Economy in 2018: Surveying the Horizon

January 25, 2018

Today we attempt to survey the horizon and take a look at the economy in 2018. Since the 2016 election, the stock market has skyrocketed to never-before-seen highs. Setting records while creating $5 trillion in wealth for pensions, retirement and savings accounts.
The economy's continuing expansion ranks as the third-longest in U.S. history. And stands a chance to surpass the record set by the 1990's economic boom.
American businesses created 1.5 million new jobs last year. As the economy expanded by at least 3 percent for the last two quarters. This bodes well for the economy in 2018, especially considering that 2016's end marked the first decade in the nation's history during which the economy failed to post a single year of economic growth above three percent.
While consumer and public opinions on the economy in 2018 have been rightfully muted, that tide has turned. Especially following December's tax code overhaul. Anticipated to increase the pace of economic growth. And contribute, at long last, to the economic bolstering of the nation's middle class. Which had long felt left behind, even as much of the nation recovered from the 2008 Credit Crisis.

Nine years into an economic recovery and seemingly interminable bull market, one cannot help but ask, "What's next?" Though the pessimists oft find themselves stating, "What's left?"
The answers may surprise you. As the tea leaves point discerning, analytical investors towards optimistic, yet pragmatic ground for the economy in 2018.
Politics dominated last year's headlines. It's important to remember what common-sense maven Warren Buffett counseled at this time last year. "If you mix your politics with your investment decisions, you're making a big mistake."
History shows that investment markets pay no mind to who inhabits The White House. Or which party holds sway in D.C. Stocks rise on the wings of improving earnings and enhanced economic growth. Both of which are currently in ample supply. Whether you like Trump or not, the combination of business deregulation (delivered throughout the year) and tax reform (end of year) serve as manna from heaven to public and private businesses across the nation.
Business confidence, as measured by the NFIB index, sits near record highs. And many firms appear set to increase capital expenditures and hiring, while continuing share buybacks and other equity-friendly activities. Not to mention a potential wave of capital repatriation as American companies use the lowered corporate tax rate (down from 35 percent to 21 percent) to bring pools of overseas cash back home.
Not to be outdone, consumer confidence has also skyrocketed. With U of M's Consumer Sentiment Survey revealing near-record levels of Main Street excitement over the current economic prospects. Revealed during the recent Christmas shopping season which ranked as the best holiday period for retailers in over seven years.
What's driving the current momentum?
The Economy
The slow, plodding economic recovery of mid-2009 through early 2017 has been called a plow-horse economy. It was no thoroughbred. But it wasn't going to keel over and die either. Growth plodded along at a sluggish but steady 2.1 percent average annual rate.

