horse race

Growth Strong Out of the Gate: 2018 Investment Outlook

For investors, 2018 has started off much like 2017 – which is to say strong equity returns, uninspiring bond returns and very little volatility. Before we get to our 2018 outlook, however, let’s have a look back at 2017 and what made it such a bountiful year for equity investors.

2017 was a remarkable year in the markets for a number of reasons. In my nearly 20-year career as a professional investor, I cannot recall a market that marched so steadfastly and steadily higher in the face of such uncertainly on the geopolitical front. And not only did both domestic and international stocks generate returns significantly higher than their long-term averages, but they did so with very low volatility. For the first time since 1897 (yes 1897!) the U.S. stock market delivered a positive total return (price appreciation plus dividends) in every single month of the year. Moreover, it did so while never pulling back more than 3% from its previous high. While Kim Jong-Un was launching ever-more capable missiles through the year and exchanging increasingly nasty insults with President Trump, markets yawned. The S&P 500 Index made a 1%+ daily move only eight times in the more than 250 trading days of 2017.

Bonds did not fare as well as stocks during 2017, but they did deliver positive returns despite their very low yields. Interest rates remained fairly stable during 2017 as inflation, still mired in the 2% area, barely budged. The U.S. 10-year Treasury began the year yielding 2.45% and ended it yielding 2.40%. This modest decline in rates permitted investors to notch a small profit on most of their bonds in 2017.

With such a positive year now in the rear-view mirror, many investors are wondering if equity markets can continue to push higher in 2018. There are several major reasons why the environment remains constructive for stocks both in the U.S. and in international markets as we enter the new year. As always, there are risks to consider as well.

First and most importantly, the global economy is now in a sweet spot of accelerating growth with (so far) little inflation to show for it. It has been years since we have seen such a strong synchronized global expansion with all of the major growth engines (the U.S., China, Europe, Japan) contributing to the rise. With growth momentum strong around the world, investors are expecting 2018 to be yet another year of solid corporate earnings growth for both domestic and non-U.S. companies.

Second, the change in the corporate tax rate from 35% to 21% will have a very positive financial impact on many U.S. companies. While few multinational companies pay anything near the 35% statutory rate, many small domestic companies, which have fewer opportunities to massage their tax rates lower, pay closer to 35%. Thus, the tax cut will provide a substantial sum of found money that companies will be able to use for investment, dividend hikes, share repurchases or increasing employee wages. From a news flow perspective, 2018 will be replete with companies announcing what they are going to do with all of that extra cash they will not have to send to the IRS.

Perhaps the single biggest risk the global equity markets face in 2018 is a flare-up in inflation. If there is a sharp rise in inflation, the Federal Reserve may be forced to increase the tempo of its interest rate increases. While the Fed did raise interest rates three times in 2017 and has penciled in a further three 0.25% increases in 2018, stocks have yet to feel the gravitational pull of higher rates. (All else equal, stocks will trade at lower price-to-earnings (P/E) multiples if rates are higher.) Stocks may be unaffected as yet because long-term rates have not risen as much as short-term rates. The Fed only controls the short rate; long-term rates are determined by the markets and are generally considered to have a greater effect on stock prices than short-term rates. Thus, with the Fed pushing short rates higher and long rates not changing by the same amount, the yield curve is getting flatter. In a normal economy, short-term rates are lower than long-term rates because investors demand higher yields for securities that have longer maturities due to the higher risks in holding securities for a greater length of time. When short rates are higher than long rates, the yield curve is said to be “inverted.” An inverted curve shows that long-term bond investors are skeptical about the economic outlook. Investors care about the relationship between short-term and long-term interest rates because every recession in the U.S. in the last fifty years has been preceded by an inverted yield curve (… but a recession has not occurred after every inverted yield curve.) The shape of the yield curve will elicit more interest from equity investors if the Fed hikes short-term rates according to plan but the long end of the curve does not move commensurately higher.

High valuation is another factor that poses a significant risk to U.S. stocks in 2018. International stocks, which now trade at lower multiples than U.S. stocks, contain less valuation risk. But to be fair to stocks, many other assets classes, including bonds, are also trading well above average valuations. At this writing, the S&P 500 Index companies are trading at a price-to-earnings multiple of 18.7 times expected 2018 earnings. At this time last year, the P/E on the S&P 500 forward earnings estimates was 17.5 times. Thus, returns in 2017 were fueled not just by strong earnings growth, but also by an increase in the multiple that investors were willing to pay for those earnings. While U.S. equity valuations are above average right now, so too is the rate of earnings growth. S&P 500 companies, aided by the tax cut, could deliver double-digit earnings growth in 2018.

Outside of an inflation spike and high valuations, other obvious risks in 2018 are difficult to identify. There are, of course, plenty of one-off geopolitical events that could dent markets, but the global economy, as a whole, appears quite healthy for the moment. But just because it is hard to single out many specific risks for 2018 does not mean they don’t exist – they are just not, as yet, in plain sight.

Please do not hesitate to contact me if there is anything about the markets or your portfolio you would like to discuss.

Share This!

Join Our list!

Join our email newsletter list to receive more market updates and financial articles like this one.

Picture of Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

Wondering if we can help you reach your financial goals?

Let's Talk!

Schedule a quick introductory call with you and see if we would be a good fit for you.