The positive economic momentum that lifted equities over the past year should continue into 2018, with higher interest rates and inflation posing the biggest risks, notes ClearBridge Investment Strategist Jeff Schulze.
2017 was a unique year for investors. Simply put, everything worked. President Donald Trump was able to pass tax reform, the Federal Reserve continued to slowly tighten, credit spreads continued to narrow, and stocks and bonds both ground higher.
Although it can be useful to reflect on the past, it is equally important to anticipate what is to come. Looking toward 2018, we see the potential for continued economic growth to drive solid equity returns.
Although the S&P 500 Index is up almost 300% from the March 2009 lows, we believe the path of least resistance for equities is higher. Just because we are approaching the 10-year anniversary of the global financial crisis (GFC) does not mean the rally should end. We do not ascribe to the belief that business cycles die of exhaustion or old age. In fact, Australia, is currently in their 26th consecutive year of expansion. Business cycles can end for several reasons, often one or more of the following: overly aggressive central banks, commodity price surges, or an overheating of cyclical sectors of the economy (often financed by an asset bubble). Today, we see no evidence of these precursors of an economic downturn.
To identify the potential for economic turbulence, ClearBridge maintains a proprietary Recession Risk Dashboard. This tool evaluates 12 separate indicators that measure four vital fault lines upon which our economy rests: consumer health, business activity, inflation and financial markets. At present, 11 of our 12 variables are flashing green. Corporate profit margins are the only variable flashing a yellow sign of caution.
Over the course of 2017, margins have expanded as revenue growth has improved while wage gains (the largest expense for many companies) have been held in check. As a result, and given the potential for further margin expansion in 2018 from tax reform, corporate profit margins have improved to yellow from red. However, the coast is not entirely clear for margins, which have most likely peaked for this cycle. Taking a broader view, the economic outlook for 2018 appears healthy, and based on our indicators, we put the probability of a recession in the coming year at less than 10%.
Outside of the U.S., the global economic backdrop appears similarly supportive. In fact, for the first time in over a decade, the world is experiencing synchronized global growth and an improving global corporate profit environment. According to the IMF, the world will see the fewest number of countries in recession ever in 2019. This is important because the recovery from the GFC over the past 10 years has been led by the U.S. As our own business cycle matures, better global growth should help offset any slack in the domestic economy. Europe and the majority of emerging markets are in an earlier phase of their economic and monetary policy cycles than we are. This should result in an environment that experiences risk assets moving higher globally.
Number of countries in recession:
Another driver of upside performance could be re-leveraging by both consumers and corporations. On the consumer side, improved confidence could help boost spending. For businesses, a lighter regulatory touch should help loosen the purse strings. In the banking sector, for example, a new Vice Chair of Supervision at the Fed (Randy Quarles) and new appointees at six other financial oversight institutions should give banks greater latitude to use more of their capital as they see fit. This could help drive an improvement in loan growth and money velocity, both of which would help boost economic activity. Most importantly, the U.S. banking system has rarely been in a better state than it is currently. This strong foundation increases the potential for a secular bull market to be built.
Stronger growth and deregulation could help unleash animal spirits that have been held in check for much of the period since the GFC. However, we do not believe that the excesses of the GFC are likely to be repeated in the near term, in part because of the nature of human psychology. Humans have a much higher sensitivity to fear than joy. The pain from losses tend to stay with us much longer than the ecstasy of winning. As a result, speculation and risk-taking remain well contained.
The GFC altered the psychology of not only investors, but also businesses. Many corporate management teams remember how bad things got. These scars from the crisis are visible in the laser focus on cost management many companies continue to demonstrate. Arguably, this reluctance to spend has helped reinforce the current slow growth environment. The lack of investment is often cited as a reason for lower productivity, which is half the equation for GDP growth (along with labor force growth).
While the slow growth environment has been frustrating for many investors, the upside is that the next major downturn is likely to resemble a more normal and shallow slowdown rather than the carnage we witnessed in 2008. If the boom isn’t as big, the bust won’t be as severe, although it appears likely that we will have to wait until 2019 or even 2020 to confirm if that is the case.
