After a whirlwind year of Washington politics, GDP growth north of 3% and a stock market marching through year nine of a bull cycle, it’s time to shift focus toward 2018.
Rather than making a prediction on where the Dow might close on December 31st, let’s review the macro themes that we believe will most profoundly impact the global economic picture. We expect these factors and emerging trends to dominate headlines and drive investment perspectives as the year unfolds.
Tax Cuts Spur Economy
“Shock and Awe” is perhaps the best way to describe the recent GOP tax overhaul. Trump’s package will deliver an immediate $205 billion boost to the U.S. economy in 2018 – equating to over 1% of U.S. GDP. Of this, $120B will come in the form of individual tax cuts, while $85B will go to corporations. Despite the naysaying from many economists, the scope of this package cannot be underestimated. This is the second largest tax reform package in U.S. history, behind only Reagan’s 1981 cuts and decidedly larger than the Bush cuts in 2003.
To put this in perspective, consider that in 2002 and 2003, real annual GDP growth averaged 1.5%. Following the cuts, real GDP rose to 4% in 2004 and stayed above 3% for the following two years. I expect a similar growth pattern, as real GDP has averaged around 2% in 2016 and 2017. Of course, longer term, the impact is dependent on corporates’ willingness to spend. But we anticipate a fresh wave of corporate investments, considering new tax provisions that allow for 100% expensing of capital purchases over the next five years. This loosening should infuse the economy with billions in investment. Combined with our belief that 90% of Americans will get a tax cut, spurring consumer activity, robust GDP growth is likely. Whether the GDP growth rate spikes to 4% or 5% in the new year is anyone’s guess. However, if history is any indication, the recent tax cuts mean significant tailwinds for coming year growth.
(To access a tax calculator and learn more about what the tax cuts mean for you in 2018, check out our recent Tax Reform post).
Interest Rate Rise Continues
The Federal Reserve hiked interest rates on three separate occasions in 2017, and will likely follow suit in the coming year. As recently as September, the U.S. 10T hit 2.03% and closed the year above 2.4%. If economic growth does jump as expected, then interest rates will follow a similar path. Again, using the 2003 tax cuts as reference, the 10Y T yield rose from 3.1% to 4.6% in less than two months. This is a topic we have been discussing and have prepared for over the last several years. And despite persistently low rates, a humming economy will be a catalyst for a long-awaited rising interest rate cycle.
The Bull Slows Its Pace
As US markets began to sniff out the economic realities of the tax reform package, they accelerated toward the end of the year closing up approximately 20%. Markets are hungrily forward-looking, and when the corporate tax rate move from 35% to 21% was announced, they began to price in expectations of after-tax profit increases for the majority of S&P 500 and small-cap companies. Across the S&P 500, these tax cuts may deliver a full 7% earnings lift.
While investors have certainly enjoyed the late-2017 growth, the climb has been accompanied by milder volatility. Over the last half-century the S&P 500 has moved by an average of .75% per day. In 2017, volatility was less than half of that – the lowest since 1960s – closing out one of the most placid years on record. In 2018, as the Federal Reserve continues to raise rates, a move to historically normal levels of volatility should be expected. While this likely won’t remove gains entirely, it may check the large runs investors have come to enjoy.
The Bitcoin and cryptocurrency craze reminds us of 1998-99; dozens of new daily startups with eye-popping valuations and stock charts. Like the late 90s, a wave of capital is chasing something that most investors can’t define – let alone understand, and reasonably value. And the bitcoin bulls’ perspective of “if it was overvalued, then the bubble would burst” oversimplifies market realities. Periods of surprising and irrational valuation often last longer than expected. But, when the tech bubble finally burst in March of 2000, carnage ensued. Many venture capital funded firms became insolvent and simply disappeared. Many zero-earnings companies in the public market went bankrupt. Even blue-chip names in technology like Cisco and Intel were caught up in the negative tide, dropping 80% and 60% respectively.
A similar story could play out with the cryptocurrency market. Much like how the Internet and .com tech didn’t die, bitcoin and its’ underlying technology may not either. But that doesn’t mean that the coin itself or the latest crypto startup won’t see its valuation slashed, or fizzle completely. Investors and consumers will need to see proven business models, obvious use cases and more stable valuations. 2018 will be a proving year for these coins: are they enduring financial vehicles, or lucky recipients in the 2017 cryptocurrency capital craze?
