January 12, 2018
by Liz Ann Sonders, Jeffrey Kleintop, Brad Sorensen, Charles Schwab and Company
Key Points
- 2018 has gotten off to a good start, picking up where 2017 left off. But investors should be careful not to confuse this year with last.
- U.S. economic growth has accelerated and could get a further boost from tax cuts, but that means the potential for inflation increasing is growing.
- The global economy is coming off its best year in some time, and although 2018 won’t likely be an exact repeat, the immediate future looks bright.
Déjà vu?
The ball has dropped, the presents opened, the first kisses had (we hope), and the decorations have come down (we really hope!); but the stock market apparently hasn’t yet gotten the message that we’re in a new year. After the first year ever that saw the U.S. stock market gain in every month (based on the S&P 500), the first weeks of January got off to a bang. Much attention remains on tax “reform”—or better put, tax cuts—and numbers are being crunched by economists and analysts alike to assess to impact on the economy broadly, and corporate earnings specifically.
But the market’s gains, and the enthusiasm around tax cuts, have brought with them elevated investor sentiment. We keep a close eye on the Ned Davis Research Crowd Sentiment Index, which is a composite of seven distinct sentiment gauges. It recently hit an all-time record high (since the data began in 1995); and we have gone a remarkably long time (since November 4, 2016) without a decent-sized pullback (3% or more).Sentiment doesn’t necessarily forecast and we aren’t predicting an imminent correction, but it appears that some of the “cushion” we may have had, should something go wrong, has disappeared. There are any number of catalysts which could trigger the first pullback of some size, and investors need to be ready for it—even if it’s in the context of an ongoing secular bull market. It doesn’t mean making major shifts to asset allocations, but being mindful of staying disciplined around tried-and-true things like diversification and periodic rebalancing. With correlations having come down sharply—both within and among asset classes—and sector rotations occurring more frequently, the benefit of using these disciplines has likely improved.
Technicals, breadth and momentum still offset sentiment concerns
A key reason we aren’t raising more concerns about a major correction at this point is that the aforementioned stock market action has good foundation of support under it. Market breadth remains healthy, momentum remains strong, earnings growth is accelerating further, and financial conditions continue to be loose. And, the economic picture continues to brighten, illustrated by the Citigroup Economic Surprise Index, which continues to show the economy surprising on the upside.
Economy continues to surprise on the upside
Source: FactSet, Citigroup. As of Jan. 9, 2018.
That said the index above—which measures how economic data is coming in relative to expectations—is mean-reverting by its nature. We expect a continued rolling over of this index, but if the action by stocks repeat their pattern from last year’s first half, an easing of this index won’t necessarily dent stocks to any significant degree. But any time the expectations bar gets set quite high, it’s something on which to keep an eye. The strength we’ve seen perhaps just represents what us finance geeks learned about the ripple effects of a robust labor market (the latest labor report showed 148,000 jobs were added and unemployment stayed at a 17-year low 4.1%), ample liquidity still sloshing around, and more business-friendly fiscal policy in place. In keeping with that, business confidence remains elevated, with the survey-based Institute of Supply Management’s (ISM) Indexes both showing continued strength, and the NFIB small business optimism index near cycle highs.
Business confidence remains high
Source: FactSet, Institute for Supply Management. As of Jan. 9, 2018.
The changes in the tax code on the corporate side have been meaningful: a lower statutory rate of 21%; 100% expensing immediately; territorial tax treatment (companies with earnings overseas will take an initial hit, but then get to bring those assets back to United States tax free). We believe this will result in a decent uptick in capital expenditures (off an admittedly already-elevated level), and at least a modest boost to economic growth.
We also could see some upside surprises to an already relatively solid consumer segment of the U.S. economy. As mentioned, the labor market is tight and we’re starting to see an upward bias in wage pressures. In addition, according to a survey done in late December by Strategas Research Partners, at least 95% of Americans will see larger paychecks as a result of the tax change. Interestingly though, “most” think that their taxes are going up or staying the same; so those folks will be in for a nice surprise come February, when paychecks are adjusted, which could lead to an increase in consumption. That is precisely what occurred when the 2003 tax cuts hit workers’ paychecks. It would serve as a boost to the increase we’ve already seen, as the Mastercard Spending Pulse survey reported that the holiday retail period (between November 1 and December 24) saw a 4.9% year-over-year gain—the best since 2011.
Who’s eyeing the punch bowl?
