Economic & Market Update
“There are 65 pages in the Guide to the Markets. However, we believe that the key themes for the third quarter can be highlighted by referencing just 10 slides.”
DR. DAVID KELLY, CHIEF GLOBAL STRATEGIST
Economic & Market Update: Using the Guide to the Markets to explain the investment environment
1. The U.S. economy has recently heated up, but should resume a slow and steady pace in 2019
LEFT: This has been a slow but resilient expansion
This economic expansion has been like a healthy tortoise – slow but steady. In fact, at 10 years old, this is the second longest expansion since 1900. Growth accelerated meaningfully in 2018 on the back of fiscal stimulus and an improving trade deficit. Moving forward, however, growth should slow as trade numbers worsen, the effects of fiscal stimulus fade, and structural limitations become a drag.
RIGHT: The economy has grown faster in 2018
Growth has accelerated through the first half of 2018 and looks set to remain above trend for the next several quarters, 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, but wage growth should remain sluggish
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 through the end of this year should cut the unemployment rate further, perhaps to its lowest level since the 1950s. Despite this, wage growth is likely to remain sluggish as companies continue to resist raising wages.
3. Corporate profits have been strong thanks to topline growth and margin expansion
Profit growth has been extremely strong in 2018. Revenues have been boosted by a falling dollar, a surge in oil prices, and above-trend GDP growth. Margins have also risen thanks to corporate tax cuts and persistently low inflation and interest rates. Share buybacks, a product of excess cash, have also modestly boosted earnings per share.
In 2019 and beyond, however, many of these factors will fade. As a result, earnings growth should return to a mid-single-digit pace.
4. Inflation should stabilize over the next 12 months
Despite rising home prices, bond prices, and stock prices, consumer prices have not moved too much over the last 10 years. While recent inflation prints have shown some heating up, these increases mostly reflect a big surge in oil prices. Since oil prices are likely near their peak, overall CPI inflation over the next 12 months should moderate.
Beyond this, the use of information technology around the world has empowered buyers of goods and services, a powerful structural force that will continue to put downward pressure on inflation globally. This force will likely remain in 2018 and beyond, which should temper the rise of inflation moving forward.
5. The global economy is still in good shape, but growth has slowed down
After two years of very mediocre growth and various setbacks over the last decade, the global economy started to show signs of life at the end of 2016. So far in 2018, this story remains broadly intact. However, momentum has declined in recent months. In developed countries, this is largely due to weather-related disruptions. In Emerging Market countries, this is largely due to sharp declines in confidence and currencies, particularly in Argentina and Turkey. More broadly speaking, rising U.S. interest rates, a high dollar, and trade concerns have put a damper on growth. Nonetheless, PMI data show that global economies are still firmly in expansion mode.
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. Moreover, inappropriately expansionary fiscal policy and the desire for future flexibility of monetary policy in the event of a recession has made the need to normalize policy more immediate. The decision to raise rates again in September reflects this. Barring any significant negative shocks, we anticipate the Fed to further raise rates by 0.25% three more times in the next three quarters.
7. Careful fixed income positioning is necessary in a rising rate environment
Long-term interest rates remain very low, especially compared to historical averages. As the Fed continues to raise interest rates in a low-inflation environment, there is the possibility of a yield curve inversion. While this has historically been a reliable signal of an impending recession, recent unprecedented central bank policy may mean that the yield curve has been distorted. As a result, a yield curve inversion may not mean what it used to.
As rates rise, and the economy continues to grow, credit risk, rather than duration risk, is more appropriate in fixed income investing. That said, as interest rates continue to rise and bonds approach normal valuations, flexibility will become increasingly important.
8. U.S. stocks are slightly 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 slightly expensive relative to history, with both forward P/E and Shiller P/E ratios trending higher than long-term averages. That said, valuations in 2018 have moved more in line with average, thanks to improving analyst estimates of forward earnings in the face of tax reform and strong economic growth.
9. International stocks may offer better opportunities
For most of the last three decades, both U.S. and international markets moved sideways. However, come 2011, U.S. markets took off while international markets remained stuck. In 2017, international markets started to outperform, but 2018 has so far been a year of U.S. outperformance, leaving many to wonder if international strength was short-lived. However, international equities remain attractive over the long run thanks to strong economic growth and a downward trajectory for the U.S. dollar. Moreover, valuation measures suggest that international stocks are cheap relative to both the U.S. and their long-term histories.
10. Higher valuations and uncertainty underscore the need for broad diversification and careful portfolio management
Despite continued political turmoil in 2018, 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. 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.