It was a banner year for risk assets in 2017, but investors may be facing more challenging markets going forward. While asset valuation levels have risen across the board, market volatility has stayed extremely low – relative to historical measures – and several perceived risks didn’t materialize as expected. So what lies in store for investors in 2018? Given significantly heightened valuations and looming geopolitical concerns, investors may be hard pressed to unearth investment opportunities that provide an attractive risk/return profile. The risk premium on all financial assets has declined notably. U.S. equity risk premium – a single gauge of equities’ expected return over government debt – has been falling since the global financial crisis. In the face of this data, we believe overall market returns may be muted in the coming year; which makes selectivity, and a dynamic investment approach, a necessity. We look to non-U.S. markets to provide more attractive investment opportunities in 2018, with a constructive view on emerging markets, and to a lesser extent, developed Europe and Asia. We continue to carefully re-evaluate the balance between growth and value, as growth stocks reach dot-com levels of outperformance relative to value. Within the fixed income space, we look to the higher-quality end of the credit spectrum for additional downside protection. However, at the same time, we feel comfortable taking slightly more duration risk, as we expect the new Federal Reserve Chair, Jerome Powell, to continue on with Janet Yellen’s gradual approach to monetary policy.
US Market Outlook
U.S. capital markets extended their bull run in 2017 for the 8th straight year, and we expect further expansion into 2018 despite valuations that are above-average levels in almost every major domestic asset class. While high valuations don’t necessarily foretell a market crash, it’s reasonable to expect smaller rewards for the amount of risk taken in the coming year.
The U.S. labor market is tight, but wage inflation has been muted relative to past tightening periods. Optimism has remained high in the face of increasing domestic policy debates and shifting geopolitical paradigms.
It’s important to separate this optimism from the lower-trend growth relative to past periods. The U.S., like other developed economies, is experiencing anemic productivity growth and unfavorable demographics as baby boomers leave the workforce. Such secular trends necessitate realistic GDP growth expectations.
This year saw an acceleration of the Federal Reserve’s normalization of monetary policy with three interest rate increases, and we expect this to continue in 2018. While the market hasn’t reacted negatively to an increase in interest rates on the short-end of the curve, we remain cautious if the curve were to invert, leading to a decrease in expected long term growth. Such an environment has been negative for capital markets in the past and could lead to a meaningful correction.
U.S. equities posted yet another year of impressive gains in 2017, led by technology stocks. Nearly every sector returned double digit gains with the exception of Telecommunications and Energy. Fundamentals are favorable among U.S. corporations – business optimism remains strong, demand is solid and capital investment is improving. Given this, analysts are expecting S&P 500 earnings growth of 11.8% in 2018, on top of a 9.6% expected increase in 2017.
With growth stocks posting the highest relative returns to value stocks since the dot-com bubble, many on Wall Street are left wondering whether a meaningful shift into value is imminent. The relative P/E valuation spread of the S&P 500 Growth and S&P 500 Value has widened to levels not seen since 2005.
More importantly, earnings growth for both indexes is similarly slated to increase by approximately 11% in 2018. This leaves disciplined investors questioning the need to pay a higher valuation for growth stocks when value stocks offer the same level of earnings growth while mitigating downside risk. Additionally, as the U.S. economy is expected to benefit from a resurgence in economic growth – supported by a continued synchronized recovery taking shape on a global scale – value stocks may benefit from exposure to economically sensitive areas of the market including the Financials, Energy and Industrials. This offers a compelling argument for investors to underweight growth and overweight value names as we enter into the latter innings of the current economic cycle.
As an additional tailwind to this already optimistic scenario, corporate tax cuts should help drive further gains in domestic equities. All else equal, a 21% corporate rate could give around 7% lift to 2018 S&P 500 EPS. At the sector level, Consumer Discretionary, Utilities and Staples, on average, pay the highest median effective tax rates in the index. The lowest are in Real Estate, Technology and Healthcare. The latter two could have the most unpredictable response to reform legislation. Not only are technology and healthcare companies generally the lowest taxpayers in the S&P 500, they also have the most cash overseas. The Trump administration has shown a commitment to deregulation which should further bolster the Finance sector, which already has a tailwind from being able to lend at higher interest rates.
