Economic and Market Outlook For 2018: Is This The Year For Value?
The markets in both Canada and the US moved higher in 2017 as the strength in the US came as a surprise.
In this environment, the Canadian portfolio was well ahead of the market average and the US portfolio was just slightly behind. As you are all aware, we are value-oriented investors, and do not like to lag. History has proven that a value philosophy has greatly outperformed over time and has done so with much less risk or volatility.
However, growth stocks performed twice as well as value in the US during 2017. While we underperformed the index by a bit, we greatly outperformed the value sector and other value managers. That bodes well for 2018. If history is any guide, value will probably shine this year, and it has started well in the first two weeks of the year.
What is ahead in 2018?
The world economy is strong across the board; Asia, North America, Europe and the developing world are all doing better simultaneously. The synchronized outlook has not looked this rosy in over a decade.
In the United States, the large reduction in the statutory corporate income tax rate from 35% to 21% and the 100% expensing provision for investment should drive down the effective cost of capital for business – helping to propel expectations for higher corporate profits. Consensus estimates that earnings per share growth for S&P 500 companies are over 13%, against growth of about 9.5% in 2017. Positive leading indicators, high CEO confidence, and strong labour markets all show continuing good times ahead.
Where do we go from here?
Short-term forecasting is always difficult, and it is not our strength at Kingwest, nor is it what we do. Nonetheless, there are some interesting developments that, depending how they unfold, will strongly influence the course of investment markets over the year.
Firstly, the reversal of the loose monetary policy around the world is causing interest rates to change direction and move higher. Since 2009, rising asset prices have been in large measure the result of central banks fuelling the market through the vast stimulus. The risk is that the massive amount of liquidity sloshing around the world begins to fall, causing interest rates to rise faster than expected, and all of this negatively impacts asset prices.
Secondly, inflation is rising. Over the past decade, we have enjoyed an inflation-less recovery in Canada, the US, and Europe. Inflation has been running under 2% which is considered the ‘target’ in the advanced economies.
Nominal wage growth in most advanced economies remains markedly lower than what it was before the Great Recession. The bulk of the wage slowdown since 2009 can be explained by labour market slack, inflation expectations, and trend productivity growth, according to the International Monetary Fund.
Wages look like they may have begun to rise faster than the growth in the economies which may in turn push inflation higher.
There are plenty of jobs now. The unemployment rate in Canada fell to 5.7% in December of 2017, the lowest jobless rate since they began to compile this data in 1976. Just 4.1% of Americans are unemployed. The UK unemployment rate stood at a 42-year low of 4.3%. Even in Europe, a dour situation is showing signs of improvement. The euro area unemployment rate is 8.7%, down from 9.8% a year ago.
The improving labour situation is not surprisingly beginning to push wages higher. In Canada, wages are rising at a 2.7% rate versus growth in the broader economy expected at 2% in each of the next two years.
Wage growth has picked up in the US as well. Wages have been rising above a 4% rate over the past 12 months. Until now, there has been very little wage gains except at the extreme ends of the spectrum with lower level workers in retail, healthcare, and hospitality, and strong sectors such as the financial services and technology taking all of the gains. The vast majority of the economy has seen no wage improvement in years.
The reason may be a cultural, rather than a typical cyclical pattern. Baby boomers and millennials are now the two largest segments in the workplace. The 50-plus crowd that is worried about being replaced by technology do not appear to be asking for a raise, even as the job market tightens. Their main goal seems to be focusing on ensuring they retain their current position until retirement.
Millennials live and work in very different ways than the rest. They care more about freedom and flexibility than higher wages, and spend more on experiences than tangible goods. Whether this trend will continue when these 20-somethings start having their own children and buying homes is questionable, but it certainly appears to be that way for the next few years. Companies understand this! The most recent minutes of US Federal Reserve noted that many employers are giving out additional benefits or non-traditional working arrangements rather than raises. Overall, the strong economic growth and the largest tax cut in 30 years are about to give the economy an additional boost. In that environment, it is probable that wages will continue to rise, pushing inflation higher.
Thirdly, improving corporate investment on plants and equipment. According to Republicans, the point of the tax cut was “to encourage companies to bring back their overseas cash hoard and invest it in productive capital expenditure”. There have been a few post-tax cut announcements about bonuses and more hiring on the part of companies such as AT&T, CVS and FedEx.
It is likely however that the majority of companies will spend the bulk of their tax savings on acquisitions, share buybacks, and dividend payments, just as they did last year rather than expanding plants.
Capacity utilization in the US is just 76.4% and companies do not generally spend money on expansion until the operating rates exceed 83%. It appears that capital spending will not rise for a while, even with the higher growth.
With more than half of executive compensation linked to rising share prices, managements are incentivized to want higher equity prices.
Finally, on the negative side, media coverage suggests that stock prices are in a state of euphoria. This is assuredly true in a few areas — the ongoing mania for cannabis stocks in Canada and crypto currencies in the US exhibit bubble psychology, but euphoria is hard to measure and it requires touchy-feely metrics.
On the other hand, the largest five companies by market value in the US have an aggregate value of $3.3 trillion — that was the value of the entire US market in 1993. These stocks led the market last year and they trade at inflated valuations — roughly 60 times earnings. These stocks substantially skew the aggregate data and are not indicative of the market as a whole. The rest of the market trades more in line with historical norms.
The technology sector is the S&P 500’s largest at almost 24% of the index. Any declines for technology present a significant hurdle for a rise in the overall index, which many strategists and investors predict for 2018.
We always emphasize that we do not own the market but rather individual companies, so this calculation of ‘overvalued-ness’ has little relevance to your portfolio.
The US corporate tax cut will trigger a short-term boom, but the Federal Reserve is likely to counteract with the longer-term economic fillip. The stimulative impact of the tax cuts will be particularly positive for smaller US companies, but the rising chances of interest rate increases could swamp the gains. We will have to watch carefully as these developments unfold. It is a unique moment to have monetary tightening and fiscal stimulus at the same time. At some point, they will begin to negate each other, but it will take a while. We will see a strong economy over the next six months but it is reasonable to expect the higher rates will negate that over time.
The ‘bull’ market may end soon, or it could easily last more than a year, as it did in 1999 and 2000. We are not exiting the stock market for the moment, but these factors are causing us to take a much more cautious approach than we have for a number of years. Our portfolios have a lot more cash than usual currently, in light of this.
Nevertheless, there continues to be opportunities in the market, but we are going to be very cautious about how we take advantage of them.
We continue very positively on the financial sector as it had very strong performance for us last year. Banks earn money on their spread between what they charge their customers to borrow and what they pay on the deposits. As interest rates increase, banks should be able to widen that spread and therefore increase profitability. When the Fed raised rates a month ago, JP Morgan raised its main lending rate by 0.25% but left its rate on deposits unchanged. That was typical in the industry. A quarter of one percent may seem small but when you multiply it by the trillions of dollars in loans outstanding, it will drive bank earnings dramatically higher. A stronger economy, increasing earnings growth, and relatively low valuations — earnings multiples are only 2/3 the multiple of the S&P500 — lead us to believe that financial stocks offer substantial potential for 2018.