As the calendar changes to reflect the start of a new year, it’s time to look ahead for opportunities and dangers that may affect investing in 2018. Investors were rewarded in 2017 with solid returns across most asset classes, with an unprecedented level of low volatility. Things in 2017 were good enough to prompt questions over whether we have entered bubble territory, with the next economic collapse around the corner in 2018. These concerns are normal, given the accelerating growth of a stock market that only seems to go up. To help investors make an informed asset allocation decision heading into 2018, we have assembled the following 2018 Outlook with our findings and views on equity, fixed income, and alternative investments for the coming year.
Synchronized global growth and easy monetary policy have been “wind in the sails” for economies and financial markets around the world. Here in the US, economic indicators continue to signal strength with little sign of over-heating. Unemployment has dropped to 4.1% while inflation, though rising, has remained below the 2% annual target stated by the Federal Reserve (the “Fed”). Consistent with a mid-to-late expansion phase of the business cycle, the US recovery from the most recent recession is more mature in terms of valuation than most developed and emerging markets. This disparity in valuation provides an opportunity, we think, to invest in certain international equities that may offer superior returns on a risk-adjusted basis and continue their out-performance from last year. One cannot however, ignore the potential benefits to US corporations from the recently enacted reduction in corporate tax rates, and the associated potential benefits to business investment, competitiveness globally, and growth.
“Synchronized global growth and easy monetary policy have been “wind in the sails” for economies and financial markets around the world.”
Expectations for inflation measured by core CPI (Ex. food & energy) are to increase moderately in 2018 to around 2% annually, as recently stabilized broad-basket commodity prices move higher on sustained global growth. A recent uptick in headline inflation rates has been driven significantly by higher energy prices, a dynamic that is unlikely to persist as we believe oil prices should not hit any escape velocity to the upside due to increasing supply and the ability to on-ramp production quickly from American shale producers. Rising prices for industrial metals due to an increase in emerging market manufacturing should cool as China slowly pivots to a service-driven economy, although technology demand for certain metals will continue to be very high. If there is a significant increase in commodity prices in 2018, it would be considered a late-cycle phenomenon, a sign of an over-heating economy, and a historical predictor of an impending US recession.
We view risk of a US recession to be low in the coming year, but we cannot disregard other risks that may induce the return of volatility, such as geopolitical risk, and perhaps one of the largest risks – central banks getting it wrong. Major central banks around the globe, including the Fed, the European Central Bank (the “ECB”), and the Bank of Japan (the “BOJ”), have injected liquidity into markets by buying financial assets on an unprecedented scale. The Fed, through careful communication, is leading the way in reversing this policy and will continue to methodically reduce the size of its roughly $4.5 trillion balance sheet by letting Treasury and Mortgage-backed securities run-off at an increasing rate quarterly until it reaches $50 billion per month. They also plan to raise the benchmark federal funds rate by 0.25% three times in 2018 to 2-2.25% from the current 1.25-1.5% range, as forecasted by the most recent release of the Fed dot plot. The market, however, is discounting the Fed’s ability or willingness to raise rates. The probability that the Fed funds rate is at or above the 2-2.25% target for the December ’18 meeting, as indicated by Fed futures, is less than 50/50 as of this writing. The lack of inflation has allowed the Fed to maintain a gradual pace of rate increases, but any surprise in implementation or communication from new Fed Chair Jerome Powell could lead to disruption across all markets.
Figure 1 – The market believes the Fed will under-deliver on promised rate hikes. Data from Federal Reserve.
The record-breaking US equity bull market remains intact and poised to proceed into 2018, but US equities may have a difficult time repeating 2017’s performance. Volatility was non-existent in 2017, as the S&P 500 hasn’t had a 3% draw-down since November 2016. This won’t last forever and volatility may return at any time caused by any of an assortment of issues including a geopolitical escalation in the Middle-East, North Korea, or elsewhere, a cyber breach, a bursting bubble in an asset class, or other. An unlikely hard landing in China or a miscalculation by the Fed could also lead to volatility. These things are unlikely to precipitate into a full-on bear market, but could cause pain in the short-term.
