01/02/2018
As tumultuous as the social and political landscape was in 2017, the financial landscape was anything but. The S&P 500 gained just over 19 percent on a price-only basis (19.4 percent), nearly four times its average annual gain over the past twenty years, and it did so with record low volatility. The MSCI All Country World index rose 22 percent, approximately five times its average return of the past twenty years, also with dramatically diminished volatility. The yield on the ten-year Treasury note began the year at 2.44 percent, and ended it at 2.41 percent. It did trade in a 60-basis point range, but failed to establish any clear direction, mostly because trailing twelve-month core consumer prices fell from 2.1 to 1.7 percent. Shorter maturities were a different story. The two-year note yield rose from 1.19 to 1.88 percent, as the Fed raised the overnight rate three times in the belief that inflation, whose absence was a “mystery,” would eventually show up.

Other enumerated risks to the year’s generally upbeat forecasts also failed to materialize, including a stronger dollar, political strains in the Eurozone, a debt crisis in China and trade disputes. The global economy evolved into a synchronous expansion, and domestic investors were rewarded with a year-end corporate tax cut. In retrospect, 2017 was a year in which almost everything that could’ve gone right for markets did go right, and almost nothing that could’ve gone wrong went wrong.

Could 2018 be as Rewarding as 2017 was?

As 2018 gets underway, it may be tempting to assume that it will not be as rewarding as last year, not this late in the economic cycle, and certainly not starting out the year with valuations as full as they are. But such an outcome, while perhaps not likely, is not unprecedented. In 1997, after six straight years of gains on a total return basis, the S&P rose another 31 percent and ended the year at the same trailing P/E ratio as today at 22.5X. It then went on to rise another 27 percent in 1998 and 20 percent in 1999 in the longest bull market in history. Of course, it was the era of “irrational exuberance,” and after the P/E ratio reached nearly 30x in 1999, the index proceeded to give back almost 40 percent of its value over the ensuing three years.

If the current bull market survives until Labor Day, it will become the longest in history. For it to get there, once again a lot will have to go right. But from the vantage point of New Year’s Day, it certainly has a chance. With a boost from tax reform, the U.S. economy has a chance to produce growth near 2.75 percent. If it does, it would be the strongest annual growth of this expansion. And, it will be getting help from the rest of the world as global growth accelerates to 3.7 percent, according to the International Monetary Fund’s projection. That would be its strongest pace since 2011, and assumes just 2.3 percent growth in the U.S.
 
The outlook for earnings also looks promising. According to Factset, U.S. corporate earnings are forecast to grow by 11.8 percent, the fastest pace since 2011 and coming after an expected final growth rate of 9.6 percent in 2017. And the 2018 projection could be subject to upward revision with the full effect of tax reform factored into the forecast. So far that does not appear to have happened. While top down forecasts by market strategists have seen some significant increases following passage of the tax bill, some by as much as 14 percent, bottom-up aggregate analyst forecasts have barely budged. We do need to get through 2017 Q4 earnings season first, and expectations are high at 10.9 percent. And what management teams have to say about the impact of tax reform will be critical.

What are some of the Looming Risks in 2018?

Valuations are one area of concern. On a trailing basis, the current P/E ratio of the S&P 500 is 30 percent above its ten-year average, and 20 percent above its five-year average. That may be justified in light of prevailing interest rates, but rates are expected to rise further. By how much is the question. The Fed raised the overnight rate three times in 2017, faster than expected by most. At its December meeting it also left in place its expectation for another three rate hikes this year, also not widely expected. Whether the Fed follows through depends on the strength of the economic data, most importantly inflation. If inflation stays dormant while the Fed continues to raise rates, the yield curve will likely continue to flatten, but not to the extent where it becomes problematic for valuations, and stock prices. This is our base case.

But if inflation strengthens, and the Fed becomes more aggressive, market multiples could come under pressure. Our economic forecast for 2018 anticipates unemployment falling to 3.6 percent. If it does, the pressure on wages would likely firm, spilling over to core inflation. That would be good news for consumers, but something of a headwind for valuations.

The remaining risks to the continuation of this bull market, at least the ones that we can see, are mostly holdovers from 2017. Politics, geopolitics, a stronger dollar, rising volatility and China are all still on the list. These we can monitor, and with any luck they don’t become problematic. It is the risks that we cannot see, that are not on the list, that keep us on guard.
Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Ameriprise Financial, Inc. and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.
Past performance is not a guarantee of future results.
S&P 500 Index: Is an unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
MSCI-All Country World Ex. U.S. Index: Is an unmanaged index representing 48 developed and emerging markets around the world that collectively comprise virtually all of the foreign equity stock markets.
Indexes are unmanaged and are not available for direct investment.
The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.
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