Economic Commentary: What’s In Store for Investors in 2018 and Beyond
Written by CUNA Mutual Group Annuities
The dynamic nature of current economic conditions imply that business and investment cycles will inevitably change, almost certainly in a negative direction. In principle, financial markets are priced at the margin, which means that even small changes in expectations can translate into large changes in asset prices.
The key point is that economic fundamentals are constantly undergoing change as the business cycle unfolds, and that market values respond to changing perceptions of future economic and policy trends. This market phenomenon is amplified by the forward-thinking nature of financial markets, which tends to discount shifting fundamentals well in advance of the actual fact.
While timing is highly uncertain, the 2018 economy is likely to experience significant change as the year unfolds. Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., shares his perspectives on what may be in store for investors.
Q&A with Robert DeLucia
2018 is likely to be a year of numerous economic inflection points. Which do you find to be of greatest significance?
I find the most notable inflection points to be:
- GDP Growth Momentum: US GDP growth will likely peak for the cycle at 3.5% during the second half of this year, and then enter a prolonged period of deceleration into 2020. The specific problem facing the U.S. economy is not demand but rather supply: A diminishing source of productive resources necessary to meet robust demand as the U.S. economy moves further into a state of full employment.
- Corporate Earnings Momentum: Business profits will likely peak at an annual rate of 15% in Q3 and decelerate progressively throughout 2019. The problem is that Wall Street analysts have raised their 2018 estimates to 17% from 11% just prior to passage of the tax bill.
- Inflationary Expectations: Core consumer inflation is likely to surprise on the upside and trend gradually higher over the course of this year and throughout 2019.
- Monetary Policy: The FOMC is almost certain to raise its policy rate at a faster pace than currently discounted in fixed-income markets, with likely negative spillover effects on all financial markets.
- Long-Term Interest Rates: The current slow-moving bear market in bonds is likely to intensify as this year unfolds, with long-term interest rates rising at a much faster pace than currently anticipated. Eternally bullish bond investors are almost certain to be caught off-guard by changing economic and policy trends, possibly resulting in a disorderly spike in rates later this year and in 2019.
What’s your 2018-19 forecast for the world economy?
In summary, my world economic forecast for 2018 and 2019 is as follows:
- US GDP growth likely accelerating from 2.5% in 2017 to a range of 3% to 3.5% in 2018, followed by slower growth of 2.5% in 2019. The probability of recession over the next 18 months remains low, but should begin to rise considerably late next year and into 2020.
- World GDP growth possibly exceeding 4% this year, up from 3.8% in 2017, and then slowing to 3.5% in 2019.
- Corporate earnings potentially rising by 12% to 15% this year, slowing to only 5% in 2019 and zero to negative in 2020. Profit margins should peak in the first quarter of this year.
- Business capital investment should be the most dynamic sector of the U.S. economy over the next two years, with annualized growth in excess of 10% through 2019.
- Inflation is the primary wildcard in the outlook. My forecast assumes a rise in core consumer inflation to 2% by the middle of this year and to 2.5% by year-end, up from a current rate of 1.5%. Currently rising at a 2.5% annual rate, average wages could be rising by 3% during the middle of this year and by 3.5% at year-end.
What risks do you see to the current outlook?
There are always risks to the outlook, and the present is no exception. Primary risk factors include:
- Inflation: While inflationary pressures are minimal, a sudden and unexpected rise in the inflation rate could rattle investors and trigger a more aggressive tightening in monetary policy by the Federal Reserve.
- Monetary Policy: As opposed to two or three rate hikes currently implied in the futures market, the FOMC is likely to hike its policy rate four times during the year. The result would be higher borrowing costs and a higher discount rate used to value stocks, bonds and commercial real estate.
- Bond Yields: A combination of greater-than-expected inflation and monetary restraint could push bond yields significantly higher over the next 12 months, with negative implication for common stock valuations.
- U.S. Dollar: A sharp change in the value of the U.S. dollar (USD) in either direction would have a destabilizing effect on both the U.S. and global economies. A steep rise in the USD would have deflationary implications for the world economy, whereas a slump in the USD would be inflationary, pushing bond yields higher and compelling the Federal Reserve to tighten policy more aggressively.
- Trade Protectionism: Adoption of protectionist trade policies by the Trump administration would be disastrous for both the U.S. and world economies, and could lead to a global economic slump, accompanied by higher inflation.
How do you see best and worst case economic scenarios playing out?
The “ultimate bear case” — or worst case scenario — involves the emergence of traditional late-stage business cycle pressures that culminate in an overheating economy, which compels the Federal Reserve to respond decisively with increased monetary restraint. Rising inflation and interest rates immediately undermine equity market valuations as forward-looking markets anticipate a weakening economy and slower profit growth. An equity market decline of 10% to 25% is plausible under this unfavorable scenario.
The “ultimate bull case” — or best case scenario — is that traditional late-stage business cycle pressures are suppressed by positive long-term economic fundamentals associated with ongoing disinflation and corporate tax reform. The result would be a longer period of price stability and non-inflationary growth, accompanied by continuation of the current favorable corporate profit cycle. Further, a capital goods boom resulting from the new tax bill would raise labor productivity and contribute to enhanced international competitiveness for U.S. corporations. Lower taxes on capital would attract foreign capital flows into the U.S. and spark a potential surge in foreign direct investment. Equity market gains of 10% to 15% would be consistent with this bullish economic scenario.
How should investors interpret the current outlook and its potential impact on their investment strategies?
A casual observer might conclude that current near-perfect economic and policy conditions have unambiguously positive implications for investment strategy. Nothing could be further from the truth. The current investment outlook is extremely complex and should become increasingly challenging as the year unfolds. While it is true that the economic picture is “as good as it gets,” the view appears to be fully discounted in current equity market valuations, which have risen to the highest level in nearly 20 years.
Equally worrisome is the apparent widespread optimism among investors, who have embraced the positive economic outlook with exuberance. Having been highly cautious economic skeptics for nearly the entire bull market dating back to 2009, investors are now fearlessly extrapolating the current good economic news into the indefinite future. This change in market philosophy has triggered a decisive shift to the downside in the risk-reward ratio.
In general, what should investors conclude about the 2018 economy?
The bottom line is that conservative investors should adopt a more defensive investment strategy with a reduced emphasis on risk assets, including common stocks. The risk-reward ratio for the domestic equity market has deteriorated to the worst point since 2007. The cyclical bear market in fixed-income assets is still at an early stage and not sufficiently advanced to offer attractive long-term rates of return, adjusted for inflation. International equities — mainly in Europe, Japan and emerging Asia — offer superior return prospects relative to that of the U.S., but would almost certainly decline in sympathy with a bear phase in U.S. equities.
It is certainly possible that world equity markets could continue to rally in future months, in a final blow-off phase. This scenario would be consistent with the tendency of markets to overshoot on the upside (1999-2000) and undershoot on the downside (2008-2009). This tendency underscores the daunting task of market timing — an attempt by speculators to predict market peaks and troughs. Regardless of the precise market peak, variations on common stocks have risen to a level from which prospective long-term returns are likely to prove extremely disappointing. In an increasingly speculative market environment, a conservative investment posture appears warranted.
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All opinions and commentaries expressed are those of the writer, Robert DeLucia, and do not necessarily reflect the opinions of CUNA Mutual Group, CBSI, or its management. MGA-2059437.1-0318-0420