While preparations are underway to toast to a new year with the raise of a glass,
I hope this time finds you with fond memories of the year soon to pass.
How quickly a new year comes as another one ends,
I hope you ring in 2018 with family and friends.
It is that time again when I want to share my cheer,
and a few thoughts of what to expect in the market’s and economies next year…
Happy 2018!
John Gardner
We Wish You a Happy & Healthy New Year!
John and Greg
U.S. Stock Market:
There was a moment during my wedding day when I thought to myself, “I wish this day would never end!” For stock market investors this year, many may have wished 2017 would never end. For the first time since the inception of the S & P 500, over 90 years ago, it has not posted a negative monthly total return this year. The major stock markets around the world had a terrific year. The Dow has gone up the most since 2013 as I write this. And, if a “Santa Clause” rally helps with a year-end boost, it could be the best year for the Dow since 1995. 2017’s stock market performance can be summed up as extraordinary, relative to the norm. The S&P 500 is up nearly 20% this year, far above the roughly 8% average yearly gains since 1945. Now before looking ahead to 2018, a little more perspective on this year’s stock market may be helpful. This time last year market mavens were full of FUD (fear, uncertainty & doubt), about their stock market outlook for 2017. Wall Street’s consensus forecast for ’17 was the lowest since going into 2005, an expected gain of 5%. Also, the S&P 500 had been up eight straight years on a total return basis (through 2016), and few thought the all-time record for consecutive up years (nine, from 1991-1999) would be tied. Now, some thoughts on the stock market in 2018.
2018 is expected to be another positive year, breaking the nine-year-in-a-row record. A perfect 10. Not, however, without the return of the long forgotten market volatility. With volatility, meaning market ups AND down, 2018 is unlikely to be another 12 months of straight ups. While it also serves as a nice round number, many market strategists are calling for the S&P 500 to reach 3000 in 2018. That would be about a healthy 12% gain from today’s price. However, the consensus target forecast for the S&P 500 next year is closer to 2850. Still a broad-based outlook for another winning year, though a more modest 6% or so above now. As I often contend, earnings matter. That was a potential risk to the market I noted in my 2016 Outlook. In my 2017 Outlook, I stated earnings could be the catalyst to a positive stock market upside surprise. Continued strong earnings will likely be the legs under 2018’s stock jump, supported further buy more share buy-backs, dividend increases, business investment and an overall increase in confidence in a stronger U.S. economy as more people are employed, enjoy more pay and, in many cases, pay less taxes. The first overhaul of the US tax code in more than 30 years, a potential delivery of a $1 trillion infrastructure spending plan to improve the condition of U.S. roads, bridges, airports, and other public works next year, and the likelihood of regulatory reform in the financial services sector are all positive for corporate earnings in 2018. Consensus 2018 earnings forecast for the S&P 500 is about $146, more than an 11% jump from this year’s $131. So, with that level of earnings growth, the S&P 500 gets to 3000 with a P/E ratio (price-to-earnings) of 20.5. When considering the market’s near 30 P/E going into Y2K, a 20 P/E is reasonable, though high, compared to the 20-year average of about 18.
I repeat, throughout my 30+ years of analysis, company earnings stand out as the single most important determining factor to long-term stock price appreciation. Therefore, expect increased equity values in 2018. And remember, it’s never really “different this time.” Stock market volatility is normal and necessary. It is not gone from markets now because of some “it’s different this time” line of reasoning. Extraordinarily low volatility was one big surprise in the 2017 stock market. The S&P moved 1% or more on only eight trading days this year; the average since 1945 was 50 days. Volatility will be less a surprise in 2018, and more a return to its cause of normal price swings.
US Economy:
It’s been a long time, but I can now say it again. To describe the U.S. economy now and into 2018, I call it “Goldilocks.” While nothing is perfect, the economy is pretty good porridge. Although at a naggingly slow pace, the U.S. economy is in its 8th consecutive year of growth. 2018 will be number 9. This extended economic expansion is the longest since World War II. The new and improved news looking forward to 2018 is the likely break of 12 straight years of sub-3% GDP (Gross Domestic Production) growth. 2018 could be a year of GDP over 3%. Tax cuts for both businesses and individuals should lift the economy in 2018. GDP, the broadest indicator of the economy, measuring the value of final goods and services produced in the U.S., is heavily reliant on the actions of consumers. Consumer spending accounts for about 70% of U.S. economic growth. As recent holiday sales indicate, Americans are spending! Holiday sales (excluding automobiles) rose 4.9% from November 1 through Christmas Eve, the largest year-over-year increase since 2011, with e-commerce sales vaulting 18.1% compared to a year ago. With unemployment the lowest in nearly 18 years and the best jobs market in about 45 years, consumer confidence is high and should support continued spending. Additionally, tame inflation and the strongest housing market since 2007 are boosters to consumers. Besides the consumer, corporate and government spending make up the other two legs of the economic stool. Corporate spending is on the rise. Investment in equipment just jumped 8.6% in the last quarter for 4-quarter growth streak, the longest since 2014. Government spending, driven by defense, health care, pensions and education, is about 20% of U.S. GDP. The government is expected to contribute little to GDP in 2018, with flat spending except for defense. There is positive economic momentum heading into the new year. The Goldilocks economy will have a healthy 2018.