Following policy changes out of Washington, however, that plow horse has broken into a trot, another great sign for the economy in 2018.
Under new management, real GDP grew at a 3.1 percent annualized rate in Q2. And 3.2 percent in Q3. Moreover, it appears like Q4 brought a 3.3 percent annual rate, marking the first time we've had three straight quarters of 3+ percent growth since 2004-2005.
Brian Westbury points out that the past nine years bear similarities to the 1970s. When the Fed pulled the entire yield curve down. And big government (taxes, regulation, and spending) held growth back.
Today, growth and inflation are accelerating, while the Fed lifts short-term rates. Just like in the 1980s, tax cuts, deregulation, and contained government spending will disprove what the pundits said would be long-term secular stagnation.
For the economy in 2018, Chairman Powell's Fed will increase the federal funds rate in three, possibly four, quarter point moves. Real GDP growth will clock in at roughly 2.8 - 3 percent. And inflation will hit roughly 2.5 percent. Placing nominal GDP growth as high as 5.5 percent. Marking the fastest top-line growth the nation has incurred since 2006.
While the economy has long been grinding higher, most of the gains were concentrated in coastal centers like New York, California and Washington, D.C. While Middle America struggled with high unemployment and low growth. But that has changed.
Economic growth in the Midwest has begun to outpace the urban coastal regions. With the U.S. Bureau of Economic Analysis reporting that the biggest growth is coming from the heartland. Texas. Colorado. Oklahoma. New Mexico. And Wyoming.
Crude oil hit over $60 per barrel. Causing oil producers to run their drills and hire in droves. Homes are being built at a frenetic pace. Manufacturing has picked up. And given the Midwest's former manufacturing base, the workforce and the infrastructure had been simply waiting for the lights to be switched back on.
In fact, to keep up with hiring needs, many employers have had to lower long-kept hiring standards. With some no longer requiring a high-school degree. Others have waived prison records. Wal-Mart recently raised its minimum wage to $11 an hour to attract entry level employees.
So, as the global economy in 2018 heats up, so too has the long-forgotten Rust Belt. Often left for dead throughout the last decade's malaise of sub-2.5 percent economic growth. Now benefiting by a rising tide capable of lifting all boats.
Yet, everywhere you look, asset classes appear overpriced or unrewarding.
The 10-year U.S. Treasury bond currently yields about 2.6 percent. Almost half of its 5 percent historical average and only slightly higher than the Federal Reserve's 2 percent inflation target.
Regarding equities, the cycle-adjusted price/earnings ratio, or CAPE--the valuation metric that does the best job in predicting future 10-year rates of return--sits at 34. One of the highest valuations ever. Exceeded only by the readings in 1929 and early 2000 (gulp). Today's CAPE suggests that the 10-year equity rate of return will be barely positive.
Reason to worry about the economy in 2018? Perhaps. But keep in mind that no valuation metric can dependably forecast the future. CAPEs were unusually high in the mid-1990s when Alan Greenspan gave his famous "irrational exuberance" speech in 1996. Those buying stocks and holding since then have enjoyed a generous 8.5 percent annual return despite the punishing bear market of the early 2000s. CAPEs were close to 30 at the start of 2017, prompting many market gurus to say stocks were overvalued. The S&P 500 index returned 21 percent last year.
Further, investors the world over face one consistent decision: where can capital be allocated to maximize return per unit of risk undertaken. And for all the babbling about equity overvaluations, the bond market -- with its meager yield -- simply does not provide a viable alternative to stocks. Cash? Even worse. So Japanese pension managers, British hedge fund managers and Middle East sovereign wealth funds continue to choose equities. And with global liquidity amounts still high, they continue to have a lot of capital to put to work.
So, let's survey the horizon and take a look at the economy in 2018. And see if we can't chart a direction for the year ahead.
U.S. Equity Markets
We recently attended an investment conference at which renowned market observer Jeremy Seigel spoke. And what Professor Siegel said may surprise you.

Nine years into a recovery that has seen the S&P 500 return over 15 percent annualized, stocks remain reasonably valued. That's not to say they're cheap. But they're certainly not in bubble territory. Especially given the fact that interest rates remain towards the lower end of their historical range.
Since 1954, the average P/E ratio for the S&P 500 is 17.02. Stocks currently sell for 22.5 times last year's earnings, and 19.2 times 2018's estimated earnings. A P/E ratio of 20 forecasts a real return of five percent (seven percent nominal return minus two percent inflation). That represents a 4.5 percent "equity-risk premium." The range between projected equity returns and an investment in risk-free Treasurys. Or, the disparate return equity investors expect to be compensated to forgo the relative safety of Treasurys for the prospective risk-laden return of equities. The historical equity-risk premium is 3.5 percent. Marking stocks as an attractive place to be, given the other choices.
Another bullish factor for stocks? The falling dollar. Which has begun the year like a drunk exits a party: falling over and over again. A lower dollar is great for American companies selling products and services overseas. As it makes their wares more competitively priced against their foreign competitors. The dollar rose from mid-2011 through the end of 2016. Serving as a headwind for U.S. multinationals. Whereupon it reversed course and began to drop against foreign currencies. And became a tailwind. These cycles tend to run for three to five years. Which spells good things for the economy in 2018, especially U.S. large caps.
The plunging dollar should enhance the performance of gold and internationally oriented U.S. stocks. Like P&G, Coca-Cola and Lockheed Martin. In fact, stocks with the greatest international exposure are up 33.5 percent since January 2017. Versus a 15-percent return for ones with the least international exposure.
We believe the S&P 500 could deliver a high single-digit return this year. With markets unlikely to post eye-popping returns following the outsized gains incurred last year.
That said, we cannot overstate the importance of low inflation to our positive outlook for the economy in 2018. Low inflation allows price/earnings multiples to expand. A process that serves as the hidden lever behind stock appreciation. Further, low inflation will also keep central banks at bay. Preventing them from hurriedly raising interest rates to levels that hurt economic growth.
Remember, the fed's core mandate has always been to fight inflation. Which it will do with conviction. And the biggest tool it has to do that is to raise rates and stymie the ample liquidity that's been driving the recovery for most of the decade.
The single biggest threat to the economy in 2018? Rapidly rising inflation. Which would cause central banks to quickly raise rates in response and -- in so doing -- drain every last drop of the global liquidity punch bowl, effectively ending the equity party.
Still, don't forget your passport. Because fixation on domestic equities may cost you dearly. In fact, most investors suffer from "home country" bias. Too concentrated, as they are, in domestic equities. Yes, U.S. companies do business all over the world. But many leading firms are based abroad. The U.S. accounts for under half of the world's economic activity. And much of the world-particularly emerging markets, with their younger populations-is growing faster than the American economy.
Foreign Equity Markets
Despite a powerful 25.1 percent advance last year, developed international equities remain about -30.3 percent below trend and represent the last equity asset class offering a substantial discount to average valuations. Professor Siegel agreed with this assessment. Citing lower valuations and higher upside potential in developed European and Asian markets.

