Wednesday, October 4, 2017
Economic And Financial Market Outlook 2017 Q4
The Marietta Investment Team projects that the current attractive economic and financial market environment will continue through the end of the 4th quarter and into 2018. Favorable factors include accelerating global GDP, accommodative central banks, manageable inflation, and robust corporate profits. Equities have responded well to this backdrop and if these trends continue, next year should provide similar results. A retrospect of 2017 features resilient stock markets marching higher despite heightened geopolitical tensions, devastating natural disasters, and a lack of US fiscal stimulus. Strong economic fundamentals help to explain this advance despite headline-grabbing obstacles. While our outlook is positive for equities, bond yields and money market yields should remain low but modestly increase throughout the next 6-12 months.
The US economy has improved throughout the year. We expect GDP to rise 2.3% in 2017 and accelerate further to 2.6% in 2018. On the positive side, the labor market is healthy, manufacturing is modestly expanding, inflation is low and stable, wages are gradually rising, and consumer confidence is sustaining elevated levels. Conversely, longer-term structural challenges, including aging baby boomers, elevated levels of student debt, income inequality, and the opioid crisis, continue to inhibit stronger growth. It should be noted that this year’s expansion has occurred with the Federal Reserve raising short term interest rates and without significant fiscal stimulus. Tax reform, deregulation, and infrastructure investments are among the policies that would help to boost production but are not necessary to attain another year of economic improvement.
Throughout this year, the Marietta Investment team has reiterated that US stocks are fully valued and require a rise in corporate profits to justify a further advance. Auspiciously, S&P 500 company earnings surged by 14% in the first quarter, 10% in the second quarter, and are expected to expand a similar amount in the year’s second half (source: FactSet). We continue to think that the bull market will persist as long as corporate profits keep progressing. As investors shift their focus to next year, FactSet consensus projects a further 11.1% upswing in S&P 500 companies’ bottom lines and a 5.1% gain in revenues. This would validate another positive year for US equities, though there are reasons for caution. We are watching closely incoming data to verify our constructive view.
The first nine months of 2017 have been marked with consistent outperformance of international stocks, with the iShares MSCI Emerging Markets ETF (EEM) soaring 28% and the iShares MSCI EAFE ETF (EFA) for developed countries advancing 18%. We think there is still further upside opportunity in the next 9-12 months. Our positive outlook centers on economic growth in key countries, strength in emerging market corporate profits, stable or improving commodity prices, heightened prospects for the euro zone, low and stable inflation, and supportive central banks.
An accelerating global growth environment is one of the best possible investing scenarios for international equities. The International Monetary Fund and a consensus of economists forecast a continued acceleration next year, and we agree. Additionally, every year this century when GDP has significantly accelerated, international stocks outperform their US counterparts. The current backdrop has similar characteristics to the early stages of 2003-2007 when the EEM outperformed the EFA and the S&P 500 by over 200% and 300% respectively.
Emerging economies are projected to expand around 5% in 2018. China GDP should rise over 6%, supported by consumer spending, stabilized commodity prices, and fiscal stimulus. Prospects for India look even brighter as bank sector reforms, improvements in infrastructure, and investments in technology should drive long-term GDP growth of 7% or higher. Brazil will post a modest recovery but its upside may be limited by political scandals and lagging reforms. Headline inflation has generally been on the decline in emerging countries, allowing central banks to continue accommodative approaches to monetary policy. In addition to a positive macroeconomic environment, emerging market company earnings are thriving, increasing 19.8% in 2017 and projected to progress at double-digits again in 2018 (source: JP Morgan). Relative valuations remain attractive, with the average 2017 price-to-earnings ratio at 12.4 versus 19.2 for the S&P 500.
The outlook for developed markets has also turned more constructive. Economic fundamentals in the EU have improved: manufacturing PMIs have accelerated, unemployment has decreased to the lowest level since 2009, and consumer and business confidence has improved to multi-year highs. An exception to the story of European strength is the United Kingdom as it negotiates its exit from the EU. Recently, the UK’s 2nd quarter GDP was revised downward to its lowest level in four years while at the same time inflation has mushroomed above its target, putting the Bank of England in the predicament of having to raise interest rates at the expense of stronger growth. Political populism in Europe remains a concern worth monitoring, but thus far has not dampened economic activity in the region as a whole. The political situation in Japan is likely to be stable even as snap elections will be held this month. GDP expanded for the 6th straight quarter, the longest run of expansion since 2006. Though structural demographic challenges linger, the world’s 3rd largest economy is not a drag on growth.
Oil prices have stabilized, but the medium and longer-term issues that caused the 50% drop since 2014 endure. Energy producers have become incredibly efficient at extracting oil such that US drillers have become the world’s swing producers rather than OPEC. Moreover, oil demand has plateaued amidst a global focus on renewable energy. We project oil prices to stay in the $45-60 range for the medium term, which is good for consumers but will drag on oil company margins. Commodities ex-oil should be stable because of accelerating GDP growth and a range-bound US dollar.
At current levels, bonds and money markets provide uncompetitive returns compared to equities. There are secular trends keeping global bond yields low for longer. With this in mind, we recommend that investors pay attention to the benchmark US 10-year Treasury note, currently yielding about 2.3%. If its yield rises closer to 3%, investors should consider adding exposure to bonds.
As with any positive view, there are always notes of caution. A hawkish change at the Federal Reserve, the advent of protectionist policies, and rising inflation are among the scenarios that could disrupt stock markets and potentially cause a correction. Year-to-date the US dollar has weakened -8.9% against several major currencies including the euro, pound and yen. We think the dollar will be range-bound or gradually weaken after several years of strength, but an extended rally could result in a rotation that would be problematic for international investors, commodity producers, and US multinationals. We are carefully tracking any risks that would challenge our forecast.