The Economy and Markets at Midyear: Is the Outlook Heating Up?

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Coming off of a strong year for the economy and markets, we had high hopes for 2018, but the first half of the year didn’t play out as planned. Between the stock market pullback early in the year; the slowdown in economic growth; and rising risks, largely in trade, expectations softened. As we hit the midway point for 2018, though, it looks as if those initial hopes might be more realistic than they seemed even a month ago.

For example, job growth has actually accelerated this year, bringing us, more or less, to full employment. And with continued wage income growth and ongoing high confidence, consumers are both able—and willing—to spend. Businesses are confident, too, and business investment is showing signs of accelerating. Meanwhile, tax cuts and fiscal stimulus have taken government from a headwind to a tailwind.

With this foundation, we should see continued growth in the second half, fueled by the following trends:

  • Employment is likely to continue to grow, albeit at a potentially slower pace than in the first half of the year.
  • Businesses should keep and even increase their investment as capacity utilization rises and labor becomes scarcer.
  • Government spending patterns, now that the tax cuts and spending deal are in place, should continue to revert to growth as tax cuts spur personal and corporate spending.

All things considered, I expect to see real economic growth of around 3 percent, with the potential for better results. Assuming consumer spending growth of around 3 percent, business investment growth near 5 percent, and government spending growth around 2 percent, this 3-percent figure appears both reasonable and achievable. Combined with an anticipated inflation level of 2 percent for the year, nominal growth should approach 5 percent.

Factoring in the Risks

Looking at the economy, there are risks both to the upside and the downside. On the upside, if wage growth increases, consumer spending power could increase more quickly. If consumer borrowing were to pick up, spending could grow even faster. Business investment could respond to improving demand and rise more than expected. Local and state governments could increase investment and hiring more than expected.

On the downside, politics presents the greatest risk. Here in the U.S., the midterm elections will certainly disrupt the political process. If Democrats appear likely to take one or both houses of Congress, it could raise substantial economic uncertainties. In the nearer term, the administration’s trade policies could disrupt supply chains and increase costs, which would have consequences for financial markets. Abroad, risks include North Korea and continued political turmoil in Europe. Any of these could result in systemic damage, which could create real drag on the U.S. economy and financial markets.

Another major downside risk is rising interest rates. In its most recent press conference, the Federal Reserve seemed to declare victory on both employment and inflation, which could mean the Fed will raise rates faster than previously anticipated. Current expectations are for at least two more increases in 2018, and with long-term rates constrained, we could be at risk for an inverted yield curve—a harbinger of recession.

Turning to the stock market, 2018 could be quite exciting, in both a positive and a negative sense. Earnings growth should continue to improve overall on the heels of economic expansion, as companies continue to benefit from the tax cuts. As growth accelerates and risks from Europe and North Korea subside, valuations may rise back to previous highs. And they could move even higher on a positive shift in investor sentiment.

There are certainly risks to the market on the downside, however. Valuations are at or above 2007 levels; in other words, they are at historic highs. Profit margins are also at historic highs, and the tailwinds that got them there are disappearing as interest rates rise and wage growth continues to pick up. That’s not to mention that rising interest rates may make bonds more attractive as an investment, which could also weigh on valuations.

Looking at the past three years, 15x forward earnings has been a typical lower-end multiple. Based on current analyst expectations of $176.52 in S&P 500 earnings for 2019, and using a 15x multiple, the 2018 year-end target for the index would be around 2,650, which represents a decline of about 5 percent from mid-June levels. This is a reasonable downside scenario for the end of the year.

If the economy continues to grow, and businesses continue to operate at very high profitability levels, valuations could rise back to around 17x forward earnings. This is more in line with what I expect and would leave the S&P 500 around 3,000 at year-end, an increase of almost 8 percent above current numbers.

Things Are Looking Up

This is definitely not a prediction of a flat, boring market. Absent the Fed’s security blanket, the market should be more volatile, and I believe it will be. A sell-off at some point in the next six months is very possible, with the rising concerns about trade one potential cause. In addition, as rates rise, I also expect investors to reassess the attractiveness of U.S. stocks versus fixed income. Finally, I expect wage growth to accelerate, which should have a negative effect on profit margins, even as it boosts the economy as a whole.

While the downside risks are real, the ongoing strength of the U.S. economy should protect us from the worst and even continue to offer some upside. The outlook for the second half of 2018, therefore, looks like it’s heating up enough to provide us with more growth in the real economy and financial markets. So, as I like to say, keep calm and carry on.

Brad McMillan, CFA®, CAIA, MAI, is managing principal, chief investment officer, at Commonwealth Financial Network®, the nation’s largest privately held RIA–independent broker/dealer. He is the primary spokesperson for Commonwealth’s investment divisions.

This article is intended for informational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. This commentary contains forward-looking statements that are based on reasonable expectations, estimates, projections, and assumptions. They are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s.

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