Until 2017, U.S. equities had outperformed foreign developed equities for nine years. That trend saw a reversal last year. As the MSCI EAFE Index posted a 26.5 percent return compared to the S&P 500's 21.3 percent.
Today, the S&P 500 remains valued at 18 times forward-earnings. While the MSCI AC World Ex-U.S. index sits at 14 time forward-earnings
Over the past 60 years, U.S. and developed international stocks have established a consistent cycle of five to seven years of outperformance by one, followed by five to seven years of outperformance by the other. We believe this time will be no different. As we sit in the early innings of a period of international outperformance. Favored as they are by solid economic and earnings momentum, as well as better-than-U.S. valuations.
One of our favored regions? Japan. Where the Nikkei 225 index just crossed 23K and outperformed the S&P 500 last year. From a valuation perspective, it could be poised to do so again this year.
For 20 years, the Nikkei had been unable to break sustainably above that 20K barrier. Recently it did exactly that. Largely due to structural changes enacted by Prime Minister Abe since his first election victory in 2012 at which point the index was mired at 9K. And Japanese equity valuations remain below world averages. With an opportunity to continuing growing earnings while focusing on shareholder returns. Meriting continuing optimism.
Japan's economy is a forward indicator on global growth. Leaving some analysts to anticipate that the Nikkei could reach 72K (a 200 percent increase) once it exceeds the old high of 40,000.
How long could this take? Probably 8-10 years or one more. Another Abe term plus a like-minded successor. Abe's first five years marked a near tripling in the Nikkei. He just earned another term and with the market well off the lows, another tripling will be more difficult. Stretched over eight years, a triple would produce a compound rate of return in the mid-teens, quite possibly the best performance among the G-8 markets.
Japan had to innovate its way to prosperity after its crushing defeat in WWII. With another round of global innovation approaching, don't be surprised to see Japan as a leader in several areas. The nation faces difficult choices. Demographically. Militarily. Culturally. And in terms of its government debt. Tokyo has no choice: innovate or die.
Emerging Equity Markets
Last year was very positive for emerging markets. Returning nearly 32 percent and handily outperforming the S&P 500 after having lagged since 2010. The global reflation trade has been a boon for many of these commodities-based markets. As the global economy heats up, and infrastructure projects like China's One Belt, One Road heighten demand for the input commodities required by such projects.

Moreover, after years of commodity price depreciation, commodities have risen markedly. With the PowerShares DB Commodity Index up over nine percent these last three months. Stoking the economies within these burgeoning nations whose populations are projected to dominate the global landscape by 2050.
And will EM valuations have risen along with share prices, they still represent values when compared to most of their more established peers.
The CAPE ratio for emerging-market stocks is less than half the equivalent valuation in the U.S. The emerging-market CAPE sits below historical averages. Despite 2017's superior market performance. Market guru Burton Malkiel recently advised in The Wall Street Journal that investors should hold at least 10 percent of their stocks in emerging-market equities. And allocations up to 25 percent would not be imprudent.
Better valuations? Higher GDP growth? Larger, faster growing populations? One begins to understand why were so optimistic on EM nations.
Consider India, the world's fastest growing economy. Which has found itself on a transformative path since the election of business-minded Prime Minister Narendra Modi.
Benefiting by a "demographic dividend," India is set to become the world's youngest country by 2020 with an average age of 29. Nearly two-thirds of its population, or 64 percent, will be of working age.
India's stock market is undervalued on several measures. The ratio of the Bombay Stock Exchange SENSEX index to gross domestic product, GDP, currently hovers at 62 percent. A far cry from the historical high of 158 percent seen in 2007. Closer to its all-time low of 40 percent and below its average of 77 percent. Which suggests India's stock market is undervalued. And that optimistic outlook is attracting foreign institutional investors in droves.

We believe India, like many undervalued and well-positioned EM's. And now these markets have begun to benefit by mean reversion. Traditionally, EM's have outperformed U.S. and foreign developed markets. But the last five years have see the S&P 500 double the return of the Sensex. Over the last year, however, India's Sensex outperformed the S&P 500 by nearly 63 percent. Demographics and economics tell us that these trends may continue for some time.
Fixed-Income and Interest Rates
According to Bond Guru Jeffrey Gundlach, 2017 marked the end of the 35-year bull market for bonds. That opinion is as universal as they get in an industry where everyone disagrees.

Since the fed funds rate peaked at 16 in 1981, rates have drifted lower for the last three decades. Given the inverse relationship between bond rates and values, bond prices drifted ever higher throughout that period.
Following the Credit Crisis, many investors came to expect annualized returns of seven to ten percent on their corporate bond holdings. But those days are done. With the fed expected to raise rates three to four times this year. Bond prices will move downward. Sending shockwaves throughout the legions of bond mutual fund holders who get their statements and see the declining values of their bond portfolios.
Smart investors will look to bond surrogates. Instruments less sensitive to rising interest rates yet still capable of providing income and serving as ballast against any possible equity storms. Like convertible bonds. Distressed credit vehicles. TIPs. Business development funds. Real estate and mezzanine debt.
The Fed will hike rates three to four times this year. Leaving the Fed Funds Rate at 2.25 to 2.50 percent at year-end.
The consensus opinion? Could be a rough year for bonds. Leaving bond investors shocked when they receive three to four percent in yield, but bonds drop five to six percent in value. Leaving them with a net loss on the conservative side of the ledger. And if equity volatility returns -- as we believe it will -- then investors will rue the day they failed to diversify away from stocks, bonds and cash.
Alternative Investments
Long ago, the nation's smartest capital allocators - those running the top-tier hedge funds, college and university endowments - long ago recognized that allocations to asset classes that could move independently of stocks and bonds could help returns by lowering risk in portfolios and rendering them less correlated to stocks and bonds.

Since then, academic studies have postulated that those investors seeking to effectively navigate both bull and bear markets should allocate a facet of investment capital to low-correlation, non-traditional, alternative asset classes.
These alternative investments have revealed a proven ability to lower portfolio volatility and enhance long-term returns. Accordingly, they have become the asset classes of choice for many of the nation's most sophisticated investors, like those managing many endowments, foundations, family offices and large pension plans.
These institutions long ago discerned that Wall Street has more gimmicks than a traveling carnival. So, the less we allocate their way, the better.
Last year brought record low equity market volatility. One of the few consensus opinions throughout the investment universe is that volatility will return this year. Leaving investors with a stark choice. Either leave capital in only three asset classes (stocks, bonds and cash), two of which will yield little to nothing, and the third almost promising whiplash returns in the months ahead. Or diversify investment capital into hedge funds, managed futures, private equity, specialty credit, non-traded real estate and commodities. Investment classes sporting low correlations to U.S. and foreign equities. Capable of moving independently, regardless of which direction equities move.
For a comprehensive look at alternative investments, download our recent white paper here.
What's It Mean?
The economy is heating up. Tax reform, business and consumer confidence and continuing deregulation will serve as tailwinds. Though markets are overvalued, they are not dangerously so. And until the 10-year Treasury yield rises from 2.68 percent to 3.5 percent or higher, there's simply nothing as attractive as global equities.

