Outlook: Winter 2018

ECONOMY

The rate of growth in both the U.S. and foreign economies has been accelerating in the last few quarters and we have enjoyed a synchronized global expansion. Looking forward to 2018, the acceleration in growth is expected to continue and the outlook remains positive, fueled by aggressive monetary policies in foreign countries and tax reform in the U.S. Given the improvement, the Federal Reserve is moving away from the crisis-based policies of the last nine years. The Fed’s current guidance suggests it will raise interest rates three times this year while reducing the size of its balance sheet by approximately 10%. The European Central Bank and the Bank of Japan continue to utilize aggressive stimulus policies, but if their economies continue to improve, it is likely that they will take a less accommodative stance later in the year.

INFLATION

After peaking in February of last year, inflation rates moderated and have recently been hovering around the 2% level. At this level, inflation is close to the Federal Reserve’s target and financial markets have responded favorably to an environment characterized by price increases that are not too high or too low. This year, inflation is expected to increase given the acceleration in global economic growth. However, an aging population, high debt levels and the proliferation of technology will continue to work as structural headwinds that keep inflation from rising dramatically. 

U.S. DOLLAR

The U.S. dollar declined steadily last year, but remains at a historically high level. Improving fundamentals in foreign economies, modest growth in the U.S. and a slight increase in U.S. inflation expectations have increased demand for foreign currencies. In the coming months, we expect the dollar to remain relatively soft as the improvement in foreign economies boosts demand for their currencies.        

Asset class

Cash/Money Market Instruments

We expect short-term rates to continue their slow and steady rise throughout 2018. The Federal Reserve is, of course, at the center of the outlook. Policymakers at the Federal Reserve have been gradually raising rates since late 2015 and are projecting three more rate increases this year. Although the best laid plans often go awry, recently confirmed Chairman Jerome Powell is likely to stick with the current cautious and gradual approach.

Intermediate Government/Credit Bonds

In addition to Federal Reserve rate increases, bond yields also face upward pressure from less central bank buying, stronger economic growth and the possibility of rising inflation. For now, intermediate-term bond yields are near three-year highs awaiting further confirmation of recent trends for the next move in either direction. We think inflation is currently the most critical variable. Time will tell whether the current economic strength will translate into moderate inflation that has so far proved elusive during the expansion.

Tax-Exempt Municipal Bonds

The tax reform debate and eventual passage of the Tax Cuts and Jobs Act of 2017 created a hectic year-end environment for the municipal bond market. Although the legislation will have far reaching implications in many areas, core attributes of the tax-exempt market were not greatly affected. Future demand for municipal bonds is likely to shift as banks and insurance companies may view the asset class less favorably, but individuals in high-tax states may see additional municipal bonds as a means to shelter more of their income.

U.S. Equity

Improving economic conditions worldwide and rising earnings growth drove stocks to record highs last year. Looking forward, the ongoing economic expansion and the newly enacted tax reform bill should continue to push corporate profits up. In fact, earnings are expected to grow approximately 11% this year and that should drive stock prices to higher levels. Regarding tax reform, the companies that will receive the greatest benefit are those that generate most of their sales in the U.S. and thus have high tax rates. This includes companies in the banking, retail and transportation industries as well as many smaller firms. That said, the benefits are widespread and companies across each sector are poised to benefit. While stocks are expected to generate solid gains, volatility is likely to increase, and returns may be tempered by valuations that are above average as well as a steady withdrawal of stimulus from the Federal Reserve.

International Equity

Last year, international equities performed quite well. In fact, for the first time since 2012, foreign stocks outperformed U.S. equities. The gains are justified as economies in many foreign countries are improving and earnings growth has accelerated. In addition, the improved outlook has resulted in a decline in the U.S. dollar which has provided a nice tailwind to foreign stock returns. Looking forward, we expect stock prices to move higher driven by a continuation of the economic expansion and solid earnings growth.      

Commodity

Commodity prices were mixed in 2017 with declines in many agricultural commodities offset by gains in oil, copper and precious metals. This year, analysts expect commodity prices to continue the trend of generating mixed results with performance driven by unique supply and demand factors within each segment. While that is the most probable outcome, we believe investors are underestimating the likelihood of a more pronounced increase in prices driven by accelerating global growth, supply shortages and rising demand. 

Potential threats: Risks and notable items to watch

Rising Protectionist Sentiment

Globally, there is rising protectionist sentiment that is fueling a backlash against free trade. While much of the rhetoric is likely a function of positioning for negotiating leverage, there is a risk that global trade declines acting as a headwind to growth.

Rising Interest Rates and/or Inflation

A shift from the current environment of low interest rates and benign inflation is likely to be problematic if it occurs too rapidly. Structural forces such as aging populations and the proliferation of technology have kept inflation at low levels, but a marked upward shift may force the Federal Reserve to raise rates more aggressively which could bring the current expansion to an end.    

Increasing Government Regulation of Technology Companies

Several of the leading technology companies have established dominant market positions and they have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny in assessing their acquisitions and competitive practices. 

Geopolitical Risks

Conflicts in many parts of the world have escalated. Events in Syria are critically important to monitor given Russia’s support of the Syrian government. In North Korea, the government continues to develop and test ballistic missiles in defiance of trade sanctions and United Nations resolutions banning such tests. Just as important, the heightened tensions in the South China Sea also present some risk. Within the Middle East, a power struggle continues between and within key countries, including Saudi Arabia, Iran, Syria, Yemen and Israel.

Debt Related Issues

Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term. 

Policy Risks

The Federal Reserve has announced its intention to continue to raise interest rates and has started to reduce the size of its balance sheet. At the same time, central banks in other major economies are considering when to alter their policies to a more restrictive stance. If the world’s central banks reduce stimulus too quickly, there is a heightened risk of slowing economic growth.   

Cybersecurity

Cybersecurity is becoming a significant issue as evidenced by last year’s Equifax breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions.