For How Long Will the Bulls Run?
Volume 18, Issue 1
In this Market Update, you will learn:
· How many countries are expected to be in an economic contraction this year
· How likely the U.S. economic expansion is to continue
· Our 2018 outlook for stock prices
Will the expansion continue?
We are in the midst of the third-longest economic expansion in United States history dating back to the mid 1800s. This report reviews the likelihood of the expansion continuing, and shares our outlook for both the equity and fixed income markets. Finally, we will discuss a risk that could take the economy and markets off-course from our expectations.
Economy and Equities
The synchronized global recovery continues at a pace that feels “just right” for equity markets. The estimated global gross domestic product (GDP) growth rate is 3.7 percent for 2018, while the U.S. is expected to grow at 2.5 percent. China continues to be the global growth driver at 6.5 percent. Further highlighting global strength, the International Monetary Fund expects only six of the 192 countries to experience an economic contraction this year.
GDP growth is filtering down to corporate earnings. Double-digit growth is expected across the world, with non-U.S. companies expected to show the largest year-over-year increases. Emerging market companies as a whole should grow profits at 25 percent for 2018, based on improved demand for manufacturing and services. The improved earnings picture, coupled with attractive relative valuations of foreign stocks, caused us to increase our international allocations in 2017. Additional increases are possible in 2018.
The strength of international economies has also benefited large U.S. companies. According to FactSet, S&P 500 companies with greater than half of their revenues coming from abroad had stock returns of 13.4 percent for the 12 months ended October 2017, compared to only 2.3 percent for more domestically focused companies.
Inflation and interest rates also remain conducive to positive stock market returns. Historically the stock market has generated its best returns during periods with inflation in the 1 to 3 percent range. The Federal Open Market Committee estimated that the personal consumption expenditure (PCE) price index, the Fed’s favored inflation index, would increase from 1.6 percent in 2017 to 1.9 percent in 2018. The consumer price index (CPI) is also expected to remain tame with a target of 2.3 percent out to 2022.
Central banks have generally maintained their accommodative monetary policies, but the Federal Reserve began unwinding its holdings of bonds in October and is expected to continue the gradual increase in short-term rates in 2018. The Fed raised short-term interest rates again in December, and is projecting three more 0.25 percent increases in 2018. The European Central Bank and the Bank of England will likely become less accommodative as well in the near future, helping to maintain the muted inflation levels.
Looking at longer term rates, the ten-year Treasury yield has traded between 1.5 percent and 3.0 percent for the past six years. Rising short-term interest rates and strong foreign demand for longer maturity bonds should keep the 10-year Treasury yield within its current trading range during the coming year.
In somewhat simple terms, bond market returns are driven by interest rates and credit risk.
On the interest rate front, the current low inflation and stable interest rate environment has produced the low, yet positive, returns we have witnessed in bonds the past few years. Based on our discussion above, we do not expect much to change in 2018. Declining workforce demographics — and slow-moving productivity levels of that workforce — point toward low interest rates for an extended period. If the bond market surprises with rapidly rising rates, that would result in negative bond returns. That appears unlikely at this time.
Credit risk is a little more complex and pertains more to corporate bonds than government debt. As long as the economy continues to grow at a predictable rate and companies continue to increase profits, they will have ample cash flows to service their debt. The bond market realizes this and is paying bond investors a commensurate level for taking on this limited risk. Our most likely scenario calls for continued health on the credit risk front.
Risk to Economic Expansion
Debt is the fuel that stimulates growth within our economy. Too much debt can lead to inflation, causing the Federal Reserve to raise interest rates more rapidly.
Companies have been taking advantage of the low-interest-rate environment by issuing large amounts of debt to pay off more-expensive debt and to buy back stock, among other things. The lower interest cost on the new debt increases profits. Buying back stock spreads those higher profits to fewer shares. Larger profits per share result in higher stock prices. So everybody is happy, right?
Debt levels have surpassed past expansions
The above chart shows the total debt of corporations relative to the amount of economic output (i.e., GDP) for the United States. Debt has reached levels where past economic expansions have ended (shaded areas equal recessions).
Not only have corporations been taking on more debt, some have been extending the debt for longer periods of time. Locking in low interest rates for long periods could benefit corporations that have the ability to do so, but not all can.
Floating rate loan market has doubled
The floating rate loan market (chart above), which provides financing for below-investment-grade companies, has almost doubled in size since 2010. While the repayment ability of these companies currently looks strong, a rise in short-term interest rates will increase the debt payments for these companies much like the financial crisis did to consumers with floating rate mortgages.
Investors purchasing long-term, high-risk debt
In a search for yield, investors have purchased this long-term and higher-risk debt. The lengthening of maturities can even be seen in the Barclays Aggregate Bond Index (see chart above) which many bond funds track. The duration of the index has grown from just under four years in 2009 to almost six years currently. (Duration is a measure of bond maturities and sensitivity to rising interest rates.) This will result in 50 percent more interest rate risk when rates do start to rise. Also, the low-stated yields on bonds now offer a small cushion against a rise in interest rates.
The story is similar with the credit risk. As companies have become more leveraged, they have a decreased ability to cover loan payments, and yet investors are receiving smaller compensation for assuming this risk. The interest rate spread that high-yield (riskier) bonds earn above Treasury note yields has been more than cut in half since the early-2016 peak.
Given the current strength of the global economy, we would assess about a 10-15 percent chance of the debt issues adversely affecting the markets in 2018. We will likely be adjusting our bond portfolios toward an even larger allocation of high-quality bonds during the course of next few months.
The ability of the global economy to grow in a synchronized manner without generating rapid inflation is an ideal environment for traditional investments. Despite our human nature to want to predict the eventual end of this economic expansion, the underlying fundamentals suggest that 2018 will look much like 2017. The returns may be smaller and come with more volatility, but we believe that the path of least resistance continues to be up for stock prices.
The round table of Barron’s investment experts is similarly optimistic with an average expected gain of 7.4 percent for the S&P 500. We will continue to monitor the changing risks that could take the market off this course and offer a friendly reminder to our clients that their portfolios are built for long-term success, not timing the next downturn.
Thank you for allowing us to be part of your planning process for another year. We hope for many more!
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