Making America’s (Infrastructure) Great Again
Seizing momentum on the heels of tax reform, Trump’s administration is moving full speed ahead on additional stimulus. The GOP is optimistic about bipartisan support for an infrastructure package to the tune of at least $200 billion over the next decade. The hope is for an additional $800 billion in state and local funding as well. The president’s plan will address the country’s ailing roads, bridges, airports and other public works.
The plan would put the federal dollars in four areas: cash for states and localities, with preference for entities that generate their own funding as well; formula block grants for rural areas; federal lending programs; and money for “transformational” work. A key principle will be giving responsibility to states and localities and providing incentives for them to work with, and unlock capital in, the private sector. Should this pass, the bill’s likely beneficiaries over the next decade will be building material providers, heavy construction equipment manufacturers, steel and raw material suppliers and infrastructure or engineering service companies.
Tech Gets Targeted
Next year, we expect that the technology industry will officially replace the financial and energy industries as the political and regulatory target du jour. Politicized debate and resulting regulative legislation may impact the space’s most dominant brands like Google, Facebook, Amazon and Netflix. To a degree, this is only exacerbated by recent industry shaping net neutrality rulings. The clash of regulation and big tech is not new. Today’s controversies are remarkably similar to the IBM saga from 1970 through 1981. Amazon-like in its domination, the company was caught up in antitrust skirmishes and chastised for monopolistic tendencies for over a decade. This battle with the Department of Justice suppressed growth as the company’s stock price declined from $18.23 to $14.22 over the tumultuous 12 year period. When suits were finally dropped IBM’s mainframe market share had declined from 70% to 62%. Over the same period of IBM’s stock price decline, the S&P 500 index was up 122% (including dividends).
More and more, political candidates and nominees are building campaigns around which camp they stand in with respect to tech. Arguments for free capitalism versus limiting too-strong conglomerates that hurt healthy markets are getting louder. Whatever happens, tech companies are political footballs and undeniably in the regulatory crosshairs.
Sectors To Watch: Energy and Defense
We see both the defense and energy sectors benefiting from various tailwinds in the coming year. The energy sector was a laggard in 2017, despite oil prices rising from the mid-$40 a barrel range to $60 by year-end. The Energy Select Sector ETF XLE was down over 5% for the year, with big energy names like Chevron and ExxonMobil lagging the S&P 500 by double digits. As a group, energy companies had their worst relative performance to the general market in history. Collectively, the sector lagged but we will not be surprised to see the space sector elevate in 2018. Energy pipeline companies (MLPs) in particular may benefit from elevated oil prices.
Beyond Energy, we anticipate additional momentum for defense companies. As we highlighted in our review of Aerospace and Defense, the U.S. defense budget under President Trump has grown to nearly $700 billion, with Intelligence spending expected to eclipse $70 billion. The administration is obviously prioritizing military superiority and willing to spend to maintain our global edge over Russia and China. This focused investment will pass to the defense sector to spur innovation, advancement and defense programs.
International on a Roll
The MSCI All Country World Index ex-U.S. (ETF Ticker: ACWX) finally gained momentum in 2017, up almost 22% on the year. ACWX focuses heavily on the U.K., Developed Europe, Japan, and China. Over the past 5 years, the S&P 500 (with dividends included) has nearly doubled, while ACWX is up less than 30%. This return disparity leaves many international stocks more attractively valued relative to U.S. companies. Heading into 2018 the S&P 500 trades at roughly 18 times next years earnings, while the MSCI (ex-US index) trades at roughly 14 times forward estimates.
Fundamentals aside, the European Central Bank and Bank of Japan are currently in a more accommodative phase (with lower interest rates) than the U.S. federal reserve, providing support for their respective economies. These policies may drive up GDP growth. Lastly, international markets boast higher aggregate dividend yields than the U.S., coming in at 3.1% vs 2.0%, representing an attractive income opportunity.
For anyone fueled by social, economic and political excitement, 2017 did not disappoint. And the new year? Well, it’s shaping up to be another exhilarating one. America has much to look forward to: nearly every income-bracket will enjoy tax cuts, U.S. companies will profit from reduced corporate tax rates and the country can expect an overseas cash infusion from the upcoming Repatriation Holiday. Intrigue around infrastructure, how tax cuts impact the U.S. economy, cryptocurrencies and the future of US defense will also all stay center stage. Welcome to 2018!
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