Domestic Fixed Income
We finished the year with a total of three interest rate increases enacted by the Fed, and forecasts for another three increases in 2018 and 2019. A search for yield has pushed many investors into risky territory and we urge caution when investing in high yield and low quality instruments going into 2018. High yield is often illiquid and narrow credit spreads point to higher expected volatility in the asset class. Furthermore, investors may be expecting bond-like characteristics without realizing high yield’s meaningful correlation with equity markets.
This resulted in the short end of the curve rising to meet the long end, leading to an overall flattening of the yield curve. The risk for duration strategies remains modest should the long end remain tethered to future inflation expectations. We remain cautious for a yield curve inversion that could signal issues with investors' long term growth expectations.
History suggests that stocks should do reasonably well as long as the Federal Reserve doesn't tighten policy so much as to invert the yield curve. Over the past two cycles, a consistent pattern of flattening yield curves and rising stock prices developed. Until the yield curve inverted, stocks generally advanced. The yield curve is one of the best indicators of expansion or contraction for the economy and stocks. On average, the curve inverts 16 months prior to economic recession and 13 months before the accompanying stock-market correction.
US 10Yr - 2Yr Treasury Yield and S&P 500
Commodities and Industrial Metals tend to inflate with growth. Increased CAPEX in 2018 could lead to an increase in prices for Industrial Commodities. Furthermore, increased adoption of electric vehicles may put pressure on Copper and other niche commodities like Lithium, Cobalt, and Graphite. At the same time, rapid adoption of electric vehicles may put downward pressure on oil over the long term, even as prices have recovered somewhat from the 2017 lows. We expect electric power output from renewable sources to continue its upward trend throughout 2018 and beyond. We continue to favor exposure to commodities in the form of equities and bonds of companies that use those raw inputs to provide goods and services to consumers rather than own the raw commodities directly.
Is Low Volatility The New Normal?
Prolonged stretches of lower equity volatility appear to be the new normal. The recent outbreaks of higher equity volatility have tended to overlap with time periods of elevated instability in economic data. The current “steady” economic landscape suggests a low probability of a shift toward higher volatility levels in the equity markets.
In previous market cycles, a transition into high economic volatility has required excessive financial leverage, similar to what was witnessed leading up to the global financial crisis. We are not in a similar place today. Equity volatility is not only low, it is abnormally low within historical context. Recent readings of 4% could increase two-fold and still be around historical averages for previous periods of low volatility.
What could change the current low volatility regime within the equity markets? We are closely monitoring warning signs of rapidly increasing leverage. When looking at the developed markets, financial leverage seems to be in line with historical levels and even low in some countries. However, the picture is vastly different in China. Although cities like Beijing are working toward curbing credit growth, higher existing debt levels and weaker credit channels make the Chinese economy more susceptible to shocks.
While leverage metrics are not directly comparable across countries and historical periods, we are keeping close tabs on evidence of leverage creeping up through non-traditional channels, like structured product issuance growth and the prevalent use of financial derivatives. These investment vehicles are typically used in an effort to enhance portfolio yields, but at the same time they introduce more leverage. As active managers throughout the industry begin to use more financial derivatives and structured products to augment returns, leverage will also begin to increase. Additionally, concentrated positioning in pockets of credit markets could potentially create further risks. The question remains: could the aforementioned risks become systemic and cause financial markets to transition back into a high volume regime? We feel the probability of this happening is low, but we continue to have a watchful eye with respect to these risks and other related trends that could potentially lead to higher volatility in equity markets.
Global Markets Outlook
The global economy saw synchronized expansion in 2017 and we expect those trends to continue into 2018, albeit with less upside. While the U.S. currently maintains a path to normalizing monetary policy that was enacted during the global financial crisis, the Eurozone and Japan are somewhat behind as their respective policies remain loose. Market gains were led by emerging markets followed by developed international and the U.S.
