As we turn our focus to 2018, we remain focused on the most important factors influencing U.S. equities - employment and earnings
On the employment front, we have every reason to believe that the streak of 87 consecutive months of job growth will continue to persist throughout 2018. Economic trends remain solid and the new tax policy improves U.S. job prospects further. In what must now be a familiar chart to many clients (see below), there is a very high correlation between a rising level of employment and a rising stock market (the reverse is true as well). While further job gains in 2018 do not guarantee an increase in the S&P 500, employment trends remain highly supportive.
As we discussed in our Outlook from 2017, while employment data is helpful in setting the stage for medium-term moves in the S&P 500, from a shorter-term perspective, the pace of earnings growth often plays a larger role. While 2017 U.S. earnings growth is expected to be a strong 11%, 2018 earnings growth was shaping up to be a solid 10% before the change in tax policy. Including the lower corporate tax rate, S&P 500 earnings may grow in the 15%-18% range – quite robust indeed. So, can we expect U.S. equities to rise by 15%-18%? Let’s not be too greedy. Our best forecast would be for stocks to gain another 10%-15% (closer to the initial estimate for earnings growth) in 2018. Under this scenario, stock market valuations would actually improve from current levels.
Speaking of valuations, at a price-earnings ratio (P/E) of 20.3X, the S&P 500 trades a little above the more typical 14X-18X range it has traded in during “normal” times over the last 25 years. On a 2018 basis, the forward P/E trades at a more reasonable 17.3X-17.7X range. Curiously enough, this is the exact level as a year ago. Slightly higher than normal valuations are acceptable as long as earnings growth comes through as expected. If it does not, we would likely become more conservative in our forecast.
On the international equity side, we expect 2017 trends to continue into 2018. After many fits and starts, sustained economic improvement now seems likely. Further economic progress coupled with an earlier stage in the economic cycle and cheaper valuations should provide for continued gains. At this point, we believe international equities will provide similar returns to U.S. equities in 2018.
Finally, on the fixed income front, we begin by focusing on longer-term bond yields. As the economy continues to progress, helped by its own existing momentum and with the bolus of tax reform, we would expect 10-year Treasury yields to progress higher but still remain reasonably contained with a ceiling of 3.0%-3.25% on the 10-year yield. This would provide nearly flat total returns as income generated gets offset by some decrease in bond prices. Helping to keep a lid on yields should be the low level of global interest rates with Japan (0.05%) and Germany (0.42%) being prime examples.
Turning to shorter-term interest rates which are dictated by the Federal Reserve, at this point we expect the Federal Reserve to raise interest rates by 0.75% in 2018. This is in-line with the Fed’s own forecast and would help restrain any budding inflationary pressures. It would also help further normalize the Fed Funds rate which would provide the Fed more ammunition for the next economic turndown, whenever that might be. The one caveat to this projection is if longer-term interest rates remain stubbornly flat the Fed would likely halt after just a 0.25% or 0.50% increase as it is unlikely that the Federal Reserve would intentionally invert the yield curve.
Revisiting our discussion on the economic dangers of an inverted yield curve presented in our 2017 Year in Review, we will clearly monitor the curve going forward as this is probably the primary factor of concern for the moment. Should the yield curve invert we would likely have to negatively revise all of the forecasts made in this Outlook. That said, there is really no reason that the yield curve needs to invert (2-year bond yielding more than a 10-year bond). The most likely reason for an inversion would be related to the Fed raising the Fed Funds rate to such an extent as to intentionally cause the yield curve to invert. This does not seem reasonable, in our point of view. The Fed understands the relationship between the yield curve and the economy quite well. While the Fed would like to keep inflationary pressures at bay, it is not rational that their goal would be to throw the economy into recession. Either way, we will watch this indicator closely.
This letter was meant to provide you with a best guess as to what 2018 will hold. As always, we are certain to encounter surprises that will add to volatility and conspire to prove us wrong. That, of course, is what we endeavor to anticipate and we will make changes to our outlook and your portfolio as warranted.
Wishing you a Happy, Healthy and Successful 2018!