Outlook 2018: Running with the bulls
2017 delivered better-than-expected global equity returns, but the cycle is old and the Fed is set to step up the pace of rate hikes. The current bullish momentum will face strengthening headwinds as 2018 progresses.
We expect the following in 2018:
- The Fed to follow a December rate rise with three additional hikes
- U.S. 10-year Treasury yield at 2.7% by the end of 2018
- Flattening yield curve to heighten 2019 recession fears
- U.S. GDP growth of 2.25%
- Better returns in Europe and Japan, relative to a lackluster U.S. equity market
- Upside for the euro, yen and pound, while the U.S. dollar remains subdued
Wall of worry & the slope of hope
2017 demonstrated the capacity for equity markets to climb the “wall of worry.” Investors began the year uncertain about the new Trump administration, the potential for trade protectionism and escalating geopolitical tensions. There was the Euroskeptic election scare in France, nervousness about the Fed’s balance sheet reduction plans and worries about North Korean aggression.
However, these uncertainties turned out to matter little and by late November the MSCI All Country World Index had returned around 18% for 2017. It also helped that 2017 saw the strongest synchronized global growth and biggest gains in corporate profits since 2010.
The 2018 outlook looks less threatening. Despite an active Twitter feed, President Trump’s first year has been less eventful than feared, the Fed’s leadership is moving to the safe hands of Jerome Powell, tax cuts are progressing through the U.S. Congress, Europe has navigated most of its political land mines, and the 2017 global growth momentum seems likely to persist into 2018.
But with seemingly clear air ahead, are markets poised to fall off the “slope of hope”? We don’t think so, although many of our sentiment indicators point to the near-term risk of a pullback.
The critical issue is the timing of the next U.S. recession, as this almost always results in an equity bear market . By next April, this will be the second-oldest U.S. economic expansion on record. The Business Cycle Index (BCI) model puts the probability of a U.S. recession in the next 12 months at around 25%, a high but not alarming percentage given the age of the expansion. This probability, however, could easily rise through the year, if, as we expect, the Fed tightens another three times in 2018.
Credit and equity markets tend to price in recessions around 6-12 months ahead of time. This means that 2018 could be a year of two halves. The first, which sees the continuation of the current market momentum, and a second half where markets begin to focus on the downside risks to U.S. and global growth.
The uncertainties mean that it makes sense to look at various scenarios for 2018, rather than focus on one story. We think there are three plausible scenarios:
- Equity markets face increasing headwinds later in the year. Japan, Europe and emerging markets (EM) outperform the U.S. in what could be a relatively flat year for global equities.
- Growth and earnings are stronger in Europe, Japan and emerging markets.
- The U.S. 10-year Treasury yield approaches its fair value of 2.7% before declining as recession odds grow. The yield curve flattens and potentially inverts by year-end.
Upside scenario: blow-out rally
- Fed is dovish and tightens by less than expected, growth is ok and inflation doesn’t rise much.
- USD is weak, emerging markets do very well.
- Euphoria takes hold and investors leverage into the market.
Downside scenario: Fed mistake triggers a 2018 recession
- Fed overtightens into a sluggish economy.
- R-star (the real rate consistent with full employment/neutral real rate) turns out to be much lower than expected.
- Markets hit turbulence in early 2018.
There’s an old saying that bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The phase we have yet to encounter this time is euphoria. This is when we would see the blow-out rally scenario.
Sentiment, from our CVS investment decision-making process of cycle, value and sentiment, provides the main guide to this scenario. It currently seems complacent and overbought, but not euphoric. One of the best indicators is that margin debt has yet to take off. According to the New York Stock Exchange (NYSE), margin debt grew by just 15% in the year through October 2017. Looking through this NYSE data, it often grows by more than 40% in the year before a major market peak, as overconfident investors borrow to gain market exposure.
Bull markets don’t have to end in euphoria. As another market saying holds, they can be killed by the Fed. One of the key recession-risk issues is working out when Fed policy becomes restrictive. In other words, where is r-star? The chart on the next page shows the average real Fed funds rate from peak to peak in each cycle over the last 37 years. It's stepping down because of rising debt, poor productivity and weaker potential growth.
The Fed’s rate hikes have so far slowly reduced the amount of stimulus from monetary policy. Given the uncertainty around r-star, it’s entirely plausible that a couple rate hikes could lift the Fed funds rate above r-star and turn policy restrictive. We will be monitoring the yield curve closely. This is one of the key inputs into the BCI model. The yield curve has inverted before every recession over the last 50 years. The spread between yields on 10-year and 2-year Treasuries has narrowed from 140 basis points, when the Fed started tightening at the end of 2015, to 60 basis points in late November.
Real U.S. Fed funds rate (based on the core PCE2 deflator)
Source: Datastream (Fed funds data), Russell Investments calculations; as of October 31, 2017. Gray columns represent National Bureau of Economic Records (NBER)-dated recessions.
Our 2018 annual outlook overview is very U.S.-centric. The U.S. still dominates global markets and is further advanced in its cycle than other economies, which means that most scenarios are likely to be driven by the U.S. It's worth asking whether there are any global factors that could trigger a global bear market.3 The last big global negative shock was the Organization of the Petroleum Exporting Countries (OPEC) oil crisis in the early 1970s. The eurozone sovereign debt crisis in 2011 did not have much impact beyond Europe.
Keep an eye on China
The main candidate for a non-U.S. shock is China. We're not expecting a China-sparked crisis, but high debt levels are a risk and outgoing People’s Bank of China governor Zhou Xiaochuan recently warned about the risk of a "Minsky moment.”4
The recent Communist Party National Congress entrenched the power of President Xi Jinping, giving him the authority to pursue his reform agenda in his second five-year term. Near the top of his list is deflating the debt bubble. Chinese central bankers have many more levers than their counterparts in developed markets, so the likelihood is they will be able to engineer a gradual deleveraging. But tightening credit in a high debt economy is a fraught exercise. China’s monthly money and credit growth statistics will bear close watching for signs of a sharper-than-expected slowdown.
Finding a path between euphoria and danger
The cycle is very old and the Fed is preparing to step up the pace of tightening. This creates plenty of uncertainty. Our central view is that equity markets can push higher over the first part of the year, before facing headwinds later in 2018 as markets factor in rising risks of a 2019 recession.
Running with the bulls can be dangerous. It’s easy to get swept up in the elation of the crowd and underestimate the risks.
2 The personal consumption expenditure (PCE) deflator measures the price change in the basket of goods that are captured in personal consumption expenditure. The core measure, which excludes energy and food prices, is the Fed’s preferred measure of inflation.
3 A bear market is defined as a 20% fall in equity markets. The average S&P500® Index decline in the six bear
4 A Minsky Moment refers to a sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures. The theory is named after economist Hyman Minsky.