given the mediocre wage growth for low- and middle-income earners, as well as the amount of cash sitting on corporate balance sheets before the tax law passed, one could argue that the tax law could have been better allocated.
However, there is hope that the TCJA ignites “animal spirits” of businesses and households, described by British economist John Maynard Keynes in the early 1900s. In essence, Keynes believed that “spontaneous optimism” and economic confidence drives humans to make emotional decisions that are not based on mathematical calculations. As a result, there is reason to believe that just the enactment of the new tax law will further bolster already high CEO, small business and consumer confidence. This is important considering that corporate investment and consumer spending together account for approximately 80 percent of economic output.
Federal Reserve and Central Banks
While dramatic improvements have been made in the U.S. economy and abroad, we believe that growth remains sensitive to changes in interest rates. In addition, it is our opinion that that the Federal Reserve and Central Banks will continue to be accommodative and exercise patience when raising rates and unwinding their balance sheet due to the following reasons:
- If the Fed and other Central Banks raise rates too quickly, they would likely risk pushing the U.S. and global economies into a recession. This could force them to reverse course and go back to lower interest rates and quantitative easing policies that they are currently trying to exit.
- Policymakers have two ways to stimulate economic growth: monetary policy and fiscal policy. Examples of fiscal stimulus include the recent tax reductions and the bank and auto bailouts that occurred during the financial crisis. While we would prefer economies to operate on their own, these forms of stimulus can be useful to stave off crises. With the government debt already high and projected to grow in the coming years, the capacity for the U.S. to add fiscal stimulus in the event of a recession has been weakened as a result of the tax bill. This leaves a major burden on the Federal Reserve to step in should the economy weaken.
- Historically, the Fed has lowered interest rates by 500 basis points to help spur growth1. Currently, the Federal Funds Rate is 125 basis points, which leaves the Fed with the ability to lower rates by roughly 25 percent of that amount. By letting the economy continue to grow at a modest pace, the Fed will be able to gradually raise interest rates and unwind their balance sheet, putting the Fed in stronger position to help stimulate growth in the event a recession occurs.
- The Federal Reserve has a dual mandate of full employment and 2.0 percent inflation. While it can be argued that the U.S. has reached its employment target, there is room to run given that inflation has been below target for much of the past decade. As the economy strengthens further, inflationary pressures are likely to mount, but globalization, technology and demographic trends will help to keep a lid on dramatically rising prices.
Despite the Fed’s patience in raising rates and unwinding the balance sheet, we must keep a close eye on inflation. Further, if the equity markets continue to rally at this pace, the Fed may shift its tone and focus on protecting financial stability by unwinding its balance sheet faster than currently expected.
Pent Up Demand
Despite the length of the current economic expansion, certain areas of the economy are just now beginning to reap the benefits. Wages are starting to increase among low- and middle-income earners as well as student-loan-strapped Millennials. Confidence among these segments of the population is critical for broad and extended economic growth.
Global Synchronous Growth
One of the major risks associated with a Trump presidency was the concern that he would back away from global trade. So far, these fears have not become a reality, and economic activity outside of the U.S. has started to pick up. Considering that U.S. exports are roughly 12 percent of Gross Domestic Product (GDP) and international sales account for roughly 30 percent of U.S. revenues, continued gains outside the U.S. can further the nation’s economic expansion2.
In 2017, the U.S. stock market, as measured by the S&P 500, was up every single month for the first time in history. In price terms (without dividends), U.S stocks are up almost 50 percent since the last pullback in early 2016 and almost 300 percent since the lows of the financial crisis in 20093. While we still believe stocks have the potential to produce attractive returns and will likely outperform alternatives such as bonds and cash over the longer term, we must acknowledge that stocks look rather expensive when viewed relative to various valuation metrics. Furthermore, it can be argued that the markets are long overdue for a correction.
To properly assess the outlook for stock market returns, we look at the underlying factors that can drive stock returns with a narrowed focus on earnings growth, dividend yield and valuation changes.
First, let’s assume that a dividend of 2.0 percent remains constant, which is fair given its current proximity to both this level and the 25-year average2. This allows us to focus our attention on earnings growth and valuations, which tend to be more volatile.
Consensus expectations call for 13.1 percent earnings growth in 2018, following-up a strong performance in 20174. While consensus expectations tend to be overly optimistic, it should be noted that this amount does not consider the potential benefits of the recent tax law.
As an example, let’s assume earnings grow by an even 13 percent. Assuming valuations remain constant, this would mean that expected returns for stocks would be a total of 15 percent, which includes the 13 percent of earnings growth and 2 percent for dividend yield. Using this information as a baseline, let’s consider some scenarios that could change this expected outcome.
Scenario 1: Currently, the forward P/E ratio is 18.2, which is above its 25-year average of 16.0. If this relationship moved back to its long-term average, valuations could decline by 13.75 percent¹. Assuming earnings growth of 13 percent and dividend yield of 2 percent, stock returns in this scenario would be 1.25 percent.
Scenario 2: As previously mentioned, the current 13 percent earnings growth rate does not consider the full impact of the recent tax law. If the TCJA increases S&P 500 earnings by an additional 5 to 18 percent, returns could be even more favorable.
Scenario 3: The current S&P 500 earnings yield of 5.52 percent looks historically attractive relative to the yield on the 10-year Treasury, which is 2.46 percent. Should the difference between these two return to its long-term average of 250 basis points, valuations could add another 11.47 percent to 2018 returns5.
Scenario 4: During the last two bear markets in 2000-02 and 2007-09, the forward P/E declined to 12.6, which is 30.5 percent below today’s levels¹. These declines tend to correspond to recessions, which we do not expect in the near term but recognize may be useful to consider when framing investment decisions.
PWA expects 2018 to fall between the baseline scenario and Scenario 1. While Scenarios 2 or 3 are possible, we believe tax reform is somewhat baked into prices and interest rates will rise modestly in the coming year.
Investing always involves risks, and there are potential threats to our optimistic outlook, including the following:
- Prices may rise too quickly and become out-of-touch with fundamentals, which could indicate we are in a bubble
- Bond yields could unexpectedly rise due to an increase in inflation and/or the Fed’s unwinding of its balance sheet faster than expected.
- Any signs of a weakness in the economy may impact financial results. Markets are forward looking and attempt to discount what will occur in the future. However, recent economic data, including relatively strong corporate earnings, support the markets recent gains.
While the current outlook for bond returns is not particularly attractive, bonds will always be an important component of a well-diversified portfolio, especially for investors who are currently or relatively close to relying on their portfolios for retirement income. We continue to recommend a shorter-term approach with bond positioning, as the potential benefit of holding longer term bonds simply is not worth the price adjustment should rates move higher. Given the recent flattening of the yield curve, the price adjustment should rates rise, is greater than it has been historically.
In the current environment of low but rising interest rates, relatively high equity valuations and an economic expansion that is already the second longest in history, there is no certainty that the recent streak of robust returns will continue. We do believe that central banks will remain patient with rates and “animal spirits” will help to strengthen the economy and enable stocks to potentially produce attractive returns. However, given the difficulty in timing markets, we recommend that investors who are currently or close to relying on their portfolios for income take a more neutral stance on equities as a precaution against anything unexpected.
About the Author: Joseph Karl, CFA, is head of research and senior portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants.
Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/deal and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions.
Global Investment Strategy, BCA Research, August 2016
J.P. Morgan Guide to the Markets, 1Q 2018
Factset Earnings Insight, January 5, 2017