Almost all major economies are at or below their full-employment benchmark. This labor tightness should continue and could be a catalyst for one of three outcomes:
- ● An acceleration of wage growth and inflation
- ● Increased business spending and productivity growth
- ● Status quo of low inflation, wages and productivity
The central banks of developed international economies are at different stages of their monetary policy, but each appears to be accelerating the pace of normalization. The fiscal austerity that characterized Europe’s reaction to the global financial crisis for the better part of the decade has ended.
Growth prospects for Europe are brighter than they’ve been in years, and the political risk from the rise of anti-EU parties seems to have abated, though it has not disappeared entirely.
By contrast, the United Kingdom’s outlook faces greater uncertainty with the looming Brexit negotiations. The UK experienced a slight uptick in inflation caused by rising import prices due to the falling value of the pound sterling. As a result, the Bank of England may be forced to move rates more quickly than previously anticipated.
Japan is showing signs of recovery after nearly two decades of a deflationary environment. Japan’s latest expansionary cycle is primarily due to the expansion of exports as well as accommodative fiscal policy. Despite these tailwinds, wage inflation remains subdued, which partly reflects a labor supply shift to low-income part-time work concentrated in the women and elderly population segments.
Against these demographic challenges, the Bank of Japan is expected to maintain an easy monetary policy by anchoring the 10-year government bond rate to 0%. The efficacy of monetary policy plays second to the necessary fiscal reforms Shinzo Abe can implement during his newly-extended tenure.
Developed Europe Outperforming U.S.
One may be surprised to find that the underlying growth in the Eurozone is currently stronger than in the U.S. This is remarkable given that the U.S. is generally assumed to have a higher potential growth rate than the Eurozone, primarily due to more favorable demographics. In fact, based solely on population growth, and disregarding changes to participation rates, U.S. GDP should be approximately 0.5% higher than Europe. However, in 2016, the Eurozone economies grew at a collective pace of 1.8%, compared to a 1.5% growth rate in the United States. As 2017 comes to a close, we expect these figures to reach 2.25% and 2.0% for the Eurozone and U.S., respectively.
When considering potential GDP growth, two factors are highly relevant (outside of population growth): total factor productivity and capital investment. The market’s outlook on productivity growth rates – in both economic blocks – is lackluster at best. Current estimates hover around 1.0%, which are far below the 1.5-1.75% range observed over the longer term. While U.S. output is expected to grow more or less in line with potential growth estimates – according to these estimated figures – the Eurozone is growing above its estimated potential.
The aforementioned divergence may be best explained by the fact that the monetary policies in these two economies are diametrically opposed. The U.S. Fed has already started normalizing interest rates and reducing its balance sheet, while in the Eurozone, the ECB is only just beginning to phase out of quantitative easing. The ECB deposit rate remains negative, and any interest rate hikes are still considered a distant storm on the horizon. This apparent mismatch is explained in part by the fact the Eurozone is not a single economy. To illustrate this concept, one must simply consider the output gap (the difference between actual and potential growth in participating countries). Based on OECD data, Germany closed its output gap in 2015, so its economy is currently dealing with greater inflationary risks. At the same time, France and Italy continue to show huge output gaps, greater than 2.0%. But ECB policy must be enacted in a uniform manner, and as such, Germany will most likely have to accept an inflation target greater than 2.0%, while the ECB allows France and Italy to catch up.
The Eurozone’s current monetary policy is exceedingly accommodative and prevailing economic conditions may give way to a continuation of the current Eurozone outperformance, relative to the U.S., in 2018.
G7 Output Gaps, 1980-2017
Inflation: A Real Concern?
Despite the U.S. economy entering its ninth year of expansion, producer confidence hitting a 15-year high this past September, and unemployment plummeting to one of the lowest levels in 50 years, this has not precluded core inflation from falling to 1.3% in August. Before singling out the United States, it’s worthwhile to note that inflation distribution in developed countries over the past 20 years demonstrates that inflation rates have been trending down for quite some time.
Economists have several theories as to why inflation levels have been suppressed around the world. Perceived root causes range from de-unionization to greater efficiencies through big data, from digitalization to globalization and aging populations. Lowered inflation expectations themselves can have an anchoring effect. Just as higher inflation expectations can potentially lead to higher wage demands, the reverse can also be true.
