Key Points
• The factors behind this equity bull market — decent economic growth, strong corporate earnings, low inflation and easy monetary policy — should continue into 2018.
• We believe holding overweight positions in equities makes sense, but we may shift that view as 2018 progresses.
Accelerating Growth Could Trigger Inflation Pressures
Economic growth has been generally solid through 2017, and we expect a modest pickup to around a 2.5% real growth rate next year. The probability of tax reform combined with slowly tightening monetary policy will likely cause tightening in overall financial conditions and put more pressure on an already-tight labor market. At this point, we think a recession is unlikely, but that may change as 2018 progresses. The shape of the yield curve may provide warning signals. While it’s impossible to predict recessions with precision, we don’t expect the start of a recession until the second half of 2019 at the earliest. Should the current expansion continue for another 18 months, it would make it the longest on record.1
Outside of the United States, the eurozone should maintain growth above 2% and may surpass the U.S. during the next downturn. In China, policymakers are struggling to avoid financial problems caused by high private levels of debt and supply excesses. We think China will muddle through over the coming years and maintain solid growth levels.
As global economic growth accelerates, investor attention should increasingly turn to inflation. Inflation levels have remained surprisingly low, allowing the Fed to continue cautiously tightening. This has benefitted equity markets. Looking ahead, we expect inflation to pick up in 2018. Wages have been kept low through globalization, technological changes and the lingering impact of the Great Recession. We don’t anticipate a dramatic acceleration in inflation, but it will likely rise enough to keep the Fed on track to continue increasing rates.
We Expect Volatility From the Political Backdrop
The domestic and geopolitical backdrop will no doubt continue to affect financial markets in 2018. We think it is extremely likely that the Republicans will enact tax reform, but it is unclear how much that will help them in the midterm elections. We think the Democrats may well capture the House of Representatives, which could set the stage for some epic battles with President Trump.
Elsewhere, we are looking to see whether Chinese authorities are willing to implement increased financial regulation and purge excess capacity in the industrial sector. We’re also watching ongoing tensions with North Korea, trade protectionism and rising conflict between the United States and Iran. All of these issues could potentially rattle financial markets.
Timing the End of the Equity Bull Market?
Given this backdrop, we expect the equity bull market to continue—at least for now. While gains have been uneven, we expect stocks will continue to outperform bonds over the coming months. We believe the long-term bull market in government bonds ended in mid-2016, and yields should continue to experience upward pressure. Additionally, with the 10-year Treasury yield less than 50 basis points higher than the S&P 500 Index dividend yield, stocks look relatively attractive.2 Fixed income credit sectors should continue to do relatively well, but these market areas may struggle if and when financial conditions tighten during the coming year.
Equity markets are in a similar situation. U.S. stocks are more expensive today in terms of earnings and book value than at any time since the tech bubble of the late 1990s.2 We still think equities are inexpensive relative to bonds, but that would change if rates move higher. Corporate earnings growth has been impressive given slow economic growth, but future expectations are high and may be tough to exceed.
Will the potential upside in stocks outweigh the downside risks? In general, equity bear markets are usually associated with recessions. And since we don’t expect a recession before 2019 or 2020, we think equities still have room for gains. The conditions that have promoted equity prices remain in place (reasonable economic growth, strong corporate earnings, low inflation and accommodative monetary policy), so we think it makes sense to continue overweighting stocks, at least for now.