What to Watch: The Trajectory of Interest Rates
At ClearBridge, we believe one of the keys to successful long-term investing is keeping conscious and respectful of risks. Higher interest rates and a spike in inflation are two things that could create substantial disruption in 2018. The market appears complacent in the view that inflation is a relic, with the global economy to never see price pressure again. In fact, Janet Yellen herself recently mentioned that she is puzzled by the lack of inflation at this stage of the economic cycle. The passing of tax reform represents a potential catalyst for higher inflation, and thus higher rates, in 2018.
Even if inflation does not rear its ugly head in 2018, there are several dynamics in motion that should help push long rates higher. Most importantly, global central banks will be moving from net positive accumulation of global bonds to a net issuance over the next 18 months. The European Central Bank (ECB) will begin to taper its quantitative easing (QE) program in January and the Fed is already reducing the size of its balance sheet. At the same time, Japan could be facing rising inflationary pressures in the year ahead, which could lead the Bank of Japan to rethink its stimulus programs. Putting this all together, by the end of 2018 global markets could be looking at a swing of $1 trillion fewer bond purchases by central banks. This will result in additional supply to the market that will have to be absorbed by the private sector, with higher yields the most likely outcome.
European yields in particular are likely to move higher as the ECB’s QE program is proportionally much larger than in the U.S. In recent years, QE purchases by the Fed were still less than the supply issued by the Treasury. By contrast, the ECB purchases are approximately seven times net issuance in the eurozone over the past 12 months, according to Deutsche Bank. As the ECB slows the pace of its purchases, rates should re-normalize higher. At the same time, U.S. rates should also rise as many European crossover buyers return home in favor of their own (now more attractive) domestic bonds. At present, $8 trillion worth of global bonds (17% of global supply) are currently negatively yielding.
Domestic yields could also move higher for reasons within our own borders. GDP should pick up as tax reform accelerates growth in 2018. Inflation should rise due to a tighter labor market, higher commodity prices, the one-time effect from wireless service price wars being phased out and medical inflation bottoming. At the same time, Treasury issuance will explode higher in the year ahead given projections for a rising deficit by the Congressional Budget Office. Taken together, these variables point to higher rates.
Importantly, we believe higher bond yields don’t necessarily translate into a weaker stock market. The speed and magnitude of rate movements will be key clues to determine how the stock market will digest rising rates. Our base case is a gradual move higher in the 10-year Treasury to 3% by year-end 2018, up from 2.4% currently. This would not be an impediment for equity markets, which are still quite attractively priced relative to fixed income. However, if yields were to overshoot above 3.5%, a repricing of stocks could be in the cards.
Importantly, the new Fed Chair, Jerome Powell, has indicated he believes that tax reform won’t boost GDP growth substantially. Further, Janet Yellen and the Fed (including Powell) recently revised their economic growth forecasts higher without revising up their inflation projections. This is significant because it suggests the Fed will tighten policy in 2018 in a manner consistent with what we’ve seen throughout 2017. Put differently, the Fed’s path in the year ahead should be well understood by the market and does not appear likely to threaten the market rally, even with the impacts from the tax package taken into consideration.
Don’t Be Fazed by a Pullback
We would be remiss if we didn’t point out that a near-term pullback in equities would not be out of context historically. To put it in perspective, if the S&P 500 makes it to the end of January without a 5% pullback, it will represent the longest stretch of positive market performance since the Great Depression. A 5% correction can happen for many reasons, with the phenomena known as “buy the rumor and sell the news” a frequent trigger. The market may be setting itself up for this dynamic in early 2018 now that Congress has successfully navigated the difficulties of tax reform. Many investors have been holding onto gains in anticipation of selling in early 2018 once lower tax rates take effect. This could result in a choppy start to the new year.
However, we believe any pullback should be bought with the underlying drivers of the market still intact, including a strengthening global economy, robust earnings growth and abundant liquidity. In fact, both top-down and bottom-up consensus estimates from Bloomberg point to well over 10% EPS (earnings per share) growth for the S&P 500 in 2018, in part due to benefits from tax reform. This should help drive the market in 2018 as stocks have delivered an average return of 11% since 1950 in years that saw 10%+ EPS growth.