January 2018 Monthly Outlook

by on Feb 5, 2018 Categories: monthly outlook, us stock market, us bond market, us economy

Economic Commentary

The first estimate of Q4 real GDP came in at 2.6%, less than the 3.2% recorded in Q3. This slight dip was most likely due to a drop in new home sales (due largely to a shortage of supply), a downtick in inventory investment and an increase in imports (which restrains growth). We remain upbeat about 2018 as the low housing supply will spur home building, and the drop in corporate tax rates should provide short-term fiscal stimulation, both of which justify increased consumer spending. The monthly inflation reports showed inflation remaining stable in December, but there is speculation that inflation will pick up in 2018, potentially causing the Federal Reserve Bank to raise rates at a faster pace than predicted 

The Conference Board Leading Economic Index® (LEI) for the U.S. increased 0.6 in December to 107.0 (2016 = 100), following a 0.5 increase in November and a 1.3 increase in October. “The U.S. LEI continued rising rapidly in December, pointing to a continuation of strong economic growth in the first half of 2018. The passing of the tax plan is likely to provide even more tailwind to the current expansion,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. “The gains among the leading indicators have been widespread, with most of the strength concentrated in new orders in manufacturing, consumers’ outlook on the economy, improving stock markets and financial conditions.” 

Indicators point to the U.S. economy accelerating in the short term to 3% annually from a long term rate of ~2% annually. We remain in the late stages of a long business up-cycle and are starting to see signs of major excesses that have brought down some prior economic upturns.

Stock and Bond Market Commentary

Stocks got off to a tremendous start in 2018, as the S&P index increased 5.64% in JanuaryEven better, the first estimate of Q3 S&P500 earnings showed a 5.3% increase in quarterly earnings, therefore the annualized earnings yield of the S&P500 only decreased slightly in January to 3.79%.  

January's 0.32% increase in long term interest rates was fairly significant. The expectation is that inflation will increase with the large increase of U.S. government borrowing (an expected $1 trillion more in 2018 than 2017) to finance the recent corporate tax cuts. This increase in long term interest rates caused the bond index to drop 1.13% in January, and interest rate sensitive sectors such as real estate and utilities to drop over 3% last month. We have been managing our clients' portfolios in the past year to prepare for this inevitable rise in interest rates by shifting to sectors that will benefit most from the increases in economic growth and inflation.    

We continue to actively monitor market indicators for potential signs of a recession or market correction. As mentioned in previous months all 7 official U.S. recessions and 89% of U.S. stock bear markets were preceded by an inverted yield curve. The extend U.S. stock market run also presents the possibility of a market correction, defined as S&P index drops of greater than 10% but less than 20%. These occurrences are twice as frequent as recessions but shorter in duration. There are few if any warning signs and it is futile to attempt to avoid them. It is best to use these occurrences as opportunities to increase stock allocations.    

In the short term (1-3 years), until the Federal Reserve raises interest rates to a level that incentivizes investors to take less risk (vehicles like savings accounts, money markets, CD’s), investors will probably continue putting more funds into riskier assets such as stocks and real estate pushing up the price levels and valuations on these asset classes. Over the longer term, investment in businesses (i.e. stocks) should provide superior returns to all other classes.