Is it time to protect our gains or go for more? Our view is to keep fully invested through the spring as the economic and financial backdrops are just too strong:
- Economic growth on a global basis improved in 2017 and is set to expand further in 2018.
- Inflation pressures should remain surprisingly low, at least for the first half of 2018.
- As the European Central Bank and Japanese Monetary Authority continue with Quantitative Easing global interest rates should remain low and has put downward pressure on rates in the U.S.
- The pro-business tax reform in the U.S. will force other countries to follow suit for competitive reasons, resulting in improving global growth and corporate profits.
- Potential repatriation of $1 to $3 trillion in foreign earnings back to the U.S. will be used to reduce debt and buyback stock as well as increase capital expenditures, acquisitions, and dividends.
- Capital spending and real estate will be major beneficiaries of new expense deductibility rules and improved pass-through accounting.
- Threats of trade wars in combination with the new tax incentives for capital spending are likely to result in a surge of new plants being built in the U.S.
With this list of strong economic fundamentals, we are staying fully invested according to each client’s Investment Policy Statement. Stocks appear to be the best choice for investment performance during the first half of 2018. Global growth and acceleration in earnings will be the key driver of U.S. and overseas markets. I believe that the odds favor strong global equity markets into the summer.
What Worked in 2017?
Technology and emerging market stocks, particularly China, were the biggest winners in 2017 (Figure 1). The S&P 500 Index was up 21.8%, Nasdaq gained 28.2%, Europe & Japan rose 25.3% and Emerging Markets soared 37.2%. At the other end of the spectrum, Energy and Telecom stocks were the laggards both in the U.S. and globally. Surprisingly, bonds maintained their value in 2017 resulting in an average return for the U.S. Aggregate Bond Index of 3.5%.
Figure 1. – Winning and Losing Stock Sectors in 2017
Global Economic Growth Continues to Improve
It is likely that the global economy will continue to accelerate as we enter 2018 with the potential for the U.S. to lead the way for developed markets. On the emerging market side, growth in China is still anticipated to exceed 6.3% in 2018 as accelerating exports complement continued strong growth in consumer demand. Europe’s resurgence should endure as the economies of Germany, Spain, Sweden and France continue their expansions. With exports to industrialized nations as a key driver of growth, the emerging market economies will also fare well.
The pendulum has clearly begun to swing back globally from an excessively restrictive financial, regulatory, and anti-business environment to one that is more supportive of economic growth. The pro-business tax reform in the U.S. will force other countries to follow suit for competitive reasons, resulting in improving global growth and corporate profits. China has already begun offering tax breaks to foreign companies in a bid to keep them from taking profits out of China. Other countries and regions are likely to take measures that would help maintain their comparative advantage as well.
According to the IMF, global economic growth improved from 3.2% to 3.6% in 2017. The emerging market and developing economies grew at a 4.6% rate while the growth for more advanced economies was 2.2%. These rates of growth are projected to improve modestly in 2018 led by China and India. Among the advanced economies, the U.S., Japan, Germany, Canada and Spain are projected to grow GDP by more than 2%. Figure 2 below highlights the global increase in business confidence as represented by strong Purchasing Managers Index (PMI) in leading economies. As long as global interest rates remain low and business confidence high, we believe there is potential for stronger economic growth than projected.
Figure 2 – The PMI Confidence Index for Europe and Japan are at 5yr. Highs
The Impact of Tax Reform on Growth
Tax reform, while a huge positive, will benefit the U.S. economy over several years, not just in 2018. The near-term benefits of improved consumer spending are priced into the market. The longer-term positives for corporations, both domestic and foreign (to build new plants in the U.S. that will lead to job creation) are not yet seen in the market.
Hidden in the tax bill are reforms to corporate depreciation schedules that allow businesses to write-off capital spending on plant and equipment more quickly. These secondary benefits could establish a long-term cycle of capital spending on factories and real estate not envisioned in the initial enthusiasm for tax cuts. New deductions for pass-through entities benefit standard real estate investment vehicles. The full impact of the GOP tax bill will take time to be felt, but commercial real estate investors look like major beneficiaries. The benefits of tax reform will last over the next several years as all of this unfolds.
In a nutshell, what the tax reduction does for Corporate America is to provide an earnings boost that will bring the forward P/E closer to the long-term average valuation of 16-17 times earnings. Couple that with the low tax rate environment and it remains clear why stocks have continued to rally. If earnings improvements materialize as expected, the equity market is NOT overvalued at current levels.
