Economic & Market Update
Deliver the Economic and Market Update to clients
Listen to Dr. David Kelly, Chief Global Strategist, as he highlights the most important themes for 2018 using Guide to the Markets slides.
Economic & Market Update: Using the Guide to the Markets to explain the investment environment
1. The economic expansion is continuing at a slow but steady pace
LEFT: This has been a slow but resilient expansion
This economic expansion has been like a healthy tortoise – slow but steady. In fact, as of December, the expansion is in its ninth year, making it the third longest expansion since 1900. Growth accelerated in the third quarter after firming in the second, and rebuilding following a series of natural disasters, alongside tax reform, should add to growth. That said, U.S. growth may be limited moving forward by structural constraints.
RIGHT: The economy should grow faster moving into 2018
Growth should accelerate and stabilize through the end of 2018, reflecting a pick-up in exports, inventories, government spending and fiscal stimulus through tax reform. Stronger investment spending and an improving global economy should also be tailwinds. Regardless, weak productivity and labor force dynamics should prevent sustained growth at 3.0%, with growth likely slowing to 2% or less in 2019 and beyond.
2. Unemployment continues to fall, which should drive up wages
While the economy maintains a slow-but-steady pace of growth, the labor market has continued to tighten. This reflects two key trends: Low productivity growth, which implies most GDP growth has to come from employing more workers, and low labor force growth, which means that much of the job growth has come from re-employing the unemployed rather than new workers entering the labor market.
Solid GDP growth in 2017 and 2018 should cut the unemployment rate further, perhaps to 3.5% by the end of 2018, having already fallen close to 4% by the end of 2017. While wages have been slow to react to a tight labor market so far, extra pressure to find workers spurred by tax cuts could finally boost wage growth in 2018.
3. Earnings headwinds should be behind us, but future growth may be muted
LEFT: Corporate earnings are rebounding from a weak 2015
After falling 11% in 2015 due to a high dollar and losses by energy companies, S&P 500 operating earnings per share rebounded strongly in 2017. However, with the majority of the rebound now perhaps behind us, earnings growth could be more muted going forward, though a positive impact from tax reform should provide a boost, provided the stronger growth offsets higher wages and interest rates on corporate income.
TOP RIGHT: The dollar should be less of a drag on earnings in the near future
With over 40% of S&P 500 revenues coming from abroad, a weaker dollar will boost foreign sales, particularly in 2018.
BOTTOM RIGHT: Energy write-downs should be behind us
Even as the rally in energy prices appears to have stalled, write-downs in the energy sector continue to roll off, indicating that weakness in the sector did not reflect weakness in continuing operations. Energy should continue to contribute to earnings going forward, though expectations should be tempered.
4. Inflation should return to the Fed’s target in 2018
After showing signs of strength early in the year, a fall in oil prices and heavy competition amongst consumer cellular services prices has put downward pressure on CPI, both headline and core. However, we expect this weakness to be temporary and inflation to edge up through 2018, helped by a weaker dollar, higher oil prices and tightening labor and housing markets. In addition, inflation calculated by the personal consumption deflator continues to hover slightly below the Federal Reserve’s 2% target in 2017, though the Fed appears to be on track to further raise rates this year.
5. The global economy continues to pick up steam
After two years of very mediocre growth, the global economy started to show signs of life at the end of 2016. So far, it does not appear that things will cool off, with the global aggregate manufacturing purchasing managers’ index reaching six-year highs moving into 2018.
The Eurozone is growing particularly fast, thanks to a still undervalued currency, rising confidence and considerable pent-up demand, while other developed markets like Japan, Canada and the U.S. continue to accelerate. The UK appears to be weathering the impact of the Brexit vote better than many had feared, thanks to more competitive exports on a weaker currency. Meanwhile, a rebound in demand for commodities continues to be a positive for Latin America, Canada and Australia, while Chinese contribution has ebbed slightly in recent months as authorities try to restrain financial speculation.
6. The Fed should feel comfortable about raising interest rates
The global economy is generating fewer worries than in recent years and the U.S. is approaching or at many long-term targets, like unemployment and inflation, making it clear that interest rates are still too low. The decision to increase rates in December reflected this conclusion, and barring any significant negative shocks or fiscal stimulus, we anticipate the Fed to further raise rates by 0.25% at least three times in 2018, with upside risk to four, despite recent personnel turnover. In addition, the FOMC’s plan to reverse quantitative easing, the start of which was announced at the Fed’s September meeting and commenced shortly after, demonstrates that the central bank is committed to raising interest rates across the yield curve.
7. Rising rates will make fixed income investing more difficult
Long-term interest rates remain very low, especially compared to historical averages, despite a clearly improving global economy and Fed tightening. However, in 2018, some forces like further hikes in the federal funds rate, stronger economic growth and lessening accommodation by other central banks should push yields higher. This back-up in rates should result in weak total returns on Treasuries and some high-quality corporate bonds, suggesting that investors may want to consider investing in other fixed income sectors, like high-yield debt or emerging markets, or shifting their portfolio allocation to underweight bonds relative to other asset classes.
8. U.S. stocks are expensive relative to history, but not relative to bonds
Despite a very long and powerful bull market, the case for an overweight to U.S. stocks over bonds persists. As it currently stands, many valuation measures show the U.S. equity market to be expensive relative to history, with both forward P/E and Shiller P/E ratios trending higher than long-term averages.
However, the most important ratio on this slide is the comparison between the earnings yield on stocks and yield on BAA bonds (the yield of the average debt rating of S&P 500 companies) – this is, in essence, an adjusted risk-free rate, incorporating credit risk. Looking at this metric, it would still appear that owning the equity of a company is a better investment than owning the debt. Put more simply, relative to bonds, stocks still look cheap. That said, bonds, like stocks, look expensive, underscoring the importance of diversification outside of the most traditional asset classes.
9. International stocks may offer better opportunities
LEFT: Earnings prospects look more promising overseas
U.S. earnings in the next 12 months are expected to be at a record high. However, earnings in Europe remain far below their pre-financial crisis peaks, while Emerging Markets earnings are below peaks achieved in 2011. A long cyclical recovery in Europe and an improving banking system should lift European earnings while EM profits should rebound on firmer commodity prices. Both European and EM earnings appear to have more room to grow than in the U.S.
RIGHT: European and Emerging Market stocks look cheaper than their U.S. counterparts.
While U.S. P/E ratios are above their 25-year average, Europe and EM look more attractive from a valuation perspective: European P/Es are somewhat lower, and comparison to local bond yields makes for an even more compelling case. Meanwhile, EM Price-to-Book ratios remain at just average levels. If, in the long run, the U.S. dollar falls to more reasonable levels, this could add to the returns on (unhedged) international equities.
10. Higher valuations and uncertainty underscore the need for broad diversification and careful portfolio management
Despite continued political turmoil in 2017, risk assets produced generally positive returns, as indeed they have been on average over the past 15 years despite the global financial crisis and many other economic, geopolitical and financial disruptions. Entering 2018, cash is still paying close to nothing and global economic momentum and reasonable global stock valuations suggest that this is still a time to be overweight risk assets.
Having said this, it should be noted that many asset prices are higher than they were a year ago. Because of these higher valuations and potential dangers from policy mistakes or geopolitical risks, it will be even more important for investors to maintain well-diversified portfolios and be willing to make adjustments in response to changing valuations or the investment environment.