The Economy and the Markets | Fourth quarter 2017

The New Year may mirror the old, with continued moderate growth, strong employment and low inflation. We expect the U.S. economy will likely see 2.4 percent gross domestic product growth in 2017 and will register around 2.5 percent in 2018. 

We expect the Federal Reserve (Fed) will be an important force in 2018. A new Fed chair and an environment favoring interest rate increases could be critical in the year ahead. In addition, the recently passed tax bill will begin to demonstrate its potential impact. 

Quarterly GDP Growth

Everyone’s talking taxes 

Tax Reform was a focus for Washington and Wall Street during the fourth quarter. By repeatedly reaching new all-time highs, the markets celebrated the December passage of the most significant tax changes in 30 years. Under the new tax regime, undoubtedly some sectors of the economy will fare better than others. 

Some companies have publically indicated they expect to deploy the forecasted increase in earnings by raising employee pay, providing bonuses, and investing in technology and infrastructure. The question is whether these actions will be broad or sustainable enough to drive up inflation. We believe the effects will include continued growth with moderate pressure toward higher inflation. 

Retail, industrial and financial corporations will benefit from the corporate tax rate dropping from 35 percent to 21 percent. Financials will also likely benefit from regulatory relief, which should increase profitability. Retail companies will get a lift from continued economic growth. These sectors could step in as market leaders in 2018. 

Technology, which led equity market gains in 2017, may not get as much help from the new law. The effective tax rate for most technology companies is already well below the statutory rates due to the nature of the business. The bill’s repatriation provisions give U.S. companies incentives to bring money kept overseas back into the country. While technology companies may not have a strong enough incentive to participate, other companies may return money now kept overseas, a potential economic stimulus. 

Housing, which drives a large part of the economy, may feel some negative effects from new limits on mortgage interest and property tax deductibility, along with the increase in the standard deduction. We foresee a real trade-off between owning and renting, especially for younger millennials. On the plus side, the economy is already approaching full employment, and additional economic growth could help push up average hourly wages. That in turn could help workers afford more expensive homes and apartments, giving real estate a boost. Commercial real estate may see some of the biggest benefits go to real estate developers and operators, thanks to accelerated depreciation. Tax reform is expected to lead to higher corporate earnings and increased hiring, which could increase demand for commercial real estate.  

We expect the tax law’s limits on deducting interest expenses will help investment grade corporate bonds and may hurt lower quality (high yield) issues. Companies will need to rely less on debt, which could help strengthen balance sheets. 

A new head takes over the Fed 

Janet Yellen wraps up her term as Fed chair, with Jerome Powell ready to take over in February. We believe Powell will likely follow a path similar to Yellen’s, although he may be slightly more aggressive about raising interest rates. Four vacancies on the Fed’s board of governors await filling. The new occupants could affect future Fed policy as much as the change at the top. 

The December Fed meeting minutes projected three rate raises in 2018. For now, interest rate futures pricing indicates the market expects the Fed to raise rates only twice in 2018. 

Federal funds rate

How we see 2018 

We expect slow and steady growth, low inflation and a lack of market volatility. Tax reform should keep the expansion going, but it could also increase inflation and spur accelerated economic growth, which could prompt the Fed to respond. Treasury markets already appear to reflect potential inflation risk, as well as prospects for greater growth, following the passage of the tax bill. 

If the Fed begins to quickly raise rates it could put a dent in the markets. Potential rate increases in Europe, where inflation is running a little higher than in the United States, could start to drive up rates here. 

It’s worth noting that there appears to be an unusual disconnect between the stock and bond market outlooks. Stock markets see lower corporate tax rates and economic growth justifying current equity prices. Projected earnings for the Standard & Poor’s 500 are very strong. The equity markets clearly anticipate another year of market gains. 

The bond market’s outlook, as reflected in the yields of two- and ten-year Treasuries, is more pessimistic. The difference in yields between the two- and ten-year Treasury has narrowed to just over 50 basis points, down from its traditional 100-point spread. With spreads at or near post-crisis tights, investors appear to be comfortable buying corporate bonds and other forms of spread product. We believe Treasury yields haven’t increased due to concerns about low economic growth, low volatility and lack of inflation. We expect the yield curve will continue to flatten unless the economy grows more than anticipated.

Flattening yield curve

Source: Bloomberg. From 12/30/2016 – 12/31/2017.

Meanwhile, investors continue to search for yield. Low interest rates abroad are drawing foreign investors into the bond market. Foreign buyers are seeking income opportunities in U.S. corporate bonds as well as U.S. equities. The U.S. corporate bond market is three times the size of Europe’s. Foreign buyers, who had focused on Treasuries, may be seeking to invest in utility company stocks – attracted by their potential stability. 

Black swans around the bend? 

Geopolitical issues could shake things up in 2018 – the North Korea situation, rivalry between Saudi Arabia and Iran, political landscape in Japan, and Russia investigation here in the United States. All have the potential to upset the economic apple cart. 

Market volatility has been low for some time. We can’t dismiss that an unforeseen “black swan” event could bring volatility back, but our forecast indicates good things for the economy and markets in 2018.