As 2017 winds down, we see some encouraging developments that could help extend the global bull market into 2018: The U.S. Federal Reserve (the Fed)’s leadership is moving to the safe hands of Jerome Powell, tax cuts are progressing through the U.S. Congress, and Europe has navigated most of its political landmines. The global growth momentum we witnessed in 2017 seems likely to persist into next year. However, many of our sentiment indicators also point to a near-time risk of a pullback. Could 2018 be a year of two halves?
Three scenarios for 2018
The critical issue we foresee is the timing of the next U.S. recession, as this almost always results in an equity bear market. The U.S. still dominates global markets and is further advanced in its cycle than other economies, which means that most scenarios for 2018 are likely to be driven by the U.S. By next April, this will be the second-oldest U.S. economic expansion on record. The Business Cycle Index (BCI) model puts the probability of a U.S. recession in the next 12 months at around 25%, a high, but not alarming, percentage given the age of the expansion. This probability, however, could easily rise through the year, if, as we expect, the Fed tightens another three times in 2018.
In addition, credit and equity markets tend to price in recessions around 6-12 months ahead of time. Given all this uncertainty, we believe it’s best to look at various scenarios for 2018, rather than focus on one story. We think there are three plausible scenarios, with the central scenario the most likely:
- Equity markets face increasing headwinds later in the year. Japan, Europe and emerging markets (EM) outperform the U.S. in what could be a relatively flat year for global equities.
- Growth and earnings are stronger in Europe, Japan and emerging markets.
- The U.S. 10-year Treasury yield approaches its fair value of 2.7% before declining as recession odds grow. The yield curve flattens and potentially inverts by year-end.
Upside scenario: blow-out rally
- Fed is dovish and tightens by less than expected. Growth is ok and inflation doesn’t rise much.
- USD is weak. Emerging markets do very well.
- Euphoria takes hold and investors leverage into the market.
Downside scenario: Fed mistake triggers a 2018 recession
- Fed overtightens into a sluggish economy.
- R-star (the real rate consistent with full employment/neutral real rate) turns out to be much lower than expected.
- Markets hit turbulence in early 2018.
Euphoria: Still to come?
There’s an old saying that bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The phase we have yet to encounter this time is euphoria. This is when we would see the blow-out rally scenario.
Sentiment, from our investment decision-making process of cycle, value and sentiment, provides the main guide to this scenario. It currently seems complacent and overbought, but not euphoric. One of the best indicators is that margin debt has yet to take off. According to the New York Stock Exchange (NYSE), margin debt grew by just 15% in the year through October 2017. Looking through this NYSE data, it often grows by more than 40% in the year before a major market peak, as overconfident investors borrow to gain market exposure.
Could a Fed mistake bring markets down?
Bull markets don’t have to end in euphoria. As another market saying holds, they can be killed by the Fed. One of the key recession-risk issues is working out when Fed policy becomes restrictive. It’s entirely plausible that a couple more Fed funds rate hikes could turn policy restrictive.
We will be monitoring the yield curve closely. This is one of the key inputs into the BCI model. The yield curve has inverted before every recession over the last 50 years. The spread between yields on 10-year and 2-year Treasuries has narrowed from 140 basis points, when the Fed started tightening at the end of 2015, to 60 basis points in late November.
Our 2018 annual outlook overview is very U.S.-centric. It's worth asking whether there are any global factors that could trigger a global bear market1. The main candidate for a non-U.S. shock is China. We're not expecting a China-sparked crisis, but high debt levels are a risk and outgoing People’s Bank of China governor Zhou Xiaochuan recently warned about the risk of a "Minsky moment2”.
The recent Communist Party National Congress entrenched the power of President Xi Jinping, giving him the authority to pursue his reform agenda in his second five-year term. Near the top of his list is deflating the debt bubble. Chinese central bankers have many more levers than their counterparts in developed markets, so the likelihood is they will be able to engineer a gradual deleveraging. But tightening credit in a high debt economy is a fraught exercise. China’s monthly money and credit growth statistics will bear close watching for signs of a sharper-than-expected slowdown.
In sum, we’re not especially bullish or bearish about the year ahead. 2017 delivered better returns than most industry analysts expected, but the cycle is old and the U.S. Federal Reserve (Fed) is about to step up the pace of rate hikes. Our 2018 outlook view in one sentence? Equity markets may push higher over the first part of the year, before facing headwinds later in 2018, as markets factor in rising risks of a 2019 recession.
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1 A bear market is defined as a 20% fall in equity markets. The average S&P 500® Index decline in the six bear markets since 1968 was -42%.
2 A Minsky Moment refers to a sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures. The theory is named after economist Hyman Minsky.