The breadth of participation in this economic expansion has been deep and broad, expect it to continue. The US recovery continues, with the pick-up in corporate earnings auguring well for a re-acceleration in wages and higher core inflation. In the euro area, the expansion is gathering pace, with export orders at record highs and the labor market strengthening. The Chinese economy is losing momentum, dragged by softer property and infrastructure investment, yet still targets +6% growth. Thus, corporate earnings continue apace, which is supportive of fundamental health. However, late-cycle conditions such as tight credit spreads, bullish surveys, and high equity valuations that have priced in some future upside are reasons to prepare for the possibility of market shocks, i.e., a drop in asset prices and an increase in volatility. Remember, asset prices can decline even if the economy grows.
Ultra-easy monetary policy in developed economies has suppressed volatility and interest rates. Asset prices have surged and global debt levels have continued to rise. It is no surprise investors are worried about a potential reversal; downside risks that might bring an end to the current economic expansion and financial cycle. The reduction in central bank accommodations is half way through; quantitative easing has morphed into quantitative tapering. So far the market impact has been relatively limited, but perhaps there is more turmoil to come. Expect less positive momentum in asset markets and more volatility; but on its own, this is not enough to catalyst a bear market.
The US economy is pivoting to capital spending and housing as Millennials, currently age 25-to-34, start buying . In addition, lower corporate taxes and repatriation of overseas earnings may lead to more financial engineering of stock prices (increased share buybacks and dividends) as well as corporate takeovers which inflate company values. All this should be supportive of stocks. There is a lot of available money in corporate coffers and private equity funds; thus if values start getting relatively cheap, opportunistic and strategic investors should swoop. US corporate profitability is projected to improve to 11% by 2018, and could rise higher with the new US tax plan. In addition, continued hiring looks set to accelerate wages and pull up core inflation.
The euro area continues to surprise many with its strong economic expansion, gaining further momentum towards the end of 2017. The manufacturing sector has led the bounce, export orders have made new historical highs, and activity in the services sector has strengthened to an 80-month high. Other surveys convey an equally optimistic growth outlook; the labor market continues to strengthen. Eurozone unemployment rate fell to 8.8% in October, which is relatively good for Europe and well below the peak in April 2013. Employment gains have been stronger, strengthening to the fastest pace since the global financial crisis as participation rates have risen. Unfilled jobs have made new highs. Expect wage growth to accelerate here too and underlying inflation pressures to edge closer to the European Central Bank (ECB) target of just below 2%.
Global economic strength may have also helped turn the tide in Japan which recently saw the seventh consecutive quarter of positive growth, marking the longest period of expansion since 2001. The result was driven by capital expenditure, yet the broader picture remains one of strong external demand versus soft domestic momentum. The overall contribution from domestic demand was positive because of an upbeat corporate sector, but consumer spending and public investment remained a drag; still-subdued wage suppresses household spending. Thus, Japanese inflation is up, yet still low.
On a portfolio level, expect some large asset reallocations from investors during the first quarter of 2018 which may add to volatility. First, many delayed selling assets and realizing gains towards the end of 2017 in order to delay tax realization to 2018 or to fall under the new tax code; thus we may see these sales occur in January or February. Second, higher short term interest rates make holding cash and cash equivalents more attractive than they’ve been for the last seven years; this may cause some to sell some of their long dated and long duration bonds. Third, the large 2017 run-up in equity valuations may trigger a rebalancing of investment accounts that forces selling of stocks back down to their recommended allocation. The Fed drove people to riskier assets by driving rates to zero and buying $3 trillion of bonds; the unwind will drive some away from risk.
The views and opinions expressed are those of Hollencrest Capital Management and are subject to change without notice. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.