KEY TAKEAWAYS
Overall outlook for 2018 is positive as the economy continues to recover and grow.
Risks include unexpected increases in inflation and faster-than-expected interest rate hikes.
Bonds may become a less desirable investment.
Near-term stock market weakness likely a buying opportunity.
“We are positive on the outlook for both, but we observe that the rapid market advance in recent months raises the probability of a long-delayed market correction.”
Stocks began the new year in impressive fashion, while bond yields rose off historic lows pushing returns into negative territory. The economic reports for the month, combined with the newly enacted tax reform legislation, suggest future upside surprises to both economic growth and corporate profits. We are positive on the outlook for both, but we observe that the rapid market advance in recent months raises the probability of a long-delayed market correction. There are risks to any forecast, but given the favorable fundamentals, we see any market pullback as temporary and therefore a possible buying opportunity.
JANUARY STOCK RETURNS WERE HEALTHY.
S&P 500 Index posted an impressive 5.73% gain in January, following the nearly 22% surge in 2017, on better than expected fourth quarter earnings reports, healthy economic data, and a positive reaction to the tax reform legislation passed in late December. However, the good news for stocks was not good for bonds. Treasury yields broke higher during the month, pushing bond prices (and bond returns) lower.
To put the January standout performance in perspective, the average S&P 500 January return since 1950 has been 1.0% according to the Stock Trader’s Almanac, and the index usually declines 1.0% on average in midterm election years. Looking under the “hood” at sector performance, consumer discretionary stocks led the way with a 9.34% gain, with technology not far behind with a 7.63% increase. The only sector with negative returns was utilities, the most “bond-like” of the equity sectors.
However, it is worth noting that a few names clearly outperformed others. For example, Amazon gained just over 24% in January, almost four times the return of other large discretionary names. Also, small cap stocks returned a more modest 2.61%, despite broad expectations that tax reform would have a large positive impact on the companies in the index.
Outside the U.S., international stocks easily kept pace with the S&P 500, but that was due mostly to a further -3.20% decline in the value of the dollar (-11.44% over the past 12 months). Emerging market stocks, however generated strong gains as evidenced by the 8.34% rise in the MSCI Emerging Markets index.
Bonds struggled in January, as healthy economic and earnings reports stoked fears of higher inflation and a faster, more aggressive pace of Federal Reserve interest rate hikes this year. The yield on the 10-year Treasury note jumped from 2.41% to 2.71% over the course of the month, pushing the return on the broad Bloomberg/Barclays U.S. Aggregate Index down -1.21%. The one sector of the bond market that improved was the high yield market (up 0.69%), owing to stronger economic data.
THE ECONOMY APPEARS TO BE HITTING ITS STRIDE ENTERING 2018.
While the current recovery, which began in 2009, has been the most sluggish in memory, recent economic reports seem to paint a picture of broad-based and accelerating growth. The overall trend of employment gains remained steady and healthy, with the unemployment rate hovering just over 4% and initial jobless claims (a key leading economic indicator) down to the lowest level in over four decades. This overall trend bodes well for future consumer spending, which also exceeded expectations in the latest report.
The housing market also appeared to be hitting its stride after languishing for nearly ten years in the aftermath of the financial crisis. Average home values are now back above the peak in 2006, which allows “underwater” homeowners to sell or refinance their homes without taking a loss. Moreover, the home ownership rate is moving higher, powered in large measure by millennials who struggled in the early years of the recovery amid slow job growth and tightened post-crisis credit standards. Inventories of available homes for sale remain exceptionally low. Housing, normally a leading sector of the economy, is now showing signs of accelerating and fully participating in the expansion.
Activity also improved on the business side of the economy. The Purchasing Managers Index rose to a cycle high 59.7 in January (greater than 50 indicates expansion), and industrial production surged 0.9%, though boosted somewhat from higher utility output from the cold weather. New orders are rising. Importantly, inventory levels are relatively low, which typically leads to additional increases in output in the months ahead. International economic reports also generally exceeded expectations, suggesting that a synchronized global expansion is underway. This broad-based growth not only increases the opportunity for future gains in exports, it also lowers the risk to the overall economic outlook, since there are fewer potential “weak links” which could derail momentum.
