Volatility is Back!
A month ago, on January 28th, the Dow Jones Index reached its high, (26,616) well ahead of our “Dows 26,500 by Summer” prediction. The financial markets then proceeded to move from extreme optimism to extreme pessimism in a few short days. The panic started with the recognition that the trajectory of interest rates is higher. Embers of panic began with modest signs of increasing inflation in the labor market and concern that excessive fiscal stimulus on top of a strong economy would lead to inflation. Once the snowball started moving to a higher rate mindset, stock prices plummeted, losing 2700 points in 10 days. Since mid-February the Dow Index recovered 2/3 of its decline. Now what? Clearly volatility is back as the market digests the tradeoff between higher interest rates and stronger earnings reports.
The Era of Free Money is Over!
Washington and the public has forgotten that deficits matter. In 2017 the Federal deficit was $665 billion, 3.5% of GDP. Since interest rates have been low for almost ten years, borrowing money is thought of as almost free and certainly beats the rate of inflation. So why not go all in and borrow a lot more?
The President’s recent tax cut will add $1.5 trillion of fiscal stimulus into the economy. Then Congress will be spending an additional $300 billion in the new budget. Still pending is the infrastructure bill. To put this in perspective, the Obama stimulus when the economy was on the verge of a depression was approximately $831 billion. The tax cuts and new spending are like pouring gasoline onto a hot fire.
If the economy overheats, tax cuts will accelerate the need to raise interest rates, as the deficit expands. Adding fiscal stimulus when the economy is booming is a recipe for long-term disaster. Once the initial euphoria wears off, higher rates could very well shock the system and set off a sequence of problems with companies, municipalities and families dependent on cheap money. But that’s next year’s problem. For now, 2018 will see the benefits of the stimulus and the pain of higher rates will be deferred.
The annual amount of bonds issued by the U.S. Treasury is likely to increase from $420 billion in 2017 to over $1.1 trillion by 2019, a 160% increase. The Treasury never pays off prior borrowings; it just reissues new bonds. The amount of bonds that has to be sold on a monthly basis grows at an increasing rate when the deficit expands. At some point a tripling of U.S. treasury debt will crowd out other borrowing.
Interest rates are not likely to jump up overnight. At first there will be more bonds to be sold at auction, leading to an increased yield to clear the market. Then the increased fiscal stimulus will lead to higher wage rates and commodity prices. As inflation starts moving from its 1.5% – 2.0% band to 2.5% – 3%, 10-year Treasury rates could potentially reach 5% to 6%. This will increase the cost of borrowing for families, companies, municipalities and the government. Once a bear market in bonds starts, it cannot be easily stopped. The era of free money is over!
Corporate Earnings will Accelerate in 2018 and 2019
To date, the majority of companies in the S&P 500 have reported their actual results for Q4 2017. In terms of earnings, 74% of companies are reporting actual EPS above estimates. In terms of sales, 79% of companies reported actual sales above estimates, the highest level since 2008. For the fourth quarter, companies reported earnings growth of 14.0% and revenue growth of 8.0%. All eleven market sectors are reporting year-over-year earnings growth. Five sectors are reporting double-digit earnings growth, led by Energy, Materials and Information Technology.
Looking at future quarters, analysts currently project earnings to grow at double-digit levels through 2018. For all of 2018, analysts are projecting earnings growth of 18.5% and revenue growth of 6.5% bolstered by volume growth, cost containment and tax reform. S&P earnings could exceed $150 per share in 2018 and $165 per share in 2019. In addition, the global outlook is equally strong according to the OECD Economic Outlook:
“The global economy is now growing at its fastest pace since 2010, with the upturn becoming increasingly synchronized across countries. This long-awaited lift to global growth, supported by policy stimulus, is being accompanied by solid employment gains, a moderate upturn in investment and a pick-up in trade growth. Global GDP growth is projected to be just over 3½ percent this year, strengthening further to 3¾ percent in 2018 before easing slightly in 2019.” –OECD Economic Outlook (November 28, 2017)
Investment Themes for 2018
- Global fundamentals are excellent.
- Interest rates are rising and the yield curve is steepening as global growth accelerates.
- Inflation is likely to move up to 2.5% in 2018 and 3% in 2019.
- Earnings and cash flow gains will surprise on the upside.
- We project that the Dow Jones Index could exceed 28,500 by year-end with further gains in 2019.
The bottom line is to stay the course. We are shifting away from longer-dated bonds and dividend dependent equities. Higher interest rates and inflation could hurt the markets down the road. Financial sector stocks are our favorite sector as they will benefit from higher rates and volatility. Emerging market stocks should benefit from higher commodity prices. While the ride may be bumpy, we are optimistic that the performance for the year will be above average.