2017’s returns were largely driven by corporate earnings growth, and while the market is pricing in continued earnings strength, we believe that the jolt provided by tax reform increases the potential for an upside surprise. The most recent S&P 500 Index operating earnings estimates, compiled by Standard and Poor’s, project year-over-year EPS growth around 16.6% in 2018 and 9.8% in 2019. We believe these forecasts may be too low, as the number of shares in circulation will likely decline as tax reform spurs corporations to repatriate overseas funds and buy back shares. The Trump administration would like us to believe the tax cuts will spur an explosion in corporate capital expenditure (“capex”) such as acquisitions, investment spending, and R&D, to help grow the economy more than the recent 2-3% slog in GDP growth. While we may see increased M&A activity in large-cap Technology and Pharmaceutical companies that have the most cash overseas, we do not expect a general explosion in capex. Rather we see the tax stimulus being balanced between wage growth, share buybacks, dividends, and capex.
Fiscal policy is starting to take over where easy monetary policy has left off and gave a shot in the arm to US equities at the end of 2017. Valuations based on the price to earnings ratio (PE) of ~20x for the S&P 500 based on next year’s projected earnings may seem stretched but are not unjustified given the earnings growth rate and where interest rates sit. We would be remiss not to mention the Shiller CAPE ratio, which is widely cited as a more reliable indicator and has caused some investors to call a top as it approaches valuation levels rivaling the dot-com boom. As we begin 2018 the Shiller CAPE ratio stands at 33.19, its highest level since June of 2001. Despite this seemingly alarming reading, one must remember that the CAPE is based on trailing ten-year total earnings data, and as the 2008 and 2009 data drops off, and the new much higher 2018 and 2019 earnings are added, the denominator (trailing ten-year total earnings) will increase considerably – perhaps by 20% – and the CAPE ratio will decline correspondingly.
Figure 2 – Shiller Price/Earnings data – The Shiller CAPE should decline as the 2008-09 data begins to fall out of sample this year.
The bottom line is that the CAPE has merit as an indicator, but anyone attempting to call a top in the markets based on historical averages runs the risk of missing out as the market continues to appreciate. In the US, we are in a major, historically notable earnings explosion, with no imminent end in sight.
The Eurozone economy is still firing on all cylinders with the ECB remaining committed to buying €30 billion in bonds per month and pledging to increase the stimulus, if necessary. The ECB has also reaffirmed that they will not raise interest rates until after the easy monetary policy has ended. The response is very high levels of business optimism, propelling the Eurozone Manufacturing PMI to its highest level since the survey began in 1997. Political risks such as Italian elections, Catalonian secession, and the ongoing Brexit negotiations remain on our radar. The biggest risk may be that the economy overheats and the ECB is forced into action, but the underlying strengths of the Eurozone outweigh these potential risks. Even after 2017’s breakout performance, European equities remain cheaper than their US counterparts (the Stoxx 600 index trades at a P/E ratio of 15), the growth rate of the Eurozone for the first time in years recently eclipsed that of the US, and the Eurozone remains earlier in the economic recovery cycle than the US. Furthermore, despite recent strength in the Euro versus the US Dollar, exports have not declined, signaling that the European equities may have room to run in 2018. Lastly, the dollar is poised to strengthen against the euro as US interest rates show relative strength compared to their European counterparts.
In Japan, very low inflation has facilitated large monetary stimulus which is succeeding in boosting the economy, and equity markets, in the face of large demographic headwinds. A labor shortage is keeping the Pacific island from reaching its full potential for GDP, but large-cap Japanese companies are sitting on larger piles of cash compared to US and European counterparts. Some analysts are predicting that companies will put that cash to work and invest in new technologies that will help boost already improving export numbers. Relatively reasonable valuations make Japanese equities an attractive investment in 2018, but like here in the US if the BOJ fails to communicate in a clear way, increased volatility could make for a less attractive year.
Global Emerging Markets posted stellar performance in 2017, and could continue their run in 2018 amidst a favorable economic backdrop. Many areas within the Emerging Market area are better off today compared to a year ago, thanks to political and economic reforms. Recurring concerns, like over-sized current account deficits and low inflation-adjusted interest rates, have lessened. Troubled economies such as Brazil and Russia have emerged from recessions, and are now expanding. Given an improving picture in these areas, we should see earnings strengthen, with ample room for margins to expand.
