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Do Worry, Be Happy: Four Considerations for 2018


By Jeff Korzenik, Chief Investment Strategist

Do Worry, Be Happy: Four Considerations for 2018

We approach our personal New Year’s resolutions with confidence they will be fulfilled; we wouldn’t have made them otherwise, right? And yet, they often don’t come to pass. In the same vein, each year we at Fifth Third’s investment management group like to make our predictions about what investors may expect in the year ahead. While we have low confidence in our personal resolutions, we have high hopes for our 2018 predictions. We think you can probably count on 2018 to be another year of solid economic growth and investment opportunity, marking the third-longest expansion in modern American history, which by mid-year will be the second-longest. We’re also experiencing the second-longest bull market in US history. Keep in mind, however, that we are probably at the back end of the expansionary phase of the business cycle, and that means some concerns do loom, if not for this year, then for a few years further out.

Here are four considerations for 2018:

1. It Doesn’t Get Any Better Than This, and It Won’t

Did you enjoy 2017’s investment performance? We hope so, because it’s unlikely that a similar confluence of positive surprises can be repeated in 2018. Around the world, a decade or so on from the Great Recession, we find many of the globe’s key players enjoying a period of economic expansion. (This very much includes ourselves, with unemployment almost too low, Gross Domestic Product finally starting to hum, and inflation staying mum). It’s not a coincidence that the stock market had such a solid year. But looking forward, it appears a little bit more complicated than that.

For starters, we should acknowledge that one reason U.S. stocks looked so good in 2017 is that they didn’t look so hot in 2016. Sure, the domestic market rose about 10% in 2016, but that was after a brutal sell-off at the start of the year, and another uncomfortable period in mid-to-late summer. In fact, it took the surprise results of the presidential election and resultant hopes for tax reform and infrastructure growth packages to really instill those proverbial animal spirits in investors. (Tax reform is finally here, but markets have a tendency to buy on the rumor, sell on the news, as they say, so how much it will boost markets from this point on is not an obvious call.)

Another tailwind: A weakening in the dollar. Go back to January of last year, and London was, you know, almost affordable. But the dollar backed up as the year grew long. This presented upside: U.S. exports became more competitive, and the earnings abroad of multinational corporations translated more favorably when converted back into dollars. This occurred without setting off inflationary complications in the U.S.

Will that trifecta of good news—global economic synchronization, easy comparisons, a weaker dollar—repeat itself in 2018? It’s unlikely.

2. Peak Policy: Priming the Pump … Until the Well Runs Dry

A solid portion of the American economy’s (and the stock market’s) gain in 2017 reflects a period of “peak policy,” in which the executive and legislative branches, along with the Federal Reserve, have made a series of investor-friendly decisions. Deregulation has been the (executive) order of the day; the administration says it has eliminated 16 rules for every single one it’s promulgated. There will continue to be a business-friendly tone coming out of the nation’s capital, but there are only so many rules to be rescinded. A lot of the changes, and the boost from those changes, will likely have diminishing returns as 2018 progresses. Don’t look for too many upward surprises on the deregulation front.

Changes in tax policy, as noted, may have already been reflected in the markets in 2017. How much they will stimulate the economy in 2018 is open to question. Although there are certainly ongoing benefits to the lower corporate tax rate, they won’t be felt nearly as much by the average individual taxpayer. Taxes may very well fall for many people, but not necessarily by meaningful, life-altering, economy-changing amounts. Keep in mind, the economic stimulus that does occur from tax reform is coming at a time of nearly full employment. In a recession, tax reform might prove transformational. But at this point in the economic cycle, the effects will be muted. That being said, the bill is likely to spur business investment, a major driver of productivity. The combo of tight labor markets, stronger productivity and flush balance sheets is a recipe for higher wages.

