Rhythm and risk

The U.S. economy and corporate earnings have found an upbeat rhythm in 2018. Markets have observed that strength and projected it well into the future. We see healthy fundamentals persisting for the next 12 months. But we also see significant risks lurking just beyond the horizon.


The U.S. economy is performing well as we approach the middle of 2018. Consumer spending is strong, corporate earnings are outstanding, the unemployment rate is at a 49-year low and the Federal Reserve (Fed) has taken tightening steps at every “press conference” meeting since December 2016. We believe the big fiscal stimulus package from President Trump and the Republicans should keep the economy humming along, with above-trend growth through the middle of 2019. Against this backdrop, the Fed is likely to continue hiking rates to prevent the economy from overheating.

There’s a rhythm to the United States economy that makes a “more of the same” outlook a very reasonable one for the next 12 months. The challenge for investors is that we believe this rhythm is already in the price. The market’s near-term outlook for monetary policy is well-aligned with the Fed’s forecasts and our own. As such, our preferred positioning on U.S. government bonds is currently neutral: we expect the 10-year U.S. Treasury yield to hold steady at around 3% and the yield curve to flatten further with an inversion possible (on the 10-year/2-year spread) around the beginning of 2019. The U.S. equity market is expensive, but corporate fundamentals suggest the path of least resistance is a gradual grind higher until the macro environment weakens.

One of our biggest areas of emphasis right now is trying to identify when that inflection point in the cycle might occur. Our business cycle model suggests the next 12 months look reasonably safe, but we see significant risks lurking just beyond the horizon.


Evaluating the significant risks clouding the medium-term outlook, we believe the biggest threat is the prospect of a global trade war. The rhetoric between the U.S. and its major trading partners has become more bellicose. To be clear, we’ve seen very little adverse impact from trade on the economy thus far. But an escalation toward protectionism could quickly threaten the hiring and capital spending plans of U.S. (and global) businesses. Given trade authority resides with the U.S. president, this is a difficult risk for us to forecast. Our baseline view is that the threat of tariffs is being used as a negotiating tool. As such a full-blown trade war still looks unlikely. But we will need to react to events as they unfold, with a keen eye on analyzing any threats to the business cycle as policy actions and subsequent reactions become clearer.

As we stretch out our investment horizon, we see the possibility of a U.S. recession becoming much more elevated in late 2019 and into 2020. At this point in the cycle, we expect the Fed will have already moved to a restrictive policy setting; the boost from tax reform and fiscal stimulus will dissipate; and medium-term vulnerabilities from both an overheating labor market and elevated nonfinancial corporate debt levels will threaten the outlook. There is no rule to say that a recession has to happen. But with this now being the second-longest U.S. expansion ever in records dating back to the 1800s, we believe emphasizing diversification and risk management in portfolios is prudent.

Strategy outlook

  • Business cycle: Neutral. Corporate profits have come in ahead of schedule as a stronger global cycle, dollar weakness, and corporate tax cuts helped U.S. businesses deliver 25% earnings growth in Q1 2018. With the U.S. dollar firming more recently and with a modest stepdown in the global cycle year-to-date, we expect profit growth to gradually taper going forward. Elevated industry consensus expectations for the economy and earnings in our view limit the potential for the current cyclical strength to drive a strong rally in markets.
  • Valuation: Very expensive. The cyclically adjusted price-to-earnings ratio for the S&P 500® Index —commonly called the Shiller P/E ratio—stands at 32x, which is its highest level outside of 1929 and the late 1990s. Our value conditional framework suggests the expected total return on U.S. equities over the next decade is likely to be very subdued – at only about 2% per year.
  • Sentiment: Neutral. Price momentum has moderated and we do not currently see any strong contrarian indications of greed or fear in markets.
  • Conclusion: We maintain an underweight preference for U.S. equities in global portfolios, primarily on the back of their expensive valuations. Our underweight preference for U.S. government bonds and interest rate risk from prior years has shifted to neutral, as a 3% U.S. 10-year Treasury yield better reflects our macro outlook and the risks surrounding Fed policy and inflation.


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