My prediction of higher U.S. inflation and bond yields last year was partly motivated by the expectation of Trump tax cuts. Since these tax cuts passed only two weeks ago, the risk of economic overheating also subsided. But 2018 could well be the year when Trumpflation actually happens, especially if Trump is emboldened by the tax cuts to follow through on his protectionist promises too. If the prediction of higher U.S. inflation turns out to be right, it will be a game-changer, producing much more volatile market conditions and even greater under-performance by U.S. equities and bonds relative to assets in Europe and Japan, where inflation is not a risk. The follow-on question, if Anatole is right about inflation, is how the Fed will respond to it. The ideal response would have been to start tightening about three years ago. That opportunity having past, the remaining choices are all varying degrees of bad.
Now let’s move on to Louis Gave, who gives us some stock market ideas at the end of a long, thoughtful essay on liquidity.
Putting it all together, 2018 does seem to be starting on a different note than 2017. While the bull market may not be in peril, it is a tough environment for a price/earnings ratio expansion to occur. Such an outcome usually relies on excess liquidity moving into equities. Yet in 2018, equity markets are more likely to be a source of liquid funds than a destination for them. It follows that if a multiple-expansion is off the table then equity gains will rely on earnings rising. The area where such an improved profit picture is likely is financials (higher rates and velocity) and energy (higher prices). The fact that both of these sectors presently trade on low multiples also helps.
If you want specific sector ideas, there are two good ones.
Personal aside: the corporate tax cut is estimated to add as much as $10 per S&P share to overall earnings, which should in fact contribute to an upward bias for stocks, at least by the end of the year.
Lastly, here is a note from Chen Long, who covers China for the Gavekal Dragonomics service.
From a financial market perspective, the biggest question is what the “key battle” against financial risk means in 2018 after a year of regulatory tightening throughout 2017. Some press reports of the CEWC [Central Economic Work Conference] claimed that the government is already soft-pedaling efforts to control debt, on the grounds that the communiqué made no specific mention of “de-leveraging” and that the early December Politburo meeting talked about “keeping macro leverage under control” rather than “de-leveraging”.
I disagree: the policy stance on leverage remains pretty much the same as it has for the past year or more. As I have repeatedly stressed, the “de-leveraging” goal pursued by Chinese policymakers is not a reduction in the gross debt-to-GDP ratio that many analysts focus on. Instead, Beijing wants to de-leverage the corporate sector (by cutting debt-to-equity ratios) and the financial sector (by cutting the claims that banks have on each other and on non-bank financial firms). The overall aim is not to bring down total nationwide leverage, but to reduce financial risk while maintaining credit support for the real economy (see The View Into 2018).
Seen in this light, the language from the latest meetings might represent a slight softening in tone, but certainly signals no policy reversal. The communiqué of the 2016 CEWC talked about making “corporate de-leveraging as a priority under the precondition of keeping total leverage ratio under control” – essentially the same as the statement from the December 2017 Politburo meeting.
Kotok: A Permanent Shift Upward