“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
— John Kenneth Galbraith
Fourth Quarter Recap
As they had done throughout most of the year, financial markets finished in a rally mode. Economic growth has been steady, coupled with the passage of sweeping individual and corporate tax reform legislation. Although some form of tax overhaul was anticipated, the timing and scope was a positive surprise for most. Bond yields rose slightly, as the Federal Reserve Bank fulfilled its earlier promise to raise short term rates for the third time in 2017. Oil prices rose to the highest levels since mid-2015 as production quotas reduced inventories, raising demand.
The phenomenon of political volatility not translating into general market volatility continued both here and abroad. Global equity markets also displayed a remarkable steady ascent. This reflects an improving economic outlook, not just in developed countries but emerging ones, as well.
In spite of an absence of volatility, there was a clear delineation of individual winners and losers. Equities such as FANG (Facebook, Amazon, Netflix and Google), aerospace and transportation stocks ended very strong while most traditional (brick and mortar) retailers plummeted. Money managers have had to be extremely vigilant in investing in winners while avoiding the “landmines”. This investing dynamic is expected to continue, with many disruptive new technologies displacing companies with vulnerable business models.
Major Things to Consider in 2018
S&P 500 earnings were already slated to rise 10-12% this year, but they now get an additional 6-8% boost from corporate tax rates dropping from 35% to 21%. This does not take into account incremental changes or profit repatriation strategies which could have both positive and negative implications for individual companies in 2018 and future years.
The outlook for individuals is less clear, with numerous winners and losers. There should be a modest bump in paychecks, which will help support consumer spending. Higher wages will also benefit the consumer as the economy nears full employment. Manufacturing is picking up, and the more favorable treatment of depreciation expensing should improve capital spending plans. Corporate sentiment is also improving, with small business optimism at its highest since 1983. Commodity prices are rising, aided by increasing global growth especially in the emerging nations Though crude oil prices will probably trade in a higher range (a ceiling in the mid-60s for West Texas Intermediate, or WTI), as many frackers (shale drillers) are expected to ramp up production.
Not to be overlooked are coming changes from the Fed. In addition to new Chairman Jerome Powell, there are a number of vacancies to be filled during the year. It will be interesting to see if the new appointees take a more hawkish stance (leaning towards higher rates) or dovish stance (leaning towards fewer rate increases). For now, Chairman Powell has indicated a continuation of the gradualist policy begun by his predecessor, Janet Yellen, and this should reassure investors.
Of concern to economists and investors has been the flattening yield curve (a line that plots Treasury rates from shorter to longer maturities), due to the increase in short rates while longer rates have barely budged. While important, it is the inverted yield curve (short rates higher than longer ones throughout the curve) that has historically served as an early warning signal that a recession will occur. Fortunately, we are not at that point yet, and foresee longer rates finally picking up as a decrease of central bank buying both here (the QT, or Quantitative Tightening program) and abroad, particularly in the second half of 2018. We will continue to closely monitor the yield curve for future signals about the economy.
The economy still shows few signs of overheating.
- The job market may be tight, but wage growth at 2.5% is nowhere near a danger point. As a reference, full employment was reached in 1995, but the expansion cycle lasted another six years.
- Capacity utilization remains well below normal.
- Capital spending has lagged but is finally picking up.
- Rising business investment is usually a hallmark of the middle, not the late stages, of an economic cycle.
- Inflation is relatively tame, in part because of a tepid expansion — the cumulative real GDP growth of 20% is well short of the 1960s (52%) or the 1990s (43%) economic expansions.
We remain constructive on U.S. and global equities, realizing that overbought conditions do exist and that a pullback can occur. However, if it happens, we will look at it as a buying opportunity unless the economic outlook deteriorates. Our cautious view on fixed income remains unchanged.