These aforementioned lower inflation expectations may explain the ECB’s current tenacity in deciding to continue advocating for overly accommodative monetary policy. Ultra-loose monetary policy may have significantly destabilized asset price inflation. Over the past five years, several asset classes (including personal residences, equities and most bonds) have become very expensive, escalating the odds for another boom-bust cycle.
U.S. inflation looks poised for a re-awakening, while price pressures in developed European economies are minimal. The Fed is likely to place even more distance between itself and other central banks with additional interest rate hikes in 2018.
While superior growth potential has historically been a key reason to allocate to emerging markets over developed, the former has not delivered in recent years. In fact, 2016 was the first time in five years that emerging market earnings per share grew faster than developed market earnings per share.
Emerging economies have better long-term growth prospects, based on demographics and improved productivity. With prior cyclical headwinds such as currency weakness and economic slowdown now easing, emerging markets should once again grow earnings at a faster rate than their developed market counterparts.
Following five consecutive years of contraction, emerging market return on equity (ROE) expanded in 2016. DuPont analysis reveals the key drivers of ROE compression in recent years were falling margins and lower asset turnover. Looking ahead, ROE should expand as margins and asset turnover begin to recover, and this may be further bolstered by stronger earnings growth and improving corporate management. Rising emerging market ROE is even more impressive when considering that leverage is falling from peak levels. While part of the uplift is being driven by a recovery in commodity prices – which are coming off depressed levels – another pivotal driver is a growing representation of the higher margin, information technology sector within the EM index. This compositional shift in the index should ensure a structurally healthier ROE profile for the asset class.
While near-term valuation multiples have appreciated significantly over the past year and a half, emerging markets remain attractively valued on longer-term measures and relative to developed markets. On a cyclically-adjusted price to earnings (P/E) ratio, which measures valuation on a multiple of 10-year trailing earnings, emerging markets are trading near a historical trough. Conversely, the U.S. cyclically-adjusted P/E is near the high end of its historical range, excluding the tech bubble. After five years of underperformance, the discount exhibited by emerging markets compared to developed markets has been as wide as one standard deviation. In other words, emerging markets appear to still be significantly undervalued when compared to developed markets. Recent P/E data suggests that emerging markets are currently trading at a greater than 20% discount to developed markets based on two widely used indices (MXEF and MXEA). Several valuation studies have historically tracked relative economic growth rates for the two groups, and after five years of convergence, the growth spread of emerging over developed has begun to expand once again. This should ultimately favor a relative re-rating of emerging markets.
Despite strong relative performance of emerging markets since the trough in early 2016 (emerging has outperformed developed over this time period), investors remain under invested to the asset class. Historical fund allocation data shows global fund managers with extreme underweights to emerging markets. We see strong potential for funds to flow from developed to emerging as asset allocators embrace the improving absolute and relative case. Investors who have grown accustomed to the conventional, and perhaps outdated, view of emerging markets may be surprised to learn of the changes that have taken place over the past decade.
Challenges for emerging markets during this volatile period have laid the foundation for a steadier and more sustainable future. The representation of highly cyclical industries within the index has fallen, replaced by more sustainable and compelling growth companies in areas such as Technology and Consumption. Progress is being made with historically elusive structural reform, while companies are being managed better. Earnings growth and returns of the asset class are improving on absolute and relative terms, while valuation looks attractive on longer-term measures and relative to developed markets. Although the asset class will no doubt remain susceptible to shorter-term periods of volatility, we are optimistic about the multi-year outlook and believe emerging markets' attractiveness within a global asset allocation continues to rise.
China: Looming Concerns around Leverage
Based on its current trajectory, the Chinese economy is slated to achieve a growth rate of 6.8% in 2017. However, this accelerated growth has come at a price: it has been fueled by an unprecedented increase in the country’s debt ratio. The total debt of non-financial sectors – Household, Government and Corporates – is estimated to have reached 270% of GDP in 2016. The current regime may have allowed this level of economic growth to remain unchecked due to political motivations, as President Xi Jinping aimed to increase and solidify his power base for the next five years during this past October’s five-year Congress of the Communist Party. The alarming rise in debt levels is clearly unsustainable and amplifies China’s economic vulnerability. On September 21, 2017, Standard & Poor’s brought worldwide attention to this issue by downgrading China’s credit rating for the first time since 1999.
