Market Memo: Five things to watch this year

01-04-2018

It would seem hard to expect a repeat of the year just passed. 2017 saw all the major equity indexes repeatedly reach new highs; the economy string together two 3%+ quarters of annualized growth, with a third one possible when the final numbers are in for the fourth quarter; and passage of a tax reform package that sharply lowered corporate tax rates, nearly doubled the standard deduction used by most taxpayers and created incentives for businesses to step up the pace of capital expenditures (capex). All of this provides a nice tailwind for the year ahead. Here are five things to watch for a repeat:

  1. What will corporations do with their tax savings? The reduction in the top line rate from 35% to 21% improves the after-tax returns on investment, which should encourage companies to invest more in business capital, via increased capex and R&D, and in human capital, via increases in hiring, wages and benefits. This, in turn, should boost productivity, allowing for improved economic growth without a troublesome pickup in inflation (which we also are watching closely). To date, several companies already have announced raises and bonuses in response to tax reform. The provision that allows for 100% expensing of capex over the next five years should start to have an impact, as well. Finally, the tax overhaul would allow multinationals that have stockpiled some $2.5-3 trillion in cash overseas to repatriate those earnings at two discounted tax rates—15.5% on income held as cash and cash equivalents, and 8% for illiquid assets.
  2. What will the Fed and its new chair do? When Jerome Powell takes over the reins when Fed Chair Janet Yellen’s term ends Feb. 3, markets will be paying close attention for any change in tone on the monetary policy and regulatory front. While it’s thought Powell, like Yellen, favors easy money, his comments and record suggest he’s not as big a fan of regulations. And his is one of a handful of changes in store as the Fed has a number of unfilled seats and the possibility that the New York Fed presidency also may turn over. As for rates, the Fed’s dot plots currently suggest three rate hikes in 2018; futures markets currently are pricing in only two.
  3. Will the yield curve continue to flatten and maybe even invert? Short rates rose faster than long rates for most of 2017, and consensus sees this flattening continuing this year. Some even suggest a potential inversion, where short rates exceed long rates. We are not so sure. Market participants have a history of underestimating the positive impacts of fiscal policy. The last time there was a tax cut, in 2003, the yield curve flattened by 40 basis points in the four months preceding the cut, a similar magnitude to what occurred before the new tax law passed, followed by an 80 basis-point steepening in the subsequent two months on improving longer-term growth expectations. To be clear, the new tax law represents structural reform that should have a far more profound impact than the temporary stimulus provided by the 2003 Bush tax cuts. We care about the yield curve because an inversion has preceded each of the last seven recessions, with a lag from 8 to 23 months between the inversion and start of a recession.
  4. What’s next for Washington? With tax reform in the rearview mirror, we expect lawmakers to pivot to infrastructure, which may prove unpopular with parts of the GOP caucus but potentially could—could—earn some Democratic support. Other possible geopolitical hiccups include flare-ups in ongoing tensions with North Korea, the overhang of the Mueller investigation into potential Russian meddling in the 2016 election and the 2018 midterm elections. Various polls suggest Democrats could overtake Republicans and regain control of the House, with the Senate remaining in GOP hands. It’s early and we’ve all learned that polls aren’t always to be trusted.
  5. Will earnings continue to be the underpinning of the stock market? We think so. The consensus currently projects S&P 500 earnings growth to accelerate from 10% in 2017 to 12% in 2018. At Federated, we are forecasting a more robust 15% growth rate for this year. We also anticipate that, in this low-rate, low-inflation environment, this earnings acceleration will lead to a richer price-earnings (P/E) multiple, pushing the S&P to our 2018 target of 3,000. We won’t have to wait long for our first earnings data of 2018, as the banks start reporting fourth-quarter 2017 earnings next Friday.

Rest time is over—time to get back to work. Happy New Year, everyone!