As the world prepares to put 2017 to bed, investors are looking to 2018 as a year of shrinking opportunities and growing risks.

As 2017 comes to a close, the financial news continues to be cause for investor optimism, but Roger Aliaga-Diaz, Vanguard’s chief economist for the Americas, believes that the extended period of strong market returns and low volatility may have investors feeling too complacent and that a correction is possible within the next 12 to 24 months.

“It’s like the market’s conviction and the current environment of growth and inflation has become part of the status quo and the consensus,” said Aliaga-Diaz. “We feel like this complacent optimism could struggle from a knockdown in some of the growth and inflation indicators.”

Investors should not be confused by the tremendous performance of equity markets, said Stephen Wood, chief market strategist at Russell Investments. Russell expects U.S. GDP growth of 2.25 percent in 2018 as the bull market momentum should carry over into the first part of the year.

Brad McMillan, chief investment officer at Commonwealth Financial Network, says that slowing job growth, declining personal savings rates and peaking consumer confidence create the conditions for an economic slowdown in 2018.

“We’re probably going to have a good first quarter, and likely a good second quarter as well, but at some point growth should pull back and roll over,” said McMillan. “We’re running out of juice to grow the economy and we’re running out of workers. Between job growth topping out and people running out of the ability to borrow more to keep spending, we’re not going to see the kind of growth in 2018 that we’ve seen thus far in this bull market.”

Interest Rates

Vanguard believes Federal Reserve is likely to hike to at least 2 percent by the end of 2018, and expectations for future rate increases will grow throughout the year, bringing the era of accommodative monetary policy to a close in the U.S.

“A little inflation wouldn’t be bad, but if we see those numbers increase significantly, it would embolden the Fed and other central banks to press forward with their rate hiking plans,” said Aliaga-Diaz. “That’s something the bond market is not prepared for.”

Vanguard believes that the labor market will continue to tighten in 2018 as unemployment falls below 4 percent.

If tax reform ends up stimulating the economy, the Fed is more likely to proceed with monetary tightening, said McMillan.

McMillan says that interest rate increases, combined with growing labor costs, will eat into corporate earnings growth and most likely business confidence. At the same time, many of the positive economic and market trends of the past several years will persist.

“The Fed sees that we’re moving toward the end of the economic cycle and they want to reload their bullets so that they’re able to cut rates when we hit the next recession,” said McMillan. “We think that a new Fed chair will want to establish their bona-fides as an inflation fighter right away, and thus they will lean towards higher rate increases faster.”

Russell sees the risk of a recession in 2019 if the Fed’s tightening inverts the U.S. yield curve, which could happen as soon as late 2018. As short-term interest rates are raised, long-term rates lag and remain low, causing the curve to flatten, then invert, an event that typically precedes recessions.

“The flattening of the yield curve is in progress; it’s something we’re watching,” said Wood. “This is an amber light for U.S. equities: Looking outward, we think there will be good but not spectacular economic growth, but with the flattening of the yield curve, one gets a less optimistic view pushing into 2019.”

Political Impacts

Political turmoil might also disrupt financial markets. With Republicans pinning their hopes on the success of tax reform, Democrats have been buoyed by victories in the 2017 governors’ races and the Alabama senatorial special election, possibly signaling a sea change in the 2018 midterm elections.

“We expect there to be more political disruption, not less, as we approach the midterms,” said McMillan. “So far, the markets have virtually ignored domestic politics, but the possibility of politics becoming a headwind is quite real.”

It’s unlikely that domestic politics negatively impact the markets, but geopolitics are more concerning. McMillan identified North Korea as a potential source of international discord, as the U.S. will likely have to go to war to prevent the state from becoming a nuclear power.

Yet Wood says that North Korea’s ability to impact markets with its bellicose behavior has already waned, noting that during the recent crescendo of tensions between Western allies and the North Korean government, the economy and markets of South Korea grew unconcerned.

Issues like internal nationalist and independence movements, for example, the recent referendum in Catalonia, rarely impact financial markets as these internal regions and national groups have no markets of their own.

“These events tend to be transitory; even major geopolitical events tend to be quickly digested by the market,” said Wood. For example, the Greek crisis is nearly five years in the past, and the suffering of the Greek people continues, “but the capital consequences were only attendant to Greek debt and the potential for a Greek debt default.”

Inflation, Taxes, Deficits And Debt

McMillan is concerned that inflation could become an issue in 2018, but he doesn’t expect a sudden spike in inflation rates. Instead, he argues that low interest rates and investor complacency make financial markets more sensitive to mild increases in inflation.

Tax reform may end up blowing up the national debt, according to McMillan, with current proposals anticipated to cost up to $1 trillion in additional federal budget deficits over the next decade, increasing the national debt by up to 50 percent. As interest rates increase, more of the federal budget must go to servicing debt and taxes will have to be increased again, or spending will have to be “dramatically” cut.

“The deficit is not a headline issue today because the sequesters worked, lowering the deficit to a point where it was no longer trouncing the expansion of the tax base,” said McMillan. “Now, we’re seeing the deficit increase again, and if tax reform is passed, it will be that much worse,” but because Democrats are comfortable with deficit spending, and Republicans will have caused the deficits, McMillan does not expect the debt to become a campaign issue over the next election cycles.

However, any expectation for up to $1 trillion in new infrastructure funding should die with the passage of tax reform, said McMillan.

The next year is largely expected to be marked by growing market risks and declining investment returns.

“If we see inflation start to pick up, the market will start to have to get closer to where the Fed is at,” said Aliaga-Diaz. “That could result in more volatility. In the past, the Fed has started the year with a hawkish path and has had to change course to bring expectations back to where the market is. This year, the risk is that it goes the other way and the market follows the Fed.”

Low bond yields mean investors will continue to take risks to generate portfolio returns, said Vanguard.

Russell, on the other hand, believes that U.S. markets could enjoy a blow-out rally in 2018 as other countries’ economies ignite and grow. Wood expects the 10-year Treasury yield to hit 2.7 percent by the end of 2018.

High valuations will mute returns moving forward, said McMillan.

“Though earnings growth should continue, when you see historically high valuations in the present, you have to believe that they’re going to moderate when confidence does roll over,” said McMillan. “We could be in a year where we see higher earnings, but lower multiples eat into the returns,”

As interest rates continue to increase, markets will test the assumptions of investors who believe higher valuations are justified by accommodative monetary policy.

As a result, Investors might be better off looking outside the U.S., said Wood.

“There are now multiple ways to participate in the global growth story, there’s no single global theme,” said Wood. “There are broad investment themes now available to investors who are willing to be globally diversified.”

Russell believes that emerging markets, Japan and Europe will outperform the U.S. over the course of 2018. Similarly, the yen, euro, British pound and emerging markets currencies should offer better opportunities to investors than the U.S. dollar.

McMillan said that investors might also consider increasing their allocations to cash and mixing alternative strategies into their portfolios.

“I would also be diversified on a strategy basis,” said McMillan. “Historically, almost everyone is long-only, buy-and-hold investing, and there have been quite a few hiccups on alternatives, but there’s little doubt that alternative strategies can add value.”

Since growth, though muted, will continue over the mid-term, Vanguard recommends that investors stay the course for 2018.

“Really, it’s better if you maintain a three-year investment horizon,” said Aliaga-Diaz. “You almost want to look through 2018 in the sense that you don’t want to react to the potential volatility, and you don’t want to try to time how long the equity market continues rallying.”