Market Data for year end 2017:
• S&P 500 Stock Index: 2674, up 19.4%
• Ten-year Treasury Note Yield: 2.41%, down .04%
• Gold: $1,309 per ounce, up 13.6%
• Oil: $60 per barrel, up 11.1%
Global stock markets advanced strongly nearly across the board in 2017, as solid economic growth and corporate profits were paired with continuing low inflation and interest rates. In the United States, stocks had the added impetus of a large corporate tax cut that is seen by analysts as adding up to seven percent to earnings per share for the S&P 500 stock index. Long-term bond yields continued to hover near historically low levels as inflation remained subdued. With this benign backdrop, realized and implied volatility in both stocks and bonds reached record low levels.
Moving into 2018, there is reason to expect that the environment will be more difficult for the stock market. While we are not forecasting significant weakness due to continued strength in the economy, stocks are facing increased headwinds on two fronts: valuation and liquidity. On valuation, the stock market is expensive. Sentiment is widely positive with expectations for earnings and economic growth elevated. While the momentum coming out of 2017 is formidable, high valuations and sentiment increase the scope for disappointment and losses. The market’s margin for error, basically, is substantially reduced.
In terms of liquidity, stocks are going to face increased competition for investor funds from bonds. To date, a significant component of appreciation in the stock market has been driven by global central banks purchasing large numbers of bonds (known as quantitative easing or “QE”), effectively removing them from the market. With fewer bonds available for purchase by investors, stocks benefited with the consequent reduced competition for investment dollars. This process is now being thrown into reverse. The Federal Reserve is unwinding its bond portfolio by effectively selling bonds onto the market, while the European Central Bank has significantly reduced its bond buying program and may continue to taper it over the course of the year. Furthermore, with the passage of the tax cut in the US, the US Treasury is going to have to issue a greater supply of bonds to make up for the lost revenue. The bottom line is that to the extent stocks benefited from central bank bond purchase programs, they will likely be negatively impacted by their reduction and reversal.
Further risks to stocks include an increase in wages and inflation, financial instability in China, and war. On wages and inflation, the US economy is moving into the ninth year of an economic expansion, with unemployment coming in at 4.1%. Standard economic models would expect to see stronger wage gains and inflation with these conditions than has yet to be realized. We believe extensive global industrial capacity and additional workers still available to come into the workforce have suppressed wages and inflation, and may continue to do so. It is a risk, however, that further economic expansion will start to elevate wages and prices, and that would be a negative for stocks through increased costs for labor and capital.
As we have discussed before, Chinese economic growth has been driven increasingly through an ever expanding mountain of debt. Debt financing is inherently unstable, as was witnessed in the US housing crisis of 2008. With debt levels elevated, the Chinese economy walks an increasingly narrow tightrope to continue its expansion. Thus far, Chinese authorities have been able to keep the music playing. As they are not omniscient, however, there is the possibility for error that would destabilize the Chinese financial system and significantly weaken economic growth. As China is currently the world’s second largest economy, weakness in China would negatively impact global financial markets.
A large scale war either on the Korean Peninsula or in the Persian Gulf could have significant negative economic implications, possibly leading to global recession. Such an event would severely impact stocks, likely leading to losses in excess of 20%. However, as President Trump’s only leg to stand on politically is the strength of the US economy and financial markets, (as he reminds us almost daily), we find it unlikely that he would risk the negative economic and financial impacts of war with North Korea or Iran. We put the probability of such an event at under ten percent.
On balance, we expect the US stock market to continue its advance into 2018 but at a reduced rate and with greater volatility than 2017. For 2018, we expect the S&P 500 stock index to trade in a range of 2500 to 2900. It finished 2017 at 2674. Thank you again for the confidence and trust you have placed in us. As always, please do not to hesitate to contact us with any questions or concerns. We wish you a happy, healthy, and prosperous 2018.