2017 fourth quarter investment and economic update

January 11, 2018|Dave Isaacson

Global equity markets continue to hit record highs fueled by continued low interest rates, anemic inflation, accelerating profit growth and growing economies.

The U.S. economy—the expansion continues

The U.S. economy posted a 3.2% annualized growth rate for the economy in the third quarter, making this the best sequential quarterly growth rate since 2014. Early indications of fourth-quarter economic growth, according to the Atlanta Federal Reserve, are expected to be 2.7%. There is typically a larger margin of error associated with fourth-quarter growth estimates given the results are predicated on holiday consumer spending.

The U.S. consumer—looking pretty good

The U.S. economy is benefiting from a continued strengthening job market with the country at 4.1% unemployment, making this the best headline unemployment number in 17 years. Unemployment is expected to continue its improvement dipping below 4% in 2018.

What has been surprising is the lack of wage growth associated with what many economists consider a fully employed economy. Wage growth in the U.S. has had year-over-year average growth during this expansion of 3.14%. The last time unemployment was this low was 2000, but wages were growing over 6%. Even when adjusted for inflation our current wage growth is lower than historical norms.

We believe wage growth will be picking up in 2018 due to continued tightening employment, the economic stimulus caused by tax reform and minimum wage increases at the state and municipal levels.

In January 2018, 18 states and 20 cities will increase their minimum wages with many states setting the minimum wage at $15 per hour.

Other than employment, housing is often the greatest indicator of how the consumer feels about the economy. Existing home sales hit an annual rate of 5.81 million homes in November 2017, bringing the market back to rates last observed in 2006. New home sales have posted 733,000 annualized units sold in November 2017, bringing the market back to levels last experienced in July 2007. However, this is significantly off the peak of new home sales in July 2005 which crested 1.38 million units.

The U.S. business environment looks strong

The business community has been anxiously awaiting the tax reform bill that was signed December 22, 2017, by President Trump. Many consider this to be the most significant fiscal change for corporate America since the Reagan-era tax law changes.

We do not yet know how this recent tax reform will impact the U.S. economy given the benefits are predicated on how consumers and corporations respond to the new tax code.

According to the Joint Committee on Taxation’s publication JCX-69-17, the tax reform bill is expected to increase gross domestic product (GDP) by 0.7% over the next 10 years, but will cost $1.46 trillion. The U.S. consumer will experience a 2.5% reduction of their effective marginal tax rates on wages, among other areas, until the expiration of the individual income tax provisions, which are scheduled to sunset in 2026 based on the wording in the law.

Median corporate tax rates for small and midsize companies (companies within the Russell 2500 Index) are over 30% whereas median tax rates for large U.S. companies (S&P 500) are 25.5%. The new corporate tax bracket at 21% will provide the most benefit to small and midsize companies.

We expect the repatriation of foreign-derived profits to largely be returned to shareholders through dividend increases and share buybacks with an increase in capital expenditure and labor being the primary driver of economic expansion. In 2018, we expect tax reform to contribute approximately 0.6% to GDP growth.

The MNI Chicago Business Barometer, which is an economic leading indicator, jumped to 67.6 in December of 2017 from 63.9 in November. It is the highest reading since March 2011 as both output and demand rose to multiyear highs. Also, production increased the most in 34 years; new orders were the highest in 3 1/2 years and order backlogs also grew.

Investment markets—not a time to become defensive

U.S. fourth quarter equity returns came in with large- and mid-cap stocks posting the strongest quarterly returns of the year. Small-cap stocks performed well, but did not perform as well as larger companies due to stretched valuations.

  Growth Core Value
U.S. Large Cap Equity 6.80% 6.64% 6.33%
U.S. Mid Cap Equity 7.08% 6.25% 5.36%
U.S. Small Cap Equity 3.90% 3.96% 4.03%

 Source: S&P Dow Jones Indices; S&P 500 Index, S&P 500 Index, S&P 600 Index

Many investors are questioning if the equity markets have gone up too far, too fast. With returns across major markets exceeding 20% total returns in 2017, it is a good and reasonable question for investors to ponder.

In our opinion, the continued global growth expansion, low inflation and low cost of borrowing, combined with the near-term stimulus of the federal tax reform, justifies the current valuation premium in the U.S. equity markets. While it would be difficult to match the returns of 2017, we believe high single-digit returns are a reasonable expectation for 2018. 

Volatility in the equity markets have set all-time record lows in 2017. We adamantly do not believe this is a “new normal” and fully expect a return to normal market volatility in 2018. Specifically, we fully expect to experience an intra-year correction in the market of approximately 10% even though our expectation is for positive investment returns in 2018. 

Interest rates

The Federal Reserve moved the Fed Funds rate to 1.50% in December marking the third interest rate increase in 2017. Even though the Fed moved interest rates up by 0.75% in 2017, we still view the Fed’s monetary policy to be accommodating and not restrictive.

In November, it was announced Jerome Powell will be replacing Federal Reserve Board Chair Janet Yellen. Our expectations are for a continued cautious approach to monetary policy with decisions being data dependent.

We expect the Fed to hike interest rates at least two times in 2018 with the possibility of three or four hikes if we see an acceleration of inflation. Our view of the Fed should translate to a continued increase of interest rates in the zero to two-year maturity range.

Longer-term interest rates (10 Year Treasury) increased by 0.10% in the fourth quarter. To some, it is surprising to have a meager increase in the 10-year rate with strong equity market performance and economic growth coming in above 3%. 

Longer-term interest rates are impacted by global demand. Across the G10 countries, respective 10-year government bond yields range from 0.05% (Japan) to 2.08% (Canada). This makes the 10 Year Treasury attractive to foreign countries, keeping upward pressure on bond prices, which in turn keeps yields low.

We anticipate Europe will continue strong relative economic growth which should encourage investors to embrace risk-based assets instead of government bonds. This, combined with the Federal Reserve’s $10 billion-per-month balance sheet reduction strategy and expected strong economic growth in the U.S., should lead to rising interest rates for the U.S. 10 Year Treasury.

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Watch for Schenck’s 2018  Investment and Economic Outlook to be released soon. This comprehensive view of the U.S. and international economies will include more detailed views of our investment expectations.

For more information or insight regarding the investment and economic outlook, please contact Dave Isaacson, chief investment officer of Schenck Investment Solutions at 800-236-2246.

Dave Isaacson has more than 25 years of experience providing wealth management and financial consulting services. He is skilled in portfolio and asset management, financial analysis, and market trend analysis.

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