MARKET COMMENTARY

2018 Outlook: Economy and Markets

12.22.2017 - Ronald J. Sanchez, CFA

KEY TAKEAWAYS
  1. Markets were unusually stable in 2017
    Resynchronized global economic growth, corporate earnings and optimal financial conditions fueled equity market growth in 2017.

  2. Earnings growth could be tough to beat in 2018
    Companies may find it difficult to maintain earnings growth at the pace seen in 2017, but we still expect some positive momentum in 2018.
  3. Returns and market volatility are likely to normalize
    We expect US stock market returns to moderate and volatility to pick up this year. 
VIEW OUR FULL 2018 OUTLOOK  

Calm Waters and a Steady Breeze, but the Winds may Fade in 2018

The past year has been filled with populist rhetoric across the globe, geopolitical tensions and policy uncertainty with respect to both US and international politics.

The UK continued to weave its way through the unknown framework of exiting the European Union, strife in the Middle East flared up in several countries and North Korea brashly defied unilateral opposition to missile tests. Meanwhile in the US, attempts to overhaul the healthcare system proved futile and political discourse within the Republican Party failed to find a unifying framework.

Given this backdrop and the fact that the US economy just completed its eighth consecutive year of expansion, one might expect that 2017 was a year in which markets experienced a more challenging environment with mixed returns, or at the very least, elevated volatility. But, in stark contrast, markets were historically stable and registered robust returns across the globe.

Fundamentals, Not Headlines, Drove Markets

So, what factors drove such favorable market conditions? In our view, we see three primary drivers of the 2017 return profile: 1. resynchronized global economic growth, 2. corporate earnings, and 3. optimal financial conditions.

1. Going into 2017, our call was for a resynchronization of global economic growth, a theme that came to fruition over the year and is likely to continue. By IMF estimates, the next few years are forecast to see the lowest number of economies experiencing a recession in the modern era (CHART 1). When final data are released for the year, prognosticators expect global growth of 3.5%, energized by increased participation from the Eurozone and Japan, which are projected to grow by 2.2% and 1.5%, respectively. China, while slowing, is still expected to generate growth in excess of 6%. Possibly even more important, the destabilizing fears that emanated from China’s financial markets in early 2016 were largely absent in 2017. On the other hand, the US scorecard is likely to show more of the same, or in other words, moderate—but not great—expansion.

2. On the corporate front, earnings benefited from synchronized global conditions and reemerged from a slump in 2016. When final numbers for 2017 are released, US companies are projected to show roughly 10% profit growth over the prior year, while European, Japanese and emerging market companies are expected to generate 12%, 19%, and 22%, respectively. In the case of US equities, which are already in the midst of a seasoned bull market, earnings were especially supported by increased economic activity abroad, a shift from prior years where companies were largely dependent on domestic demand.

3. Lastly, ideal financial conditions added further support to the 2017 market environment. Interest rates were incredibly stable and remained historically low, driven primarily bystubbornly low inflation readings for much of the year. Given the strong economic and corporate fundamentals, credit spreads remained tight throughout the year and even touched their lowest levels of the current expansion—meaning companies were able to continue borrowing at favorable rates. Adding fuel to the rally was a decline in the dollar as it reached its weakest levels since 2014, which benefited US companies with an international focus.

Rational Exuberance

For US investors, this bull market has the feeling of fatigue. Since the bottom of the S&P 500 in March 2009, the market has averaged annualized total returns of 19.1%, while valuations have gradually crept higher and are currently sitting at around 21 times last 12 months earnings—well above historical averages. Combine that with the fact that volatility in markets has effectively been nonexistent, and it becomes clear why investors might view the current rally as excessive and nearing its end. However, put in context of the year we just experienced, with broad global economic growth, solid corporate fundamentals and ideal financial conditions, we view these levels as justified.

Historical data show that in low inflation regimes, price-to-earnings (P/E) ratios in the low 20s are well within norms (CHART 2). With inflation in check, interest rates remained anchored, which provided direct benefits to the private sector via low borrowing costs, and in turn, healthier profit margins. Even without the benefit of low rates, earnings have benefited from a larger opportunity set; that is, increased global economic activity provided US multinationals with other sources of demand.

From a historical perspective, prior high P/E regimes were often accompanied by excessive risk-taking and speculation in equity markets—for example, in the late 1990s during the technology bubble. Thus far, we have not seen the signs of excesses from prior cycles. In fact, during the past year, returns have been driven more from earnings growth than multiple expansion. Perhaps even more surprising is that during this rally, flows into US equity markets have actually been negative. In contrast, US bonds experienced record inflows in 2017.

2017 Will Be a Tough Act to Follow

From an economic perspective, we expect much of the same in 2018. Economies around the world should continue to grow in a synchronized fashion. Companies may find it difficult to maintain earnings growth at the same pace given the solid year in 2017, but we still expect some positive momentum. The dollar weakness we experienced over the last year should continue to be a tailwind, but with valuations already nearly full we see few prospects for multiple expansion.

Additionally, we believe financial conditions most likely peaked this past year, but we do not expect a sudden tightening. Inflation shows no signs of accelerating, and central banks have thus far been patient as they seek to normalize monetary policy. To be sure, an unexpected spike in inflation would have profound and destabilizing implications for financial markets, but this is not our base case. Against this backdrop, we expect stock market returns to moderate in 2018 and anticipate a pickup in volatility.

On the fiscal policy front, tax reform and other stimulus measures could be net positives for the US market, but any expansionary benefits of a tax overhaul plan could take several years to percolate through the US economy. The main takeaway is that while it may provide a boost to markets, our base case is not dependent on tax reform.

Finding Opportunities Abroad

Taking these factors into consideration, we are slightly overweight equities going into 2018, and are optimistic about pockets of opportunity both at home and abroad. We expect international markets to present opportunities, and we continue to seek wider diversification in select areas such as Europe and Japan, where valuations appear reasonable and economies are in the early stages of a growth cycle.

Additionally, select areas in US equities appear particularly attractive, including technology, healthcare and financials, and we are watching several emerging trends driven by the tastes and lifestyles of millennials. We also see potential opportunities in carefully selected municipal bonds and certain hedge funds for their potential to provide additional diversification and guard against volatility.



This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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