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Ten predictions for 2018: From nearly perfect to less perfect
- 2017 The year in review: In many ways, 2017 was a “perfect” year for financial markets.
- 2018 Outlook: We expect another solid year for equities, but conditions could grow more difficult.
- Key themes for investors: Investment selectivity is likely to grow in importance as volatility rises.
We expect a year marked by continued decent economic growth and corporate earnings as well as low but rising inflation and yields. We anticipate more market volatility and less of a tailwind from the political backdrop. In all, this should create a still-good environment for stocks but not a continuation of the perfect world from last year.
Ten predictions for 2018
- U.S. real GDP reaches 3% and nominal GDP 5% for the first time in over a decade.
The negative impacts from the financial crisis have finally moderated. This backdrop, combined with a significant corporate tax cut and a rising capacity utilization rate, should lead to a return to somewhat more normal growth. Late in 2017, the Leading Economic Indicator series finally rose above its pre-recession level. In the past, this led to on average six more years of economic expansion, with the shortest additional expansion period being four years.1
- Despite ongoing protectionism, the global expansion continues with the fewest countries in recession in history.
We expect global growth to continue increasing at a time when global trade is not expanding. Typically in an expansion, imports and exports are among the fastest growing segments of the global economy. But anti-trade sentiment in the United States and elsewhere has held this back. Investors need to keep a careful eye on protectionist threats to global growth.
- Unemployment falls to the lowest level in nearly 50 years as wage growth is the highest since the Great Recession.
We expect unemployment to fall again in 2018, dropping to below 4%. Meanwhile, wage growth has remained fairly quiet, but last year wages were slowly starting to rise. We expect that trend will continue as a shortage of workers, robust corporate profits and generally strong corporate conditions manifest themselves.
- The yield curve flattens (but does not invert) as the 10-year Treasury yield reaches 3% for the first time since 2014.
There are several reasons why rates are likely to increase in 2018, including a pickup in inflation. In fact, we view a rise in inflation as probably the biggest threat to the financial markets in 2018. It is important to note that we expect a flattening yield curve, with the Fed raising rates faster than the curve moves up in yield, but a flattening curve is not a good predictor of equity prices. Equities tend to sag only after a period of time when the yield curve inverts, which we do not expect in 2018.
- Stocks enjoy longest bull market in history but experience a 5+% correction after the longest period without one.
While we expect the bull market to continue and become the longest in history, we also expect the uninterrupted strings of advances to fade and occasional pullbacks as interest rates and inflation rise. A solid earnings outlook, still-benign inflation and interest rate environments, along with the absence of sentiment or technical warning signs, underlie our generally sanguine outlook.
- U.S. equity returns lag earnings growth for the first time in six years, the longest streak in decades.
U.S. stock returns have outpaced earnings in each of the last six years, the longest streak on record. The last time equity appreciation exceeded earnings growth for a sustained period of time was 1995-1999.2 We expect the current streak to end in 2018, meaning earnings will outpace stock market returns. Earnings expectations for 2018 are now high – justifiably so - but in our view they will be difficult to exceed.
- Equities beat bonds for the seventh consecutive year for the first time in nearly a century.
From 2012 until the middle of 2016, stocks outperformed bonds even though bonds continued to do well. In contrast, since mid-2017 interest rates have been rising irregularly, so the hurdle rate for equity outperformance has fallen. Equities may be vulnerable to pullbacks in response to rising bond yields, but a major decline in stock prices looks unlikely as long as growth and earnings are improving.
- Corporate capital expenditures increase at the expense of share buybacks.
We think the chronic underinvestment in capex this business cycle, strong profitability, the low cost of capital, improved economic confidence, lowered corporate tax rates, the repatriation of foreign earnings and the expensing of capex in the new tax bill will combine to show an increase in business fixed investment by maybe 6% or more in 2018. At the same time, tax changes that limit interest expense deductions should curtail share buybacks.
- Telecommunication services, information technology and health care outperform utilities, energy and materials.
The technology sector features companies with strong earnings and solid balance sheets. Health care looks to be the best positioned among the defensive growth sectors. We are including telecom services as a projected outperformer for its outsized yield, reflecting its out-of-favor sentiment. In contrast, utilities are not cheap and have poor growth prospects, while the deeper cyclical sectors of energy and materials appear expensive with mixed supply/demand fundamentals.
- Republicans lose the House, retain the Senate and further distance themselves from President Trump.
The long list of Democrats up for reelection in states where President Trump won by a wide margin provides some hope for the Republicans that they will retain the Senate, but the poor polling of the president and the Republican Congress means the Democrats may well retake the House. Whatever the outcomes, we expect many congressional Republicans will further distance themselves from the president. For markets, it probably means little, if any, significant legislation after the tax bill.
Bob Doll explains important economic and market shifts that may occur over the coming 12 months—and what to do about them.
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