As for the Federal Reserve and monetary policy, interest rates have gone up as the Fed seeks to normalize the cost of credit. Rates are clearly poised to rise some more, with a minimum of three rate increases expected in 2018. And the Fed is likely to continue trimming its balance sheet, a tightening by another name. (The European Central Bank and the Bank of Japan are still buying bonds, but they are simply running out of bonds to buy.) It’s quite possible that short-term rates will rise faster than long-term ones in 2018, perhaps to the point where the yield curve becomes inverted. Such a condition, where short term rates are above long term rates, is often associated with the end of the growth phase of the business cycle, if not this year or next, then soon enough that it’s worth one’s while to keep tabs on it, and to plan portfolios accordingly.

3. Employment: What’s Wrong with this Picture?

Jobs are never far from our minds, in any year. The labor market appears to be entering 2018 as essentially a victim of its own success. Unemployment is extremely low; many observers use the term “full employment” to describe the state of the U.S. economy, as in, everyone who wants a job already has one, thus keeping the labor-force participation rate at multi-decade lows. This reflects structural changes in our economy but also a hangover from the discouraging depths of the financial crisis-caused recession. The opioid crisis reflects these trends. This crisis has single-handedly wiped out a huge tranche of workers, perhaps as many as 1.4 million prime-age males alone, according to Prof. Alan Krueger of Princeton University. But it’s vital for the health of the economy that new workers come into the workforce; we estimate that we need a net 1.25 million fresh faces a year beyond natural demographic growth and immigration to keep the economic expansion going.

So where will these workers come from? So-called Second Chancers—ex-convicts released and trained—present an enormous opportunity to fill this labor-force gap while being re-integrated into society in an enduring, positive way.

None of this is to say that labor issues present only problems, by the way. We believe productivity and wages will start to look better going forward. Corporate profits should improve with tax reform, and along with that, so, too, should the capital expenditures that lead to increased productivity. Higher productivity = higher wages. As the Millennial generation—the biggest cohort in today’s labor force—gets older, they also get more experienced (and productive).

Millennials are also finely tuned to technology and all it offers in the workplace. There is a school of thought that certain technologies, for example, artificial intelligence, will eventually replace people faster than they create jobs. If so, that will be the first time in history that has happened, and if it does occur, it will still be many, many years from now. For now, technology is a net positive for the workforce.

4. It’s Not the Debt, It’s the Liability

Pension and retiree health benefit funding can seem like the most mundane of topics, unless you happen to have a pension or are eventually in line to get one, or when you stop to consider that your tax dollars may need to rise to fund them. Perhaps it’s not such a mundane topic after all. As we sit here in the ninth year of the economic expansion, we are sad to report that many state and municipalities have not really seized the moment to get their pension-funding houses in order. Pension investment returns have been outsized, yet various states and cities around the country remain in distress. Overall, yes, the issue has been dormant, but it’s far from gone and might rise in significance as the business cycle moves forward and possibly ends. Slower growth will only put more strain on state and municipal budgets. One worry is that pension-fund administrators, if they can’t get the funding that they want, may try to get the investment returns they need. Chasing returns rarely ends well for investors, whether they are individuals or investing on behalf of many.

The Market May Be on Auto-Pilot but We Aren’t

While the financial crisis 10 years ago was global in nature, the recovery hasn’t been fully realized internationally. The U.S. economy has been way out in front of the rest of the industrialized world and also emerging markets. Unfortunately, “first in” can also come to mean “first out.” International diversification of portfolios is now more important than ever. Europe appears to have room to grow, and Japan’s policy changes seem to have some shelf life left in them.

Back at home, rising short-term interest rates may put upward pressure on long-term rates, but that doesn’t mean we see destructive inflation on the horizon. The Fed remains vigilant, and while we see rising wages, we believe productivity will provide an offset, preventing broader inflation.

Add it all up, and in baseball terminology, the U.S. economic expansion may very well be its eighth inning. As we’ve seen recently, a lot can happen in the late stages of a game. There’s the risk—but also the opportunity. In other words, do worry, but be happy.