The first half of 2018 appears very constructive as we wait to see the impact of tax reform on corporate earnings. Trump's pro-growth, pro-business agenda turned investment psychology upside down in 2017.
As shown in Figure 3, the tax bill will only modestly benefit the Technology and Healthcare sectors, which have led the stock-market rally for the last 7 years. The tax gains for the Energy, Consumer Discretionary and Industrial sectors are far stronger. Clearly the change in tax rates could rearrange the list of outperforming sectors in 2018 and beyond. We believe a switch from growth to value stocks is underway as a result.
Figure 3 – Sector Outperformance Could Change Substantially in 2018
Inflation and Interest Rates
We are not expecting any change in Fed policy under the leadership of Jerome Powell. The Federal Reserve is currently projecting 3-4 rate increases in 2018 along with regular reductions in securities purchased under past Quantitative Easing policies. We expect this will lead to gradually higher interest rates over the course of the year.
Typically, we expect that when stocks go up, bonds will go down in price. This did not happen in 2017. The big surprise was the failure of inflation to accelerate after billions of dollars of Quantitative Easing. In 2017 economic growth was stronger than anticipated and unemployment declined meaningfully without a real increase in wages. Global competition and creative destruction have put a lid on inflationary expectations. Whether inflation increases by the end of 2018 is one of the big questions and concerns facing the markets. Our expectation is a surprise to the upside for inflation in 2018.
European interest rates have been kept artificially low for longer than expected which has contributed to lower than expected interest rates in the U.S. Even though the ECB meaningfully raised its economic growth targets, it did not raise its inflation forecast nor did it alter its revised QE program of buying 30 billion euros of debt per month at least through September 2018. Draghi reiterated that the ECB would continue its aggressive QE until inflation breaches that magic 2% level. A surprise interest rate hike in Europe or Japan could be a catalyst for a global rate panic.
Overall, we believe that U.S. rates are poised to go higher. With 3-4 Fed rate increases expected for 2018 and a realistic chance of 2.5% to 3.0% inflation, higher interest rates could be a catalyst for a stock market correction in the second half of 2018.
Potential for Trade Wars
China is quietly promoting an economic model different from that of the U.S. and President Trump is endorsing a protectionist trade agenda. Either of these scenarios could cause the world to fragment into new trading blocks and cause a major realignment of trade patterns. Countries around the world are watching the U.S. back away from historic friendships and China has stated that they are ready to become a major superpower. We have already seen several Asian countries including South Korea, Japan and Philippines move closer to China. As time goes on we will need to carefully monitor the progress that China and Russia have improving their status and power overseas by filling a void created by Trump's foreign and trade policies.
The bellwether for trade is likely to be the NAFTA renegotiation's. With Mexico in the middle of its own presidential election, there is a strong possibility that discussions to modify NAFTA will go poorly; the result could start a race to the bottom for trade deals and new trading patterns. The crash of 1929 was partially precipitated by the Smoot-Hartley Act which raised import duties to protect domestic industry and agriculture.
In general, we approach the market in 2018 as a balancing act between technical forces and fundamental forces. Technically the market has achieved several key objectives and many technicians expect the market to reverse downwards and test key levels of support (Dow 23,000 then 21,300 representing declines of 7.4% and 14.2% respectively). It has been well over a year without a moderate correction and certain sectors of the market remain very overvalued. The bullish alternative is to raise the bar to Dow 26,500. As we believe that the fundamentals remain strong for the first half of the year, we will go with the higher target.
We continue to tilt our portfolios toward a value-stock focus. We believe that in 2018 there will be a rotation away from highly-valued social media stocks towards financials, global industrials, low-cost industrial commodity companies, capital goods companies and domestic steel and aluminum companies, all of which are beneficiaries of U.S. tax reform.
We remain heavily invested in international and emerging markets as they are inexpensive relative to U.S. equities. In researching this piece, we were surprised to find that of the 10 largest companies in the world by stock market value, none were from the U.S. Apple is the largest American company and was ranked 11th on the global list. U.S. investors should take a broad view of where the best investment opportunities lie as they are not always within the borders of the United States.
To balance out our equity exposure, we have made our bond exposure less risky with an eye on inflation protection. Our maturity profile is relatively short with an emphasis on investment-grade corporate bonds, floating rate notes, TIPS and some emerging market fixed income.
Overall, we remain optimistic that the global stock rally will continue for the next quarter or two as global growth is accelerating, inflation remains tame and interest rates are low. Potential negatives for the second half of the year include rising inflation, higher interest rates, trade wars and the fall election season.