Market Memo: Surprise, surprise—where the 2018 consensus is likely wrong

01-10-2018

With the market off to a strong start following a +22% year in 2017, it seems prudent to ask: what could go wrong? Where could the current market consensus be most off the mark? As we survey the field, we’ve identified five areas where we hold out-of-consensus views—in all five, we think the risks for this market are to the upside, not the downside.

Indeed, we see the odds rising that our longer-term target of 3,500 on the S&P 500 may be achieved sooner than our stated expectation of sometime in 2020, and have raised our 2018 target from 3,000 to 3,100. Against this backdrop, Federated last week again added to its equity overweight in its PRISM® stock-bond portfolio models, moving from 92% of our maximum equity level to 94%.

Without further ado, our five biggest surprises for 2018:

  • No. 1: Tax reform’s short-term impact higher than expected; 2018 earnings revised higher. As noted in our year-end piece “Tax bill, the Christmas gift that keeps on giving,” analysts’ bottom-up numbers for the S&P in 2018 were too low going into the tax reform, and remain too low—an unusual circumstance going into a new year. (Normally, analysts’ numbers start too high and are gradually revised down as the year progresses.) As most recently as last September, the bottom-up numbers hovered around $145. Today, they are $148, still too low in our view. Unexpectedly, the corporate tax cut was bigger (to 21%) and quicker (starting in full this year) than anyone expected. In addition, economic growth also is running above expectations, partly due to the optimism unleashed by tax reform, partly due to the Trump administration’s deregulatory reforms and partly just due to rising confidence. Added together, we’ve raised our earnings expectations to $155 for 2018 and $165 for 2019. Ultimately, stocks are powered by earnings, so if we are right about this surprise, it should be market bullish, even off present levels.
  • No. 2: Tax reform’s long-term impact higher than expected; 2018 and 2019 economic growth tops consensus forecasts. Currently, most economists working with traditional Keynesian (demand-side) economic models see tax reform as little more than a dangerous “late cycle” demand stimulus that, longer-term, will produce little growth and higher federal deficits. Again as we noted in December, we believe they are wrong and consensus will move toward our view as the year progresses. In fact, the huge 20%+ boost in after-tax returns on investment via the corporate tax cut should almost by definition boost investment in projects previously shelved as uneconomical. A key driver of the moribund growth to date off the 2008-09 recession has been a lack of corporate investment, which in turn has resulted in declining labor productivity. A reversal of this trend, which we believe will become increasingly apparent as the year progresses, should prove to be the perfect form of stimulus for late in an economic expansion, boosting productivity and therefore growth without necessarily raising inflation to Fed-worrying levels. Federated’s GDP forecast for this year is running at 3.0%, with an upward bias, well ahead of the current consensus of 2.7%. This productivity-led growth should produce better wage and job outcomes while also boosting corporate profits. Again, market supportive.
  • No. 3: Tax reform’s political impact more favorable than expected; Republicans sweep midterms. Online betting markets currently place odds of a Democratic majority in the Senate and House after the midterm elections at 40% and 60%, respectively—a fairly normal outcome for a midterm election. And given that Democrats seemingly have for now won the publicity war on whether the tax cuts help or hurt the middle class, a Democratic sweep seems quite plausible. Fear of such a sweep, and the potential rollback of the tax bill and/or impeachment of the president that would follow, is lingering unpleasantly just beneath the surface of this market. We see several drivers likely reversing these latent fears as we get into the spring and summer months. By late February, most of the country will be receiving their new pay stubs with the full impact of the individual tax cuts incorporated. The vast majority will be surprised to see that their taxes have gone down, not up as advertised by the opposition party. And as the year progresses, more and more people should see wage increases and improved, permanent job prospects. Ultimately, economics drive elections and by November, we expect household economics to be better. Market supportive.
  • No. 4: The Powell Fed shifts gears. Current market consensus sees three Fed rate hikes this year, with the risk of a fourth late in the year if things go well for the economy. In addition, the market believes the slow and gradual quantitative tapering (QT) strategy put in place by Chair Yellen is on autopilot, and in fact discussion of QT is not even in current market dialogue. Thus, the market expects the nearly flat U.S. yield curve to remain flat or move flatter. We expect this consensus to reverse by midyear as incoming Chair Powell shifts all Fed policy levers toward “normal” and attacks most aggressively those that are not. With inflation likely to remain low, for reasons I laid out last August, we think the Fed will declare a 2.0% fed funds target rate as “normal,” signaling at least a long pause once it does its second rate hike this year, maybe in June. Market supportive. The Republican-leaning Powell also is likely to push to bring the Fed’s regulatory arm to heel, “normalizing” its regulatory activity. This move would be growth and productivity supportive. Finally, Powell—reportedly opposed to the third wave of quantitative easing—likely will move to shrink the Fed’s balance sheet more quickly, getting it to “normal” sooner rather than later. This shift in focus as the year progresses should boost yields on the 10-year modestly, toward our 3.0% target, while pinning shorter-term yields closer to current levels. Compounded with increased focus on soon-to-come QT from the European Central Bank and Bank of Japan, the yield curve by midyear should be steepening, not flattening. This would improve earnings further in big economic sectors such as financials and dampen concerns of a coming recession. Market supportive.
  • No. 5: The consensus on a fair value for the market shifts … higher! For most of the last two years, we have been treated to endless cacophony of market pundits claiming the market’s valuation “is rich by any measure.” Most of the “any measures” reference trailing earnings, either economist Robert Shiller’s trailing 10-year earnings P/E ratio or the trailing 1-year earnings that many analysts look at daily. As we have noted repeatedly, these valuation measures are biased upward by the Great Recession of 2007 to 2010, and more recently the earnings recession of 2015 to early 2017. On Federated’s present-year estimated earnings of $155, the S&P currently is trading relatively inexpensively given the fundamentals at a 17.7 multiple. With the first four surprises positive, and with risks of a recession seemingly pushed off, we think the biggest surprise of 2018 will be that the consensus concludes that a higher, not lower, market multiple is in order: a 20 P/E. This multiple applied to our recently upwardly revised S&P earnings forecast brings us to our new year-end target: 3,100.

As always, there are risks out there that we can’t or don’t see. And for that reason, a prudent asset allocation is never “all in.” This said, we think the current balance of risks that we can see are, somewhat unusually, all tilted upward and to the right. Given this asymmetry, we continue to believe that investors should consider leaning toward the higher end of their tolerable equity exposures. So, surprise, surprise! There might just be a very big bull around that corner….