We are now in the second-longest bull market for stocks in history and many investors are wondering how long it can continue. While valuations do look a bit stretched, there is likely to be more upside to this market. Lower corporate taxes and less regulation should benefit domestic companies and the overall economy. Given the current economic backdrop, U.S. equities could generate high single digit to low double digit returns in 2018. Equity market performance this year should hinge on four variables: economic growth, corporate earnings, inflation and interest rates.
The U.S. economy continues to chug along and appears to be strengthening. Economic growth picked up speed in the middle of last year. Real GDP came in at roughly 3% in Q2 and Q3 and Q4 estimates are above that level. Real GDP had been growing at just 2.2% per year since 2009. The U.S. is now on track to have the longest economic expansion since World War 2. Global growth which began to show signs of growth in mid-2016 and accelerated through 2017, should also continue in 2018. Economies outside the U.S. are far earlier in their respective business cycles. The weaker dollar should also provide a benefit to global economies.
Corporate earnings are a function of economic growth and have been stronger than anticipated. We believe they can remain strong well into 2018. The recent corporate tax cut will help boost earnings going forward and the S&P500 EPS estimate has risen by 2.2% since it passed in December. According to FactSet, the estimated earnings growth rate for 2018 stands at 11.8%, with all 11 sectors projecting year-over-year growth. The profit margin for S&P500 companies is projected to be almost 11%; the highest in 10 years.
The lack of inflation is a positive but it remains puzzling. Wages and consumer prices have not responded to the continuous infusions of liquidity from central banks around the globe. The unemployment rate could soon be the lowest it has been in almost 20 years. This, in theory, should result in wage growth. Higher wages would put more money in workers’ pockets and boost consumer spending. Higher energy costs and dollar weakness will likely boost inflation during the second half of 2018 as well.
The Fed is in a difficult position. It must normalize rates without hindering economic growth.
There is little doubt we will see higher interest rates in 2018. How high they will go and what the yield curve will look like remains to be seen. After raising rates five times in the past two years, the Fed could hike rates another three to four times in 2018. This will depend on how strong the economy is and what inflation looks like later in the year. It is important to remember that the Fed only controls short-term interest rates. Longer-term rates are more market-driven and generally do not rise as much as short-term rates during periods when the Fed is raising rates. The Fed’s balance sheet reduction program laid out in September, will likely ramp up in 2018. This could impact rates on the longer end of the yield curve. If the Fed can increase rates at a measured pace and reduce its balance sheet in an orderly fashion, higher rates are something to look forward to rather than fear. The impact on payments for mortgages and other lending should be manageable and investors will finally earn more on bank deposits. The rest of the world will also begin to normalize policy in 2018 but these are the very early days of a tightening cycle and the impact should be relatively muted.
All of this is not without risks and 2018 has the potential for some pockets of turbulence. With the U.S. economy in late stages of the cycle, a falling unemployment rate and the possibility higher inflation, higher interest rates seem inevitable. Earnings could come under pressure from lower than expected top-line revenue growth and the impact of higher wage costs and higher interest rates. Geopolitical tensions remain in the Middle East and North Korea. The political environment here in the U.S. remains contentious at best. 2018 is only two weeks old and the threat of a government shutdown looms. These risks could all spook the market. When this occurs, volatility will return. In 2017, there were no declines in the S&P 500 greater than 3% which is unprecedented. With the lack of volatility, markets look less risky and investing begins to look easy. Volatility is normal and the risk of a bear market seems low. But whatever the future might bring, investors should not overreact to turbulence in the year ahead. The best thing to do in 2018 is maintain discipline as an investor. Don’t disrupt your strategy because of an event whose impact may be short-lived. Stick to your plan, stay invested and stay appropriately diversified.