Interest Rates:
2018 will begin just like 2017 and 2016 did relative to interest rates. Like the two previous years, 2018 starts with a fresh December Fed Funds rate hike by the Federal Reserve. The December 2015 rate increase was the first Fed Funds rate hike since June of 2006. With December 2017’s interest rate increase, the Fed indicated it would raise rates three times in 2018. The great debate in the financial markets today is how many times the Fed will hike rates next year. Many economists expect only two increases in 2018. My take on what Fed Chair Janet Yellen said earlier this month pointing to faster-than-expected economic growth and strong job creation leads me to expect three interest rate hikes next year. One clear risk to the financial markets is the Federal Reserve acting too much too fast in 2018. Another wild card when forecasting the trajectory, amount and frequency of interest rate moves in 2018 is the change of the guard, as new Fed Chairman Jerome Powell takes the helm. The market may be too comfortable with Mr. Powell’s stance on monetary policy. There’s a lot we don’t know about him yet. Yellen’s term ends in February, and the Fed next meets from January 30 – 31. In their recent statement, the Fed raised their estimate for 2018’s GDP to 2.5% from 2.1%, citing economic growth NOT do to the tax reform effect. The tax law change kicker will boost the economy and cause the Fed to act with interest rate increases at least three times in 2018.
Inflation:
As always, the biggest boost to inflation is rising labor costs. Expect this in 2018. I say that because labor costs represent roughly two-thirds of the total costs to private U.S. businesses. The jobs market is just too strong for another year of below average inflation measured by the CPI (Consumer Price Index). Historically, inflation has averaged about 3.2%. The CPI increased to an annual rate of 2.2% in November. Energy prices rose 8% this year, and could continue next year. Commodity traders expect oil to trade in a range between $48 and $68 in 2018, so expect volatility. Another inflation contributor is housing. 2017 was a strong year for the housing market. Expect rents to continue to rise and the housing market to gain another 5% next year. The supply/demand situation is driving prices higher. As the economy grows, so does inflation. Expect inflation of 2.5% or greater in 2018.
Global Markets:
Global growth momentum is likely to persist into 2018, pushing up equity markets over the first part of the year. Japan, Europe and emerging markets are likely to outperform the U.S. Despite the global markets climbing the proverbial “wall of worry” last year, 2017 saw the strongest synchronized global growth and biggest gains in corporate profits since 2010. This year began with uncertainty about the new Trump administration, the potential for trade protectionism and escalating geopolitical tensions. Then there was the Euro-skeptic election scare in France, nervousness about the Fed’s balance sheet reduction plans and unsettling threats of North Korean aggression. The new year will begin with seemingly clearer air ahead. The critical issue in the lens of the global markets is the timing of the next U.S. recession, as this almost always results in an equity bear market . By next April, this will be the second-oldest U.S. economic expansion on record. The Business Cycle Index (BCI) model puts the probability of a U.S. recession in the next 12 months at around 25%. This probability would quickly increase if the U.S. Federal Reserve raises interest rates more than three times in 2018. The potential for the biggest tightening of developed-world monetary policy in a decade will be a dominant investment theme in 2018.
- Europe: Looking ahead to 2018 in the euro-zone financial markets, I expect it to overcome that headwind of a rising Euro and the economic and political renaissance will once again drive both relative and absolute performance. Euro-zone economic growth in 2018 is expected to stay strong, exceeding 2%. Euro-zone economic sentiment stood at a 17-year high in November, according to the European Commission, and strong global growth is a boon for exports. Real economic activity such as industrial production and retail sales is expanding robustly. In light of easy financial conditions and high levels of producer and consumer confidence, Europe’s economy and stock markets look bullish for 2018.
- Japan: My 2018 outlook for investment in Japan is bright, with business surveys pointing to an increasingly confident business sector. Additionally, the 2020 Tokyo Olympics is expected to inject further stimulus into the economy. I expect the Bank of Japan is going to maintain an accommodative policy, even in the face of tightening policy elsewhere in the world. This will have a two-pronged benefit, in that it will continue to pump liquidity into the Japanese economy and put downward pressure on the yen, both of which I expect to be beneficial. The return of the consumer will be the investment theme in Japan in 2018.
- Emerging Markets: The outlook for China, in my opinion, remains positive. The National Congress revealed a Chinese government that will continue to focus on steady growth rates. The goal of doubling GDP per capita requires 6.5% per year in the three years to 2020, which I expect the Chinese economy will do. The move toward a consumption-led economy will continue at a gradual pace, which will benefit many countries in the region that produce consumer goods. A sharp slowdown in China remains a risk to the Asia-Pacific economy, although the outcome of the 19th National Congress indicates the Chinese government will not be aggressively pursuing deleveraging. Tensions with North Korea persist in the background, despite having dissipated in recent months. With more than 55% of Chinese imports coming from the Asia-Pacific region, my positive outlook on China will result in strong external demand for Asia-Pacific developing economies, making this an emerging market winner as the bull run in developing countries continues in 2018. India and Latin America will also enjoy gains in 2018 after global leading advances in 2017. India is the third-most preferred equity market among emerging markets after Brazil and Mexico for 2018, according to a Bloomberg survey of traders, strategists and investors. Confidence in Indian equities is based on the higher probability of an earnings recovery with the outlook on credit growth having improved after the recent announcement on bank capitalization.
Wishing you a great 2018!