Yahoo Finance Don't Abandon Equities Prematurely
The current U.S. economic expansion is the third-longest in history, creating concern among investors who realize that all good things must come to end.
The phrase "winter is coming" is often quoted on the television show "Game of Thrones." An economic winter is coming, as it is likely that the U.S. will enter recession within the next few years. However, the continuation of a Goldilocks economy -- "not too hot, not too cold" -- supports a bull market for equities that could extend well into 2018.
The U.S. economic recovery is in late cycle, but the outlook is for strong corporate earnings growth to continue in 2018. Economic growth in much of the rest of the world is still accelerating. European growth is supported by declining unemployment, increased business investment and stronger global trade. Japan is benefiting from the synchronized global economic recovery and from incremental improvement in corporate governance and domestic consumption. Chinese growth is slowing, but so far remains strong enough to minimize spillover effects to other countries.
[See: 7 of the Best Stocks to Buy for 2018.]
The December passage of a nearly 1,100-page tax bill provided President Donald Trump with the first significant legislative victory of his presidency. What some skeptics label as a "made for Twitter" tax bill is likely to offer a near-term economic boost. The changes in business taxation will have the most significant economic impact, as the U.S. will move from having one of the highest corporate tax burdens in the world to being in the middle of the pack. Corporate profits should get a boost in 2018, particularly small company stocks, many of which pay close to the statutory maximum tax rate.
Although an economic winter may be coming, the final stage of a bull market is typically highly rewarding. A recent BCA Research report highlighted the U.S. stock market returns in the months prior to a recession. In the seven to 12 months prior to recession since 1950, annualized inflation-adjusted returns averaged 8 percent. In more recent business cycles, pre-recession average returns were even stronger. Consequently, investors who dramatically reduce their equity exposure today may miss out on meaningful upside potential.
The major risks for 2018 involve Federal Reserve policy, Chinese growth and trade protectionism. Although asset bubbles are most feared by many investors, it's more likely that the next recession will be triggered by Fed policy responses to an overheating economy or a pickup in inflation. An environment in which inflation is at stubbornly low levels has helped to support high equity market valuations and a constructive market for "risky" assets. A significant change in inflation expectations could be a catalyst for valuation multiples to correct to less lofty levels.
Wage inflation has stayed in check despite dramatic reductions in unemployment since the global financial crisis, suppressed because of the increase in lower-paying temporary help services jobs and stagnant wage growth in retailing and financial services. Getting less attention is the rapid wage growth in industries such as construction and technology, in which employers are competing in a tight pool for talent. Economists expect wage inflation to grind higher rather than move too sharply, giving central banks the latitude to raise rates in a gradual manner. However, if wage inflation picks up more rapidly than expected, the Fed may need to move more aggressively to raise rates.
[See: 7 ETFs to Profit From GOP Tax Cuts.]
Oil prices, rebounding sharply as tensions increase in the Middle East, present another potential inflation risk for the Fed to monitor. U.S. shale oil supply is expected to increase in response to more attractive prices, limiting the upside for oil prices.
Chinese growth is a second risk factor. China is prioritizing financial sector deleveraging, a crackdown on corruption, and ongoing (and somewhat unappreciated) restructuring of the industrial sector. Skeptics view the anti-corruption moves as a way to sideline political rivals to Xi Jinping, though public sentiment favors an end to the widespread corruption that became pervasive during China's rapid economic expansion.
The Chinese Communist Party isn't blind to the frequent fate of authoritarian states after growth stalls. The party also appears to recognize that the middle class has rising expectations, and that the rise of income inequality is creating societal unrest. China is gradually reducing leverage at financial institutions and state-owned enterprises, while slowing the pace of real estate speculation.
The risk to the global economy is that China fails to effectively manage the tension between growth and reform. Overly aggressive reforms might satisfy the more austere economists around the world, but potentially at the cost of a severe slowdown in growth within China. With China representing nearly 30 percent of global growth, a Chinese hard landing would create growth challenges elsewhere in the world. If China is too cautious in economic reforms, the risk of economic overheating increases and China's long-term economic challenges will become more difficult to resolve. Consensus expectations are for a soft landing in China, but investors are monitoring leading indicators to identify signs of a policy-induced slowdown or acceleration.
A third risk is that protectionist trade moves, much discussed in Twitter threats to abandon NAFTA and impose sanctions on China, become a material part of the 2018 agenda for Trump. There are shortcomings in current trade agreements, including weak intellectual property protections, but an exit of NAFTA or a tariff war with China is likely to harm economic growth and create a surge in inflation.
Given the long bull market and elevated valuations in the U.S., the risk of a recession is a possibility that shouldn't be ignored. Overzealous policy tightening represents the greatest threat to a pro-risk stance, but with economic data positive and inflation subdued, the Federal Reserve may have the luxury of taking a slow and steady path. As the last few years have shown, moderate growth, dovish central bank policies and low inflation have been an ideal backdrop for stock market investors.
[See: 10 Investing Themes to Remember for 2018.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor's clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
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