By Tom Galvin
- 2017 was an exciting year for returns in stocks
- Investors should expect positive but moderate returns in 2018
- We believe the secular bull market in stocks is intact
2017 was an exciting year for equity markets around the world. Investors looked past rising geopolitical tensions, governmental leadership changes and anticipated shifts in monetary policy, focusing instead on the strong fundamentals of improving economic activity and strengthening profit growth. Helped by solid and accelerating global growth, corporate revenues grew nicely and margins were solid, generating EPS growth in the U.S. of approximately 10%. Rising earnings were a strong influence in the 21.8% total return for the S&P 500. The balance came from a rising PE multiple, with returns also helped by lower-than-expected inflation and interest rates.
We remain bullish on stocks, and we expect positive returns in 2018. We believe the pace and direction for U.S. equities will be influenced by several key factors. The first is our expectation that economic activity on a global basis will be solid. Tax cuts in the U.S., while likely to have a modestly positive impact on overall economic activity, will help corporate profit growth significantly in 2018 – we are looking for an increase of 10%-14% (see charts). Spending by consumers and corporations should increase modestly from 2017 levels. Inflation, while likely to rise somewhat, should remain low in 2018. This in turn should help keep interest rates low, a positive for multiples, which we believe will remain elevated. Despite the positive earnings backdrop, volatility will likely be higher in 2018 from exceptionally low levels in 2017. Potential risks are centered on rising geopolitical tensions, the ability of companies to deliver on heightened earnings expectations, potential mistakes in monetary policy, and actions by the Trump Administration that would hurt global trade.
After the dramatic surge in U.S. equity prices in 2017, we think investors should expect more modest returns in 2018, in the 5%-7% range, as valuations are high and a certain amount of the benefits of tax cuts has likely been discounted by the market. With the risk of recession low, and with a favorable backdrop for profit growth, we believe the secular bull market will continue.
Read the next article in this series: Positive Year Expected for Fixed Income Markets
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There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.
Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.
Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).
There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.
Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.
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The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.
The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.
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