Interestingly, there's a theory out there that flies in the face of the myriad pundits calling for a near-term correction. The New York Stock Exchange - a much wider swath of U.S. companies than the S&P 500 - dropped 20 percent from July 2015 into February 2016. The S&P 500 concurrently fell 12.2 percent. Leaving some pundits to chime that the market has, in fact, incurred a bear market. Making the current bull only two years old, as opposed to a more fragile age of nine.
That said, there' one thing we're assuring clients. Volatility will return this year. After hitting 26 in 2016, the VIX/Fear Index went no higher than 15 last year. Spending much of its time between nine and 11 throughout the year. That will change. Markets will move lower, at some point. Perhaps significantly. Of course, declines are temporary. Only advances are permanent.
We're moving significant sums overseas. Finding more attractive valuations in Europe, Asia and even Latin America. We're also diversifying away from a lot of the traditional bond vehicles in which we've long invested. Not entirely. But enough to protect us from the rising interest rate risk that will hound those seeking fixed incomes throughout the next few years.
We find several sectors more attractive than others. Believing that stocks in the industrial, financial, materials and technology sectors will outperform. And if oil prices can firm within the range of $60-$70? Then the energy sector could shine following last year's subpar returns.
We have a variety of thoughts on Cannabis stocks and Bitcoin. But must save those for future missives. As these robust topics requires us to cover more ground than we have available here.
The biggest risk to our thesis? Rapidly rising inflation. Followed by knee-jerk rate raising responses by central banks. That's the quickest path back to recession.
Currently, the recession indicators we follow look reasonably clear. The yield curve is not about to invert. Short-term jobless claims are not spiking. And the ISM numbers, the truest gauge of American business sentiment and activity, remain positive.
North Korea? Iran? The possibility of exogenous geopolitical events? Enough to make us nervous when tension arise. But not nearly enough to filter into investment calculations. The global economy has learned to deal with terrorism and saber rattling. More so, in fact, with every passing year.
Also troubling, though unlikely to rear its ugly head this year, is the nation's indebtedness. As the national debt approaches $20 trillion. Having nearly doubled from $10 trillion since 2008. Entitlement spending will have to be addressed at some point. As it now accounts for a much-too-large-and-still-growing part of annualized federal spending.
Mandatory spending on entitlement programs currently accounts for nearly two-thirds of the total federal budget. Social Security alone comprises more than a third of mandatory spending and around 23 percent of the federal budget. Medicare makes up an additional 23 percent of mandatory spending and 15 percent of the total federal budget. Entitlement spending must eventually be reformed. Lest we soon spend more than we have so that people can retire more comfortably than their savings would permit.
Perhaps nobody addressed that problem better than Ted Van Dyke, a 40-year Democrat involved in various administrations and campaigns, who stated, "Social safety net programs were designed to help lift disadvantaged Americans to an equal place at the starting line--never to guarantee equality at the finish line."
Bottom line? It remains a wonderful time to be alive in this greatest of all nations. Where opportunities are abundant. And the path to individual fulfillment and financial prosperity can be traversed by anyone willing to consistently wake up, navigate the day's obstacles, provide value to others, and lead with character and integrity.
As Sir Isaac Newton said, "I do not know what I may appear to the world, but to myself I seem to have been only like a boy playing on the sea shore and diverting myself in now and then finding a smoother pebble or a prettier shell than ordinary, whilst the great ocean of truth lay all undiscovered before me."
So, go forth, intrepid explorers. Work hard. Pursue your dreams. Wisely allocate your time and capital. Spending time with friends, family, and in the pursuit of creating something bigger than yourself. Should you be resolute in those endeavors? Then you may find that 2018 stands to be your best year yet.
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