The question remains: Will Xi Jinping enact changes to quell the unbridled economic expansion, or will he “kick the can” further down the road for a couple of years? Predicting the exact level of debt that would trigger a crisis is an exercise in futility, but a long-lasting rapid build-up of leverage will eventually lead to an economic crash in China. For 2018, growth rates for China have been adjusted downward by 0.3% to nearly 6.5%. This reflects the expectation that Chinese authorities will maintain a sufficiently expansive policy mix in order to achieve their target of doubling real GDP between 2010 and 2020.
The Chinese government is fully aware of the risks it faces due to its ever rising debt levels. In fact, they have recently increased their efforts to curb the aggressive expansion of credit. Yet, if history has any bearing, this debt curbing will take a back seat to the goal of reaching 2x real GDP by 2020. In the short-term, that may mean more “can-kicking,” which could potentially lead to a bigger crash in the future, adding fuel to what is already a roaring flame.
Without aggressive moves to contain the rise of debt, including reform of the credit-intensive state sector, risks will rise. A hard landing is not our base case, however we maintain a close watch on Chinese leverage.
Although financial markets are currently exhibiting historically low volatility levels, the geopolitical risks we face in 2018 are abundant. The risks range from the North Korean nuclear program, to the proxy wars between Iran and Saudi Arabia, to looming concerns surrounding trade negotiations (i.e. the future of NAFTA and trade with China).
Looking to historical data over the past 50 years provides some insight as to the lasting effects of these black swan events on financial markets. Past global reverberations have had more acute and lasting impacts on markets during periods of time when the global economy has exhibited weakness. However, at this point in time, economic data does not reflect any glaring signs of such weaknesses, although lackluster growth rates worldwide have been a central source of concern. We do see U.S. Treasuries and Gold providing a buffer against any risk asset sell-offs. These safer havens typically rally ahead of unknown market events such as high profile elections, and then lag afterwards as the uncertainty subsides and risk asset prices recover.
Historically speaking, geopolitical events have caused short-lived sell-offs in global risk assets, provided the economic landscape is steady.
With tax reform finalized, the U.S. government may now begin to take a closer look at international trade agreements. A heavy handed, tough U.S. approach on trade negotiations stands as the major threat to the global free trade regime. Recently, we have seen tensions rise between the U.S. and China over trade and security. We expect this ongoing dynamic between the two economic giants to spill over into 2018. Moreover, we view the upcoming NAFTA negotiations as acting like a barometer for Trump’s “America first” stance. Upcoming elections in both the emerging and developed markets could complicate trade negotiations in 2018. Mexico, a country whose economic fate is closely tied to the future of NAFTA, tops a long list of elections in the emerging markets. This is further complicated by the populist overtones exhibited in the current Mexican political backdrop.
The drafting of a new NAFTA agreement in the first months of 2018 is not a far-fetched notion, but an overly aggressive, uncompromising U.S. stance could derail talks. If the U.S. were to step away from NAFTA, the ensuing result may potentially be a pull-back in emerging markets' equity prices, at least in the short term, on fears of worsening trade conditions. This could have a ripple effect, due to increased globalization, with potential supply chain disruptions hurting companies such as global auto manufacturers and suppliers.
Any U.S. drawback from NAFTA negotiations could be an ominous sign for the emerging market and global trade in general. Resulting effects maybe be far-reaching, but most likely only temporary, as new trade alliances are drawn. If NAFTA ceases to exist, the biggest loser, over the long run, could potentially be the United States.
The Case for a Bull Scenario
Earnings Boost from Recently Passed Tax Legislation
- The tax legislation signed into law last year is expected to help boost S&P 500 earnings, currently projected to be up by 11.8% in 2018. That would be the highest annual earnings growth since 2011 (12.8%) (FactSet). Sectors with the highest 5-yr median effective tax rate, which will benefit the most from the tax overhaul, include Energy, Telecom, Industrials and Utilities. Sectors with the lowest 5-yr median effective tax rate, which will benefit the least from the tax overhaul, include Information Technology and Healthcare. Small cap stocks are also strong beneficiaries of a lower corporate tax rate, relative to mid and large cap stocks.