Asian Emerging Market countries led the way with economic changes to lessen the susceptibility to sudden crises, which have derailed growth in the past. An eye on fostering positive capital flows, keeping inflationary concerns at bay, and improved balance sheets during 2017 has left these countries in a positive situation coming into 2018. India is projected to overtake the United Kingdom as the world’s fifth-largest economy in 2018, and surpass China in growth at 7.3%. Meanwhile, manufacturing activity in Taiwan has risen to a seven-year high, with a December PMI reading of 56.6 out-pacing most developed countries.
There are some concerns though. While China has been the engine of Emerging Market growth, there are worries that China needs to properly address overcapacity in various industries, reform many of its state-run companies, improve the quality of life for workers, and tackle the build-up of debt, which all could lead to the slowing of the Chinese economy. Excessive debt has been of concern in the Chinese financial sector, but it seems as if the appropriate steps are being taken to address these worries.
Despite concerns about China, the health of Emerging Markets economies overall seems solid. The main source of risks is primarily external in nature. The volatile geopolitical tensions with North Korea is a serious risk to stable growth in the Emerging Market countries, particularly to China and South Korea. The risk of a more hawkish monetary policy in Developed countries, particularly the US, is a concern and could lead to Emerging Market volatility. A weaker dollar is more favorable to the Emerging Markets and a more dovish monetary policy – lower interest rates – in the US could help foster a weaker US dollar. Also, a downturn in commodity prices could present a risk, as many Emerging Market nations are commodity dependent. Overall, Emerging Markets are looking quite positive as we move into 2018. We view consolidations or price setbacks in the Emerging Markets as buying opportunities.
While the overall view of global equity markets is riding a wave of bullishness into 2018, there are many concerns and questions in fixed income markets. At the fore is whether we may be entering a bond bear market. The Federal Reserve has telegraphed a more hawkish stance in raising rates and trimming its balance sheet. The ECB has plans to gradually reduce its bond buying program. Even the BOJ is seeing some success with generating positive inflation and may be forced to modify its asset purchase program. Is 2018 the year that the bond bears finally awake after their three-decade long slumber? While we are not quite ready to concede that a full-fledged bond bear market appears in 2018, it is certainly going to be a year of limited returns and heightened risks for bond holders. We see fixed income risks outweighing the upside given current yields.
If there is one thing keeping the bear at bay in US fixed income, it is the lack of viable alternatives in foreign fixed income. For yield starved overseas investors, ten-year US Treasury yields of 2.5% per year at this writing look attractive relative to comparable German Bunds yielding just 0.5% per year. This discrepancy in yields should persist in 2018 since, given the synchronized nature of the global recovery, we do not anticipate that global central banks deviate much from their current paths.
Figure 3 – The US remains attractive relative to international peers. Data provided from Bloomberg.
Most areas of the fixed income markets seem to be on the higher side of valuation when valued on long-term historical metrics. Corporate and municipal bond spreads are tight, as yields in these areas are low when compared to Treasury yields, providing less opportunities to be rewarded. With the economic picture improving and the newly minted Tax Reform legislation set to buoy corporate profitability, the risks of yield spread widening dramatically seem small. While we do not see a big risk to the upside, we also do not see much of an opportunity for spreads to become much narrower than they already are.
2017 high yield issuance finished at around $276 billion, the largest total in three years. 2018 should see a continuation of the favorable conditions, with analysts forecasting up to 15% higher totals in the coming year. While high yield spreads are also narrow we feel they are justified by the extremely low default rate (just 1.5% on a trailing twelve-month basis per Fitch Ratings, near all-time historical lows). From a technical trading perspective, high yield looks positive and appears to be breaking out above prior resistance levels as we begin the new year.
Once again Tax Reform legislation comes to the rescue as it should help keep high yield bond defaults in check thanks to the boost in corporate profitability. Unfortunately, Tax Reform giveth but it also taketh away in that it limits deductions on bond interest payments, fortunately the more restrictive provisions do not take effect for four years. So, in the near term, tax reform should be a net positive for the high yield market. Weakness has been contained to retail and telecom sectors, and strength has returned to the high yield energy sector due to the stabilization of oil prices. Finally, for investors seeking the opportunity for higher yield in 2018, there may be an opportunity in Emerging Market bonds. Emerging Market political and economic reforms, combined with stabilization in commodity prices are supportive of Emerging Market debt. Exposure to Emerging Market local currency bonds makes sense given the strong growth potential and potential weaker US dollar.
