The first quarter of the year has been eventful for the economy and markets, to say the least. We saw a return of volatility in the markets – more than we had seen for many months. Congress passed a tax package. U.S and international economies strengthened, and economic sentiment is strong. There is a lot to feel good about. But, as investors, we need to constantly be looking forward. So, we think it makes sense to re-evaluate where we are now, and look into possible scenarios that may come about later.
As business cycle investors, it is important for us to continually evaluate our position on the cycle in order to form our investment theses for the future. From this point of view, we see the U.S. economy holding its position in the expansion phase of the cycle, albeit just past its peak. We think the U.S. is in about the seventh inning of the game, but that game could very well go into extra innings. The U.S appears to be slightly ahead of other developed economies on the curve, as the global economy looks to be about halfway through its expansion.
We expect the U.S economy to grow at a rate of about 3.0% in 2018, and global economic growth to accelerate to 3.7%, its strongest output since 2011. We think that inflation will rise slightly, but remain contained. Demographic shifts away from consumerism, lack of available labor, and moves toward greater protectionism could put a cap on growth, but also help to extend the economic expansion at a moderate rate.
We see the secular bull market remaining in place, are maintaining our overweight to equities (with some cautiousness), and are favoring large caps over small-and mid-cap companies. At the moment, we see that about 75% of industry groups in the market are continuing their uptrends. As we progress through 2018 however, things may become more challenging for equity returns. We expect continued rising volatility from the unusually low levels of the past two years, and a return to more normal, periodic corrections of 5-10%. Ultimately, we expect equity market returns for 2018 to be in the range of 7% – 10%.
With the recent signaling of the Fed, and continued economic growth, we expect higher short-term borrowing rates throughout the remainder of 2018 and into 2019. At the same time, we think we will see a flatter yield curve, as inflation remains contained. While 2018 may finally signal the end of the 35 year bond market rally, we expect credit conditions to remain positive, and bond markets to continue to provide a reasonable hedge against outside volatility for properly allocated portfolios. Accordingly, we are monitoring and maintaining our exposures to the rate and credit areas of the bond markets.
Our current outlook is for a continuation of the secular bull market in stocks, higher interest rates on the short end of the maturity curve, and stable to slightly higher rates further out. We think stocks will experience higher volatility than we’ve seen recently. In fact, we have just been through an historic run of low volatility. The MSCI All Country World Index went 349 days without a 5.0% correction, the longest stretch in its history (the average stretch has been just over 61 days).1 The S&P 500 has experienced a similarly notable stretch. That said, despite a return of interim volatility, we think that profits will continue to propel overall stock prices moderately higher for the foreseeable future.
That said, we always want to be aware of possible issues on the horizon. At this point, we think that as we move into 2019, we could see pressures to markets coming from one of two possible scenarios:
- Earnings growth deceleration
Maintaining earnings momentum could become a challenge next year. Since early 2016, earnings have come through significantly better than we expected. In fact, S&P earnings per share are up 19.8% over the last year, and 28.1% higher than 20161. As we move forward, the challenge of maintaining those growth rates increases. The passage of the tax package last month helped, and we saw stocks rally on expectations of increased future profits for companies. However, valuations could be stretched, and increase the possibility of a market reversion if increased earnings growth rates fail to materialize.
- Rate driven reversion
Higher short-term borrowing rates could be a risk for equity markets. Despite the recent correlation between rising rates and rising stock prices, at some point when inflation becomes more priced into the bond market, stocks could react negatively. However, getting rising inflation and growth momentum to a point that it becomes a more immediate threat could take some time. So, rather than try to predict a rate or market level, we’re looking at the relationship of the stock and bond markets to see when rising yields may become a threat to stocks, and will let that guide our allocation decisions.
Ultimately, we think that markets are poised for a return to more normal ranges of volatility and returns, and that investors should maintain thoughtful allocations and diversification in the appropriate ranges for their risk tolerance. As we move forward, we are staying attentive to possible changes in the environment, and will shift allocations accordingly.
As always, if you have any questions about this update, or any other financial planning topic, please feel free to contact your Atlas Wealth Management Advisor.