With the New Year fast approaching, we are taking this opportunity to share with you – our valued clients and friends – Pennsylvania Trust’s 2018 investment outlook. As our outlook for stocks and bonds depends in large part on our economic outlook, we start there.
As we conclude 2017, the U.S. economy is strong and gaining momentum. GDP in each of the second and third quarters rose by more than a 3% annual rate, and may well rise by 3% or more in the fourth quarter. If so, this will mark the first time in over a decade that the U.S. economy will have seen three consecutive quarters of 3% growth.
The unemployment rate in the U.S. is historically low at 4.1% and likely headed lower in 2018. Jobless claims, likewise, are historically low. The housing market is ending 2017 on a robust note. New home sales, as well as existing home sales, are at decade highs. Not surprisingly, U.S. consumer sentiment has hit near record high levels. Business confidence also is strong.
Against this enviable economic backdrop, and with monetary policy still accommodative and fiscal policy about to provide a substantial boost, we believe the U.S. economy will continue to grow nicely during 2018.
Importantly, we do not see any meaningful recession risk next year. Reduced corporate and individual tax rates in 2018 should generate at least a short-term economic stimulus, pushing any recession out to 2019 or later. Reduced regulation, plus the immediate expensing of capital expenditures by corporations, should provide further support to U.S. economic growth in 2018. Also of importance, inflation remains tame as we end 2017 but likely will head modestly higher in 2018.
Along with the U.S. economy, the economic picture is fairly bright throughout much of the rest of the world. We are undeniably in the midst of a rare period of synchronized global economic growth which is accelerating. All of the countries tracked by the Organization for Economic Cooperation and Development (OECD) are on track to post growth in 2017 for the first time since 2010. The International Monetary Fund (IMF) has raised its forecast for global economic growth to 3.6% in 2017 and 3.7% in 2018. As in the U.S., German consumer and business confidence are near all-time highs, as is Japanese business sentiment. With central banks around the world still accommodative, we agree with the IMF that global economic growth will remain strong in 2018.
Reflecting the strong global economic growth seen in 2017, and forecast for 2018, key commodity prices rose in 2017. Oil prices in the U.S. are up about 10% this year, and at $59 per barrel, are poised to end 2017 near two-year highs. We expect U.S. oil prices generally to trade in a range of $50 to $65 per barrel in 2018. Copper prices enjoyed a stellar 2017, up over 25% and near four-year highs. Even gold prices rose about 10% in 2017. The gold price increase (and to a lesser degree the oil and copper price increases) likely had a lot to do with the unexpected decline in the U.S. dollar during 2017, which as measured by the Wall Street Journal dollar index, is set to decline roughly 6% this year. We do expect a stable and perhaps rising U.S. dollar for much of 2018 due in part to the fiscal policy stimulus but note that potentially larger budget deficits in the U.S. and less accommodative monetary policy abroad may produce headwinds for the dollar later in 2018 and beyond.
We are closing 2017 with all major U.S. stock indices at or near all-time highs, including the Dow Jones Transportation Average – an important barometer of domestic economic activity. Indeed, assuming the S&P 500 remains up in December, 2017 will mark the first year ever when the S&P 500 posted positive total returns in each month of the year. We clearly are in the midst of an earnings-driven equity bull market. The question, of course, is whether the bull market will continue in 2018. Put differently, is all the good news already priced in to the market?
Our forecast is that the equity bull market will continue in 2018, albeit with markedly increased volatility. A strong and improving U.S. (and global) economy supports this outlook, as does a strong corporate earnings climate. However, with equity valuations in the U.S. becoming stretched, and with volatility at historically low levels, we do believe that volatility will return to more normal levels in 2018. The S&P 500 has not had a 10% or more correction in almost two years. It is likely that this remarkable run will end in 2018, as we expect several pullbacks and at least one 10% (or greater) correction in 2018.
The potential risks to the equity markets in 2018 include: continuing dysfunction in Washington D.C. (a budget deal needs to be reached in mid-January); inflation accelerating at a faster pace than anticipated; the Federal Reserve adopting a more hawkish approach to monetary policy than expected; and U.S. trade policy becoming more jingoistic. We also need to be mindful that the November 2018 election likely will produce uncertainty as we head into Fall. Outside the U.S., China – now a positive contributor to the global economy – is a source of potential economic turmoil should its growth rate slow, should it weaken its currency, or should a debt crisis emerge. Geopolitical conflict, whether with China, North Korea, Russia or in the Middle East, likewise could cause temporary market setbacks.
While any of these risks likely would produce market turbulence, they are unlikely to end the bull market. This is because recessions produce most bear markets, and no recession is seen before the second half of 2019. Active management and stock selection, however, will take on greater importance, and asset allocation will remain as important as ever. We do stress the benefits of a well-diversified portfolio for most investors as the risks rise.
The secular, 30-year bond bull market likely came to an end post-Brexit in July 2016. While bonds likely will post positive returns in 2017, our outlook for fixed income in 2018 is cautious. The combination of a stronger economy, fiscal stimulus, less monetary policy accommodation and rising inflation all are supportive of rising bond yields and falling bond prices. Bond yields have risen substantially from their July 2016 lows, yet still are near historically low levels. All in all, we see a path of gradually higher yields in 2018, with the 10-year U.S. Treasury note potentially reaching 3% or so. We also note a risk, similar to what was seen in 2003, that tax reform* produces a faster rise in the 10-year U.S. Treasury yield than currently expected.
Even assuming sub-par returns in 2018, we continue to believe that bonds are an important part of a balanced investment portfolio as they serve as a hedge against the downside risk inherent in the equity markets.
Overall, we think 2018 will be a rewarding year for investors as the earnings-driven equity bull market continues, albeit with markedly higher volatility. Pullbacks will become more frequent and pronounced, but the ultimate path should be higher.
We wish everyone a healthy, peaceful and prosperous New Year and encourage clients to contact their portfolio manager with any investment questions or concerns as 2018 unfolds.
Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.
*See Leslie Bohner’s article, “How Does the New Tax Legislation Affect You?” for more information on tax reform.