Overall, despite the potential harsher environment in 2018 for fixed income, we see the potential for positive investment opportunities for yield seeking investors, albeit with limited upside.
For commodities in general, 2017 was a tough ride. The broad-based Goldman Sachs Commodity Index was only up 3.9% in 2017 while the S&P 500 soared an amazing 21.9% for the year. But as we enter 2018, it may be a different story. As 2017 ended, oil and precious metals were both showing signs of life, with strong demand for base metals such as copper, aluminum, and zinc thanks to robust global economic growth. Commodities are generally near the lows of their historical ranges and could rally further.
While there will be some investment opportunities in the commodity space, we see oil likely having limited room to run after its impressive rally in late 2017 back above $60 a barrel for WTI. The OPEC deal should bring some price stability and shale drillers will act as an upside price restraint as they will be enticed to ramp-up production after the recent run up in prices. Price movement should be sideways and with less volatility than 2017.
China is the world’s largest consumer of zinc, and with concerns of a possible China slowdown as we move into 2018, this could put pressure on the metal. But if China’s concerns resolve to the upside it could put the metal in a positive light. Copper could be hampered going forward as mine oversupply of the base metal and forecast for lower demand for copper from China in 2018, in contrast to 2017.
There has generally been a global oversupply in the agricultural complex, particularly for grain in 2017. As we move into 2018, these resultant lower prices may finally lead to lower planted acreage and help the prices. “La Nina” conditions look to have a potentially negative effect on wheat and corn supplies, also potentially helping to support pricing.
Looking at Alternative investments, the housing market has been on fire, but Real Estate Investment Trusts (REITs) have been beaten down. One may expect that Retail REITs are the cause, given the recent headlines harkening the death of brick-and-mortar shopping. But REITs cover a broad range of sub-industries, with Retail comprising just over 20%. Industrial and Office Space is the largest component at 28%, and Residential and Healthcare combining for another 30%. The more likely reason for poor REIT performance has been the more hawkish tone from the Fed. Fears of rising rates have tempered investor appetite for rate-sensitive REITs. Pricing may now have reached the extreme discount territory where REITs may present an attractive investment opportunity. On average, REITs now trade at a 4.8% discount relative to the underlying real estate holdings. Since 1990 REITs have traded at an average 2.5% premium, so this may be a buying opportunity.
Master Limited Partnerships (MLPs) finished 2017 on a bit of an upswing helped by the rally in oil prices. But for the full calendar year the Alerian MLP Index was down -6.5% on a total return basis. Where oil goes, so will MLPs. MLPs will continue to provide a good source of yield for income-oriented investors and be more stable in 2018.
The S&P 500’s bull market will celebrate its ninth birthday in March. While historical market cycle data suggests we are in the late innings and this run can’t go on forever, valuations are not in bubble territory and the underlying data indicates another positive year is likely. Developed international and Emerging markets are similarly poised to continue their recent run, in a synchronized expansion that is reflective of today’s connected global marketplace. Therefore, equity investors can feel confident diversifying across domestic and international stocks, varying their allocation in accordance with their individual risk tolerance.
If the equity bull market is long in the tooth, the fixed income bull market is a dinosaur at 35 years old. While many respected pundits are claiming the end is at hand, these same proclamations have persisted for several years now, often from the same sources. If a bear market in bonds does in fact pan out, it will likely be more of a slow reversal than a sudden crash. With the Fed’s track record of overstating its interest rate projections and the ultra-low yield provided by global bonds, the bond bull may live to fight another day. Fixed income investors will likely be able to collect coupon payments safely for another year, but should consider supplementing their bond positions with income-producing alternatives.
In conclusion, the opportunities are there for investors in 2018. As always, asset allocation is key, and investors should be careful not to be lured into making overly aggressive changes to their portfolios in response to 2017’s smooth sailing. Volatility and temporary pullbacks are bound to return at some point, however based on the underlying data, it is reasonable to expect we end 2018 with another solid year.
Founded in 1999, Hanlon Investment Management has more than $1.5 billion in assets under management, distributed through thousands of financial planners and advisors. Serving more than 13,000 individual investors, retirement plans, trusts and institutions, Hanlon offers its own investment strategies, including new Hanlon All-Weather Models, plus offerings from BlackRock, Russell Investments, and many other managers.
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