So what’s there to worry about? For one, as it relates to the consumer, savings rates have dropped even though consumer confidence is quite elevated. Historically when we saw a similar gap, consumption ultimately faltered. And then there are more macro-oriented worries—such as a geopolitical flare-up, more natural disasters, political scandals, elevated trade protectionism, etc. In addition, we think an underappreciated risk is the potential that the Federal Reserve will be forced to live up to former Chairman William McChesney Martin’s famous saying that “just when the party is getting good, the Fed is forced to take away the punch bowl.” With inflation rearing its head, 18 states raising minimum wages (ISIEvercore), a tight labor market (with outplacement firm Challenger, Gray and Christmas recently noting that 2017 saw the fewest job cut announcements since 1990), and rising commodity prices, tighter monetary policy must be taken into consideration.
Rising commodity prices could fuel rising inflation
Source: FactSet, Standard & Poor's. As of Jan. 9, 2018.
With the current generation of investors knowing nothing but a friendly, accommodative Fed, it’s worth considering the risks of tighter monetary policy—which could include more bouts of volatility than what was witnessed last year, and more pullbacks.
Tax reform…check! Other major items…in question
Republicans in Washington are completing their victory laps about the tax reform package and now head back to the realities in DC. First up is again avoiding a government shutdown—although the degree the markets would react to such an occurrence seems relatively minimal, as there has been no discernable concern among investors during recent brinksmanship battles. But then there’s the messy process of actually getting a longer-term budget deal done, along with addressing the infrastructure package that President Trump campaigned on; while the Affordable Care Act drama hasn’t had its final act yet either. Although few are relishing the season, we’re in an election year, where Democrats are eyeing both chambers of Congress. Midterm election years have a history of bumps in volatility.
Surveying the global landscape
The global economy was booming at the end of 2017 and we look for another solid year of global growth in 2018; with the potential to be the best back-to-back years for growth in more than a decade. Surveying the 2018 landscape for investors, we offer four charts on global growth in the economy, trade, earnings and interest rates.
The pace of global gross domestic product (GDP) surprised most economists with growth considerably better than they had forecast at the start of 2017, as you can see in the chart of forecasts below. Growth is forecast to come in around that healthy pace again in 2018, supported by somewhat-stronger growth in the United States and offset by slightly weaker activity in China.
Economists continue to revise up their GDP forecast for 2018
Source: Charles Schwab, Bloomberg data as of 1/10/2018.
With world trade equivalent to two-thirds of world GDP, growth in trade volumes is important to sales and profits for most publically-traded companies. Despite fears of protectionism, global trade has been booming. One of the world’s most popular trade routes is from Shanghai to Los Angeles, where inbound container counts have resumed climbing and broke out to a new all-time high in 2017, as you can see in the chart below.
World trade is growing again and hitting new highs
Source: Charles Schwab, Bloomberg data as of 1/10/2018.
The earnings per share outlook for companies around the world that make up the MSCI All-Country World Index has been unable to break through $30 for the past decade after running up to that level three times (in 2008, 2011, and 2014). But, in 2017, it finally broke out above $30 with strong momentum, as you can see in the chart below.
Source: Charles Schwab, Factset data as of 1/10/2018. Past performance is no indication of future results.
Despite stronger growth and rates hikes by the Federal Reserve and some other global central banks, short-term interest rates for the world are not rising sharply. Unlike the sharp spike in 2005-2007, short-term rates weighted by country GDP remain low, offering support for global growth rather than flashing a warning sign.
Global short-term yields remain low
Global 3 month government yield line is GDP-weighted 3 month yields of Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States, Spain, Eurozone.
Source: Charles Schwab, Bloomberg data as of 1/10/2018.
The global economic and earnings landscape looks favorable, with solid momentum and no sharp rise in rates to weigh on growth as we enter 2018. However, that doesn’t mean there aren’t risks (see Five Global Risks for Investors in 2018); pullbacks are always possible and portfolio rebalancing is important. We will continue to watch for signs of any changes in growth momentum that could impact the rising trend in the global stock market.
So what?
This year seems unlikely to be a repeat of 2017 as volatility should pick up and the possibility of larger pullback than what we saw last year has grown. Investor sentiment—often a contrarian indicator—is extended, which could mean that disappointments or surprises could be met with greater selling than we’ve seen in the recent past. We still believe that the bull has room to run as domestic economic strength is improving and global economies look better than they have in some time, so investors should stay disciplined, diversified and invested.
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