Inflation normally rears its ugly head by this time in the economic cycle, but key measures remained low, and core inflation was below the Federal Reserve’s stated 2% long term target. The Consumer Price Index increased a scant 0.1% in December and was up 2.1% for all of 2017. However, the core CPI, which excludes food and energy, increased 0.3% in December but rose just 1.8% for all last year. Clearly, there are signs that inflation may be moving higher in 2018 and is a risk, but low inflation has been one of the notable economic surprises in the current expansion.
THE FEDERAL RESERVE SEES THE ECONOMIC STRENGTH, AND IT WILL CONTINUE TO RAISE INTEREST RATES IN 2018.
Wading through the minutes of the latest Federal Open Market Committee (FOMC) meeting, three points seemed clear to us. First, there was broad agreement that the economy is getting stronger, but second, the widely anticipated acceleration in inflation has been elusive. The third, and most important point for investors, is that additional interest rate increases in 2018 will be the most appropriate policy course. The Fed raised interest rates three times in 2017 to a range of 1¼%-1½%, and they believe the FOMC will need to raise rates another three times in 2018, which would lift the overnight federal funds policy rate to 2%. Stronger than expected growth or higher than expected inflation could cause the Fed to move rates higher and faster.
ECONOMIC STRENGTH HELPED LIFT FOURTH QUARTER CORPORATE PROFITS.
By the end of January, roughly half of the companies in the S&P 500 reported earnings. Based on reported and expected earnings, fourth quarter profits are now expected to increase 13.6% from the year ago quarter, compared to a 10.5% projected gain at the beginning of the year. Thomson Reuters reported 78.1% of the reported earnings beat analyst expectations, compared with the long-term average of 64%. Fourth quarter revenue is forecasted to increase 7.7% from Q4 2016. 79.7% of companies have reported Q4 2017 revenue above analyst expectations; above the long-term average of 60%.
By some estimates, the Tax Cuts and Jobs Act may add as much as $17/per share to S&P 500 earnings, which could add up to a 25% increase in full year earnings. This projected increase has been and could be a significant support for stocks in 2018. That said, company management is likely to guide expectations higher at a gradual pace, as they have done in the past; under-promise and over-deliver. If so, we may continue to see profits easily exceeding estimates for the remainder of the year, which would be a steady source of upside surprises.
WE REMAIN OPTIMISTIC ON THE ECONOMY, BUT MARKET VOLATILITY COULD RETURN.
Our outlook for economic growth in 2018 is positive, and 3% appears quite achievable at present. Job growth is steady, the housing market appears to be strengthening along a broad base, company inventory levels are relatively low and new orders have accelerated. These factors, along with the boost to both individuals and corporations from tax reform, suggests significant upside opportunity and limited downside risks to the economy, especially with global growth on a more sustainable footing.
The positive macro backdrop suggests continued support for corporate earnings growth in the quarters ahead, but the path of stock prices, while higher on balance, may be rockier this year. We have observed over the years that bull markets require a steady diet of positive surprises. At present, despite our optimism on the pace of growth, it would seem difficult for the news flow on the economy to get much better, possibly leaving the market “hungry and grumpy”, and vulnerable to a temporary setback.
Some of the risks we see include an unexpected rise in inflation and an accelerated pace of interest rate increases from the Federal Reserve. This tension could push bond yields and mortgage rates up high enough to cool credit demand. It appears that low bond yields, which have been a steady source of support for the stock market, turned noticeably higher in January and have become at least a neutral factor if not a potentially negative pressure on equities. Additionally, the evolution of trade policy remains a significant unknown. Midterm elections have also historically been a risk for the stock market. Throw in the “usual suspects” of geopolitical risks such as North Korea and ISIS, and there are more than enough potential risks to keep portfolio managers up at night!
Taken together, we remain positive on our outlook for the economy and the stock market for the remainder of 2018 and see market dips as buying opportunities. However, we are less sanguine on the outlook for bonds. While draconian moves are unlikely under the incoming Chairman Powell, the Federal Reserve is expected to continue removing the extraordinary stimulus injected in the post-crisis period under Chairman Bernanke. We believe the Fed will raise short term interest rates gradually and reduce bond purchases, a process begun under Chair Yellen. With the Treasury deficit (and borrowing) expected to increase this year, simple supply/demand pressures point to higher bond yields and lower prices. Bonds have been steady performers in recent years, but that may be about to change.