December 31, 2017
The economy, here in the U.S. and abroad, continues to improve with virtually all economic indicators showing a dearth of reasons to be overly concerned (which maybe is the biggest reason to be concerned). Equity valuations in the U.S., while high, are not extravagantly so, even after the impressive run up in 2017. Valuations elsewhere are a bit more in line with historical norms. It should sound familiar as it’s the same message we’ve been giving almost two years now. I guess it’s true, the more things change, the more they stay the same. Until they don’t.
You can read more of the details of our analysis below, but let’s start with the highlights:
- The U.S. economy is strengthening, and that’s before any effects of tax reform or possible fiscal stimulus are felt.
- Inflation might become a concern later in the year prompting the Fed to raise rates four times this year (they’re currently projecting three rate increases).
- Global growth remains on track, though with increased business investment in the U.S., growth leadership (across developed nations) might revert back to the U.S. in 2018 after being handed off briefly to international economies in 2017.
- We favor an overweight in equities vs. other asset classes. Within equities, we are favoring value over growth and an additional overweight in small cap stocks.
Now the details: Third quarter U.S. GDP growth was revised up modestly to 3.3% annualized (elevated from 3.0% as initially reported). This was due to a stronger showing from business investment. We view this as a very positive data point. Business investment has been lagging, and there is a growing need for reinvestment in our capital stock. Not only will this directly add to GDP by way of increased orders, but should also result in improved productivity and, hopefully, growth in good paying jobs – something else that’s been sorely lacking during this recovery.
With borrowing costs still relatively low, and the specter of higher rates upon us, we expected to see a quickening of the pace of business investment. The Tax Cuts and Jobs Act of 2017 should work to accelerate this in 2018.
After tax corporate profits increased by 5.8% q/q in the third quarter and 7.7% over the last 12 months. Surging corporate profits provide support for the record setting stock market.
Fueled by increased consumer confidence, better job prospects, increasing wages, and a strong stock market, holiday sales rose at their best pace (4.9%) since 2011 (source: Mastercard SpendingPluse – tracking both online and in-store). This matters because real retail sales typically decelerate sharply later in a business cycle (ahead of a recession). We seem to be going the other way now!
U.S. housing is still exhibiting pent-up demand, another phenomenon that usually occurs earlier in the business cycle, with housing starts up +3.3% in Nov and single-unit permits up +1.4%.
Internationally, earnings have rebounded globally (developed & emerging), with revenue growth resulting from improving internal fundamentals and continuing economic growth. Global inflation remains low while the threat of deflation, quite the concern just 3 – 4 years ago, fades further. Even in Japan, where deflation due to an aging population has been a grave concern for over a decade, data shows there is building inflationary pressures against a backdrop of firming demand. Pro-growth administrations that have taken hold across the globe, at both the national and local levels, offer the potential to add fiscal stimulus. Even China’s economic planning council agreed on an aggressive, pro-growth agenda (no news there), paired with a pro-globalization stance including deep structural reforms planned to curb the growing risks in their financial system, over which we have expressed concern before. Given that China is, perhaps, the only economy large enough to bring the U.S. economy down with it, this new found focus on corporate responsibility is good news.
In terms of the Federal Reserve, as widely expected, the Fed hiked interest rates by 25 basis points at their December meeting, taking the fed funds target to a range of 1.25% to 1.50%. Despite factoring in the imminent fiscal stimulus into their GDP growth projections for 2018, officials still anticipate only three more rate hikes next year. The market is pricing in only two. Looking at the Fed’s new projections, the big change is that the median forecast for GDP growth in 2018 increased to 2.5%, up from the 2.1% forecast made back in September. Oddly, despite the higher GDP forecast, the Fed did not change their inflation outlook. We suspect that with the rebound in corporate investment, the fallout from the Tax Cuts and Jobs Act of 2017 (which should support greater economic growth, at least in the short run), and possible additional fiscal stimulus, a stronger rebound in inflation next year will ultimately persuade the Fed to hike rates four times in 2018.
A new Fed chairperson, Jay Powell, is set to take over the helm, but we do not believe that this will disrupt the overall outlook of the Fed, their plan for rate increases, or how they will react as new data comes in.
With respect to the markets, last year was a very good year for equities as global growth pushed earnings higher and stock prices up. For the first time on record, the S&P 500 delivered a positive total return in each and every month of the year all while realized volatility was just 6.7%, the second lowest annual reading on record. Maybe this represents the euphoria that generally immediately precedes a bear market. We don’t think so. Earnings are supportive of higher stock prices, as are the regulatory and fiscal initiatives coming out of Washington. Last year, 76% of stocks in the S&P 500 were up, meaning this was a reasonably broad advance (which usually is not the case prior to bear markets). By comparison, in 2007 only 50% of S&P stocks advanced and a similar number (49%) advanced in 1999.
International markets were, by and large, even stronger than U.S. markets. We have been, broadly speaking, increasing our allocations to international equities after years of being markedly underweight there. Even with the 2017 run-up in international markets we think there is still opportunity there. The tax cuts should provide a stimulus to the U.S. economy and the U.S. stock market, perhaps making up for
the valuation differential in the short term. However, ultimately that stimulus will lead to higher inflation, causing the Fed to raise rates once too often, thereby setting in motion the next recession. While recessions are notoriously difficult to predict, we do not think it will be a 2018 event. Further, we believe the dollar is still overvalued relative to international currencies (even after its recent pullback), providing additional tailwinds to international investing.
Looking deeper into corporate tax cuts, we think it is small companies that stand to benefit the most. We expect to be increasing allocations in this area.
Fixed income remains a challenging, albeit necessary, part of any prudent portfolio. We do not expect a calamity (i.e. bond yields soar and prices fall sharply), but more of a slow bleed. Treasury yields are still historically low and credit spreads (the amount of extra yield you get for investing in corporate bonds rather than Treasuries) are very tight – meaning you’re not getting paid much extra for taking on the extra risk. Developed international markets do not really provide any comfort either, as interest rates overseas have generally bottomed and rates are likely to rise in the ensuing quarters. Emerging market debt is perhaps the only attractive part of the fixed income market.