The Continuation of Synchronized Global Economic Growth
- An extraordinary trend not seen since 2010, synchronized global growth can sustain the current bull market for years to come as emerging market countries begin to see their middle class expand and transition to a service and consumption based economy from a commodities and manufacturing based economy. The International Monetary Fund (IMF) increased its 2018 Global GDP estimates to 3.7%, which, if achieved, would be the highest level recorded since 2011.
Low Inflation & An Accommodative Fed
- Low inflation growth (Fed estimates 2% for 2018), should hold interest rate increases at a slower pace than they might be otherwise. Low inflation, coupled with low, but sustained economic growth, could lead to a dovish Fed that tightens its monetary policy by less than expected. Jerome Powell, who will replace Janet Yellen in February as the new chairman of the Federal Reserve, has little incentive to aggressively raise interest rates as he enters his new position at the later stages of a business cycle.
The Case for a Bear Scenario
Tight Valuations & Defensive Consumers
- The S&P 500 trades at historically high valuations when looking at Price to Earnings, Price to Sales, and Price to EBITDA ratios, and currently sits in the 89th percentile when looking at valuations over the last 40 years. Valuations, consumer confidence and investor optimism are all high, which typically occurs near the peak of a bull market. A drop in consumer confidence, or a down tick in economic growth, could spark a sharp correction that is fueled by investors waking up to the historically high equity valuation levels.
Potential Policy Mistakes
- The Fed raising interest rates too quickly, or shrinking its balance sheet too fast, could disrupt, or if history repeats itself, end the current bull market. While Jerome Powell, the new Federal Reserve chairman set to assume his role in February, may have little incentive to change the status quo, there is precedent for an incoming Fed chair to make a policy mistake that negatively impacts the markets. Alan Greenspan became Fed chairman in August 1987, near the end of an economic cycle, and raised interest rates prior to the October 1987 crash. Ben Bernanke became Fed chairman in 2006, near the end of an economic cycle, and raised interest rates prior to the 2008 financial crisis. If the Fed raises interest rates unexpectedly, or fails to communicate its intentions accurately, the market could experience a downturn.
- A volatile North Korea with an advancing nuclear missile program, the growing influence of China, heightened tension between Russia and the U.S. not seen since the Cold War, and the rise of populism around the globe are all causes for concern. Any of these issues, should they boil over, are capable of sending markets lower and investors into risk-off mode, which could quickly spread to other countries and sectors in this increasingly globalized economy.
Increasing Corporate Leverage
- Higher corporate leverage, which has been fueled by record-low borrowing costs set by central banks, has grown to pre-2008 levels and currently sits at $9.1T. Rising interest rates, coupled with slower economic growth, could spell trouble for highly levered companies with weak balance sheets and fuel an equity market selloff that has the potential to be devastating on global markets, especially if the fear spreads to China. Nonbank financial intermediaries, such as pension funds, insurance companies, and mutual funds have the most exposure to corporate credit, but households are ultimately exposed through these intermediaries, which is why a corporate credit meltdown could quickly spill over to equity markets.
As the current equity bull market enters its ninth year in 2018, there is an abundance of opportunities and threats that may play a role in determining if this run continues or ends. All of these factors could move markets significantly, in either direction, and will be closely monitored by all market participants.
One of the most commonly cited reasons for bearish equity-market sentiment is simply the length of the bull trend. Since 2010, there have been 18 downturns in the current bull market, 14 of which were between 5% and 10%, and four of which were between 10% and 20%. There will likely be more bumps in the road in 2018 than in previous years throughout this extended bull market.
We strongly believe earnings and valuations are long term market drivers. While we expect investment returns to slow over next 12 months, we at Tompkins Financial Advisors will continue to allocate assets according to risk/return expectations based on both fundamental and technical analysis.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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