Markets 2018: 4 key drivers
The market backdrop appears positive, but not the Goldilocks scenario of 2017.
The backdrop for US stocks in 2018 looks positive, but the year could produce more volatility as corporate earnings growth moderates and the Fed raises rates.
Investors should keep a close eye on 4 key drivers: earnings, liquidity, the Fed, and China.
All of this may well leave the market in 2018 somewhere between the strong mid-cycle returns of 2017 and the possibility of a more turbulent dynamic in 2019.
What a year 2017 was for investors!
The US stock market enjoyed a nearly unparalleled combination of high returns and low volatility in 2017. In fact, the risk-adjusted return of the Standard & Poor's 500 Index (S&P 500) through November is at the 99th percentile since 1926. In other words, during the past 91 years, the stock market's annual risk-adjusted return was higher than 2017's only 1% of the time. It was about as good as it gets.
The driving forces behind 2017's spectacular risk-return dynamic were strong earnings growth and easy liquidity conditions, juxtaposed against low investor expectations. Double-digit earnings growth (11% in 2017) and easing financial conditions—despite 5 interest-rate hikes in the past 2 years—created a strong tailwind for equity valuations. As a result, the trailing price-to-earnings (P/E) ratio1 for the S&P 500 has risen by 3 points since the 2016 election, from 18.5 to 21.7.
This illustrates how stock market math almost always comes down to 3 pillars: earnings, valuation, and liquidity. Those are the moving parts that are continually in flux to produce different market regimes over time. As shown in the chart, the performance of the US stock market (as measured by the S&P 500) is for the most part directly correlated to the direction of earnings growth and of liquidity (as measured by the Goldman Sachs Financial Conditions Index).
4 key drivers in 2018
The big question today, of course, is whether the recent Goldilocks environment can continue in 2018. While I remain constructive on the stock market, it's unlikely it will be able to replicate the ideal conditions of 2017. Here are 4 key drivers that I believe may have the biggest effect on stocks in 2018.
I think 2018 will be a year in which the "P" (price) in P/E goes up only as much as the "E" (earnings).
For one, it appears that earnings growth has begun to moderate back to its long-term growth rate of 7%. This is a normal development 2 years after a cyclical bottom. A more moderate earnings growth environment is still a positive for the markets, but it should be less of a tailwind for stock valuations than the double-digit growth we've seen since the 1st quarter of 2016.
It is possible that earnings growth will get a boost from a cut in the corporate tax rate, but how much of a boost remains to be seen. Some experts believe the effective tax rate (not the statutory rate) will only decline by a few percentage points.2 I've heard Wall Street analysts say that every 1 percentage point drop in the effective corporate tax rate could add a couple of dollars of earnings per share in the S&P 500.
So, if the effective tax rate goes from 27% to 21%, that's maybe $10 per share in earnings. That could translate to 100–150 points in the S&P 500. And I think a lot of that is already being priced in.
Ultimately, if tax reform lowers corporate taxes it could improve earnings for US companies, particularly for some domestically oriented sectors, and for small-cap stocks, which pay higher taxes today relative to large multinationals. Nevertheless, I think the overall impact of the cuts may be smaller than previous efforts at fiscal stimulus. I expect to see positive earnings growth, but at a pace closer to the long-term average of 6% than the very strong numbers of the past 2 years.
In my opinion, the bigger factor that could limit the upside for risk-adjusted returns is the liquidity environment. It's impressive that financial conditions (which are affected by the dollar, interest rates, credit spreads, and stocks) have eased substantially since early 2016. This is despite multiple rate hikes by the Federal Reserve Board (Fed), which has also now begun to shrink its balance sheet. Fed rate hikes are called "tightening" for a reason—it's what the Fed aims to do to financial conditions when it sees the threat of rising inflation.
It's possible the Fed will need to tighten further—and perhaps a lot further—if and when inflation finally starts to show up. At this point, the market is only pricing in 2½ more hikes after the Fed's 5 hikes from December 2015 to December 2016. That seems too low to me, and it's well below the 6 more hikes that the Fed is signaling via the survey of Fed member expectations known as the dot plot. As long as inflation remains well below the Fed's 2% target as it did in 2017, perhaps the market will be proven correct. But the risk is that the Fed tightens more and faster than the market is pricing in. If that happens, it could send both the dollar and real rates higher, which could lead to tighter financial conditions and less support for equities.
That being said, I disagree with some of the more dire views out there, which claim the Fed is on the cusp of committing a policy error that will invert the yield curve sometime in 2018. An inversion of the yield curve (when short rates rise above long rates) historically has been one of the most reliable predictors of a recession and bear market. But with the overnight rate at 1.375% and the 10-year Treasury yield at 2.38%, there's still about 100 basis points of room left before the yield curve inverts. It would require 5 additional quarter-point rate hikes from the Fed before the curve inverts, assuming long rates stay where they are. In all likelihood, the Fed would only raise rates that aggressively if inflation forced it to. And if that happened, long rates should rise instead of fall, deterring a curve inversion in the process.
One additional caveat is that it is still unclear how the shrinkage of the Fed's balance sheet will affect financial conditions. The Fed's balance sheet reduction will remove some liquidity from the financial markets, but so far investors have not reacted negatively to the news. Whether this reflects complacency, a delayed reaction, or simply a nonevent remains to be seen. In any case, it's an added dimension to the Fed's monetary policy discussion, and one that could play an important role in 2018 and beyond.
Another key player for the market will be China. A lot of the gains in global equities since early 2016 can be attributed to China's reflation3 in late 2015 and early 2016. China produced what we call a "credit impulse" (new credit as a percentage of GDP) of 31% in early 2016. That credit produced ripple effects throughout the emerging markets as well as the developed markets.
Now the question is how China's recent policy tightening (in an attempt to rein in speculative lending practices) will affect its economy and the global markets. In the past, the "hangover" phase of these credit impulses ended up causing enough strain to require a renewed credit impulse a few years later. It was a constant roller coaster, with new credit as a percent of GDP swinging from 19% in 2008 to 39% in 2009, back to 23% in 2011 then up to 33% in 2013, and then back down to 22% in 2015 before rising to 31% in 2016.
Through mid-December 2017, China's metric for new credit as a percent of GDP is at 28%, which shows that the Chinese leadership is keeping things running at a high level. If that continues, it should continue to provide a tailwind for global earnings. However, if the credit pendulum swings back to the low 20s as it has in the past, we could see some real pressure on earnings in 2018.
From 2017 to 2018: a tough act to follow
In trying to envision 2018 through my "3 pillars" lens (earnings, valuation, liquidity), I just don't see a continuation of the 2017 scenario, in which rising earnings growth and easing liquidity conditions push valuations higher—a situation where prices increase more than earnings, which are also rising. A more likely scenario for 2018 seems to be one in which earnings continue to climb but at a more moderate pace, while the removal of the liquidity tailwind creates a scenario in which stock prices rise equal to or more slowly than earnings.
I also sense that 2018 will produce a more balanced 2-way dynamic between equity market returns and volatility, as 2017 did for bonds. In other words, stocks may still be positive, but likely have less-positive returns and more volatility in 2018. Over the long-term, the S&P 500 has produced an average annual return of 11% against a volatility of 15.4 Since February 2016, however, it has been an annualized return of 20% against a volatility of 6. This is not normal and not something that investors should ever count on.
On the whole, I believe the stock market in 2018 may end up somewhere between the strong mid-cycle returns of 2017 and the possibility of a more turbulent dynamic in 2019. All in all, that would not be a bad outcome after the run the market's been on.