Jan-2018 Market Commentary
With global growth set to continue, we are optimistic about the new year.
US Economics. The employment outlook is improving. The economy added 228,000 positions last month, which suggested that much of the nation recovered from last summer’s hurricanes. Meanwhile wages were up modestly and the jobless rate remained at a 17-year low. Other economic data seems rosy as well: manufacturing and non-manufacturing are up, as are consumer confidence, machine tool orders, and new home purchase mortgage applications. The fourth quarter is likely to mark the third quarter in a row in which GDP rose greater than 3%. The Federal Reserve is raising interest rates to prevent overheating of the economy. The bank raised the rates once again in December by a quarter of a percentage point, and is poised for two to four more adjustments in 2018. This would still mean fairly low interest rates by historic standards.
Global Economy. Even if the Fed follows this month’s hike with four 25bp hikes next year, along with an expected $417 billion decline in the Fed’s balance sheet, we don’t expect this to produce follow-through elsewhere. JP Morgan projects a meager 8bp rise in policy rates outside the US next year. While they expect some smaller central banks to raise rates next year, these moves should be quite modest. Overall, global policy rates are anchored by expectations that the European Central Bank (ECB), the Bank Of Japan (BOJ), and the People Bank Of China stay on hold. In addition, a combined $700 billion rise in the ECB and BOJ balance sheets more than offsets the Fed’s unwind. Strong global growth enables continued Fed rate normalization as it promotes US reflation and encourages capital outflows that limit upward pressure on the dollar. At the same time, stable low policy rates and balance sheet expansion outside the US tempers upward pressure on global bond yields, supporting favorable financial conditions in the face of Fed rate normalization.
Profit Margins and Equities. Free Cash Flow margins defied gravity like the Broadway show “Wicked”, and in 15 years they have more than doubled. Automation, globalization, and low interest rates have been supportive, and lower corporate tax rates may avert the mean reversion for a while. The rise in cash flow margins has been a function of improved profitability accompanied by a sharp reduction in capital intensity. Since the prices of capital goods have been climbing slowly over last 10 years compared to historic inflation, capital expenditures don’t look depressed in real terms. Moreover, companies are picking up the intensity of their spending which should bode well for future growth.
Taxes and Corporate Earnings in 2018. Goldman Sachs estimates that tax reform will lift S&P 500 earnings by 5%. Although they believe that US equities have broadly priced the passage of tax reform, considerable uncertainty remains. In particular, investors still lack visibility into the impact of specific provisions at the company level and how corporate behavior will respond to the new tax code and the incremental cash flows it creates. This uncertainty and shifts in positioning suggest that opportunities still exist – particularly at the micro level – as the market digests the implications of tax reform. Goldman maintains their S&P 500 EPS estimate of $150 in 2018, representing 14% growth vs. 2017. Of that total, the tax reform will contribute 5 percentage points, or $7 per share. This would represent a decline in the aggregate S&P 500 effective tax rate from 26% today to roughly 22%, inclusive of federal, state, and local taxes.
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, Citi research and Nuveen.