2018 Outlook: On the other hand ...


Editor’s Note: Here’s what Linda is watching as we head into 2018. At the top of her list: inflation and the Fed. She’ll be back with her normal weekly the first week of 2018. Until then, Merry Christmas and Happy New Year!

2018 Positives

Where are we in the cycle? The Conference Board’s leading indicators index historically has been a good gauge of the economy’s growth rate. It surged in October and is in an accelerating trend, suggesting 2018 could be even better than 2017 and its back-to-back quarters of 3% growth. After this index moves above a prior peak, as it did eight months ago, it has increased for another 71 months on average before the next recession, suggesting there won’t be a recession until 2021 at the earliest.

What keeps us going? Already growing at their fastest pace in three years, capital expenditures (capex) are projected to accelerate to 9% in 2018’s first quarter, a Business Roundtable survey says. Cornerstone Macro thinks capex will be the strongest GDP component for all of 2018. As for consumers, the top-end has been spending all along, but now the mid- and lower-end is joining in. During a recent Chicago trip, an advisor whose husband is a mobile-home business owner told me customers who had been earning $10-12/hour are now making $15/hour and will “spend it all.” Accelerating capex and an emergent low-end consumer could be two strong tailwinds for growth.

Earnings watch S&P 500 earnings in the 10 years since the last economic peak have paralleled the average cycle, suggesting recent strong growth should carry over into 2018’s first half. This would be in line with the historical median 2-year earnings expansion after an earnings recession, which most recently ended in mid-2016. The unknown is how tax reform impacts the trajectory—estimates have ranged from a 7% to a 14% bump, lifting 2018 S&P earnings to $157-167 based on the current 2018 consensus of around $147. We are at $150 at Federated.

Inflation watch Wage inflation typically occurs when the money supply is growing—not contracting as is the case now. SIS Global thinks minimal wage inflation has been universally institutionalized into the labor market, with no real sign of wage increases despite cycle-low unemployment except for states that have raised their minimum wage. Based on 5-year and 10-year Treasury Inflation-Protected Securities (TIPS) futures, inflation expectations are stuck below 2%. Benign inflation can keep the Fed at bay.

2018 Negatives

Running on borrowed time? The percentage of global markets with higher forward relative to trailing earnings growth is its narrowest since 2011, with the chart looking much like it did prior to that year’s shallow cyclical bear market. Moreover, the MSCI All-Country World Index has trended higher for nearly 1½ years without a 5% correction, the longest stretch in its 30-year history, while the S&P has rallied for more than a year without even a 3% decline, the longest streak in 90 years. Volatility indexes also are multi-generation lows: the 100-day volatility gauge for the S&P is its lowest since 1965 and the 200-day measure for the MSCI World is its lowest since 1972.

A stumble out of the gates? In five of the past 10 Januarys, the broader indexes have struggled and there are reasons to expect this may be the case this New Year. After securing their best returns since 2013, many institutions likely will take a more cautious approach as the calendar turns the page on Dec. 31. Moreover, January historically has tended to be weak in midterm election years, although the first-quarter has typically eked out a gain. Since World War II, Dudack Research says the biggest midterm year gains have come in the fourth quarter.

Protectionism watch The Achilles heel of this cycle isn’t rising rates and debt service—it’s the potential for protectionism, says Empirical Research. The demise or steep erosion of Nafta could usher in increased trade friction that hurts several U.S. sectors, led by agriculture. Thus far, President Trump’s threats regarding trade have been more severe than the reality. But with deregulation and a likely tax cut under his belt, Empirical Research believes his administration may entertain the idea of a tougher stance, especially in an election year.

Correction watch The best hope for hitting aggressive 2018 earnings estimates is through a tax cut, but even potential 18% earnings-per-share (EPS) growth will not be enough to keep earnings in acceleration mode. Ned Davis Research notes analysts usually start the year 9% too high with their estimates, so investors should be able to digest mild disappointment. But if S&P EPS growth slips to the low double digits, the risk for a bigger correction should increase. Earnings deceleration is a one of the biggest risks for the market in 2018.

What else

Do shrinking spreads matter? The lack of any upward price momentum suggests longer-dated Treasuries could remain anchored even as the Fed lifts short rates, further narrowing the slimmest gap between 10-year and 2-year Treasury yields since the last recession ended. This raises the possibility of a yield-curve inversion by late next year, historically an ominous signal that has presaged a bear market for equities within 22 months. That said, Strategas Research doubts nominal growth will perk up enough to push the Fed’s target rate above 2%, keeping it low enough to prevent an outright inversion. Besides, the yield curve has a less than perfect record of calling recessions—it can remain flat for a long time without the economy falling into a downturn.

What could cause volatility to creep up? A Democratic sweep of midterms. Going back to 1960, the market consistently has corrected after midterm elections, with the average correction reaching 18%. But market performance subsequently has rebounded, gaining back as much and typically more than was lost a year later in 12 of 14 instances.

Contrary negative … or positive? Sentiment on equities is about as bullish as it’s been in this recovery, aided by an improving cyclical backdrop and likely tax cuts. Rarely does fiscal stimulus occur at the high-end of the cycle. In line with equity bullishness, investors remain bearish on bonds and the U.S. dollar. While sentiment is more informative than predictive, Cornerstone Macro says it warrants acknowledgment as a positive heading into 2018.

Cryptocurrencies are going mainstream With bitcoin futures already trading and an ETF launch in the works, cryptocurrencies may be on the verge of becoming just another investment despite criticisms that it’s a bubble akin to 1660s’ tulip mania. While describing risks and reiterating that federal securities laws may apply to assets and trading venues not properly registered with his agency, SEC Chairman Jay Clayton recently said the technology on which cryptocurrencies are based “may prove to be disruptive, transformative and efficiency enhancing” and could “provide promising investment opportunities for institutional and Main Street investors alike.”

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