United States: Too much of a good thing?
Global growth has lifted the U.S. economy and multinational earnings to their strongest position in years. But with an eight-year-old U.S. expansion, imbalances gradually building, and expensive market valuations, we believe some caution is warranted for U.S. equities. We forecast lackluster U.S. equity market returns in 2018 and view end-of-cycle risks as becoming elevated thereafter.
Strong growth, growing risks
The U.S. economy has been strong in recent months. Business surveys are indicating some of the best economic conditions for the eight-year expansion thus far. The unemployment rate is at its lowest level in 17 years; the consumer is a pillar of stable growth; both capital expenditure (capex) and housing have turned a corner; and corporate earnings results have come in ahead of schedule all year. When we look under the surface of this improvement, one key observation to note is that a lot of the positivity seems to be flowing into the U.S. from a stronger global cycle. For example, FactSet statistics show large multinational U.S. companies have been significantly out-earning their domestically focused peers. In our previous quarterly outlook report we called this “secondhand growth,” and that continues to be a theme dominating U.S. markets as we look toward 2018.
The challenge for investors as we get later in the cycle is that strong growth comes at a price: back in 1999, New York Fed President William Dudley famously said that “too much of a good thing is a bad thing.” That comment feels very relevant again. This is already the third-longest business cycle in NBER records dating back to the 1800s. And after eight years of growth, many of the signs of an aging business cycle are starting to flash amber.
The labor market is already at or beyond full employment. Continued, strong employment growth at this stage of the cycle comes at the expense of wage and cost pressures for businesses.
The Fed’s estimate of the output gap — which measures the amount of spare capacity in the economy — has closed. And this puts pressure on the Federal Open Market Committee (FOMC) to keep raising interest rates. The Fed’s policy stance isn’t that accommodative anymore, as the chart below illustrates. Most estimates of the neutral rate — the level at which Fed policy pivots to becoming restrictive and a hindrance to growth — are only one to four hikes away from current levels. If the neutral rate is much lower than expected, the Fed could inadvertently make a policy mistake in 2018. However, the more likely scenario in our view is that the Fed continues its gradual hiking process and takes the punchbowl away sometime in late 2018 or early 2019.
The Investors Intelligence bull-bear ratio5 shows investors are the most optimistic that they’ve been since 1987. We use this as a contrarian market risk indicator.
The corporate debt-to-GDP ratio is elevated and matches prior business cycle peaks.
And, perhaps the biggest warning sign is that the yield curve has flattened significantly. With a low unemployment rate and strong medium-term inflation fundamentals, we expect the Fed will be able to raise its policy rate by another 100 basis points by the end of 2018. That forecast, coupled with our forecast for a 2.7% 10-year U.S. Treasury yield, suggests the yield curve is likely to invert in late 2018.
Fed policy isn't that accommodative anymore
Sources: Federal Reserve Board, Federal Reserve Banks of New York and San Francisco, BlueChip, BEA, Thomson Reuters Datastream and Russell Investments. Data as of November 16, 2017. The long-term FOMC forecast is the Committee's longer-run fed funds forecast minus their longer-run core PCE inflation forecast. The long-term economist survey is an average of the Blue-Chip estimate (3-month T-bill yield 5-10 years into the future) and the NY Fed Primary Dealer survey (longerrun fed funds target minus 2 percent). The long-term model is an average of the r-star estimates in Laubach-Williams (2003) and Holston-Laubach-Williams (2016). The long-term market pricing is the 7-10 year ahead risk neutral yield from the New York Fed's term-structure model minus 7-10 year ahead inflation expectations from CPI swaps. The actual real rate is the federal funds rate minus a smoothed version of core PCE inflation. The forecast is Russell Investments’ forecast for the same.
Forecasting recessions is a difficult and inexact science. The current run-rate of growth is strong and the BCI model suggests the risk of a recession in 2018 is still modest, at about 25%. But, as mentioned earlier, too much of a good thing can be a bad thing. Imbalances are gradually accumulating in the U.S. economy, and as we look out beyond 2018 to 2019, many of the pre-conditions for a recession are likely to be in place. An economic downturn doesn’t have to happen — after all, Australia has gone 25 years without one — but recession risks are likely to become elevated.
What could go right? Arguably the biggest macro surprise of 2017 was the soft patch in U.S. core inflation. If growth stays strong and this inflation weakness persists into 2018, incoming Fed Chair Jerome Powell (once confirmed by the U.S. Senate) might be forced to slow down or halt the Fed’s hiking process. That would likely be a Goldilocks environment for U.S. equities and could create a blow-off rally. The other upside scenario that we are paying attention to is the potential for a younger and stronger global cycle to continue to boost U.S. corporate earnings. Coupled with a possible cut in the corporate tax rate, earnings could surprise to the upside again next year and sustain already high valuation levels.
- Business cycle: Corporate profits have come in ahead of schedule this year as a stronger global cycle helped U.S. multinationals. Nevertheless, the pace of growth has moderated from 14% in Q1 2017 to 10% in Q2 to 6% in Q3, according to FactSet. It looks like earnings growth is settling down at mid-single-digit levels, but corporate tax reform could provide a one-off boost in 2018. The combination of strong growth but growing late-cycle risks leaves us neutral on the cycle.
- Valuation: U.S. equities are very expensive. The Shiller P/E ratio6 for the S&P 500 Index stands at 31.3x — its highest level ever outside of 1929 and the late 1990s.
- Sentiment: Price momentum is firmly positive and a tailwind. But several of our contrarian measures show the U.S. market may have moved too far, too fast this year. Equities look complacent and vulnerable to bad news. The market doesn’t look euphoric yet but our sentiment signals are suggesting some caution is warranted at current market levels.
- Conclusion: We continue to have an underweight preference for U.S. equities in global portfolios, primarily on the back of their very expensive valuations. Our interest-rate forecasts support a modest underweight preference for U.S. 10-year Treasuries.
5 The bull/bear ratio indicates overall investor sentiment in the market by comparing the number of bullish and bearish investors. This market indicator is calculated and published weekly by the Investors Intelligence Sentiment Survey.
6 The cyclically adjusted price-toearnings ratio, commonly known as the Shiller P/E, is a valuation measure usually applied to the U.S. S&P 500 equity market. It is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average longterm annual average returns.