The S&P 500 Index surged almost 875 points from late January 2016 through the end of 2017 and then another 75+ points in the first six days of 2018. This “gallop” higher represented more than a two percentage point per month average increase. And, for the first time ever, the S&P 500 Index posted 12 consecutive monthly total return gains in 2017.
An improvement in economic activity, a rebound in corporate profits, steady and predictable normalization by the Fed, a reduction in regulations, and, most recently, a much-anticipated cut in corporate tax rates were all catalysts to this rally.
Even with the strong start to 2018, the stock market may transition from a gallop to a grind higher as “good news” may have a smaller impact on returns, especially if signs develop that inflation may be poised to move higher and the Fed shifts to a more hawkish tilt.
The Economy and Earnings Drive Returns
The U.S. economy, in line with our long term view, has clearly moved into a stronger growth mode as the domestic economy expanded at around a three percent pace in the final nine months of 2017. The short-term stimulus from the tax cut package is likely to produce continued solid growth in 2018. On the earnings front, corporate profits expanded at close to a double-digit year-over-year pace in 2017, and, with the added help from lower corporate tax rates, after tax corporate profits and, most importantly, corporate cash flow should increase to the mid to upper teens in 2018.
Markets React to Stronger Growth Expectations
Interestingly, the stock market’s initial reaction to the passage of the tax package was muted. A significant portion of this good news may have already been priced into the capital markets as equities rallied about 10 percentage points from mid-August to late-December in anticipation. Portfolio rebalancing at year-end, particularly by pension funds, also served to limit the upside response from domestic equities. As the calendar flipped to 2018, so did some asset allocation models as the New Year brought a surge in equity prices, at the expense of U.S. Treasuries, as witnessed by the latest back-up in 10-year Treasury yields to 2.55 percent.
The rise in U.S. Treasury yields appears to partially reflect increased market expectations for unintended consequences of the tax plan, including higher budget deficits and growth potentially leading to higher inflation. The result may be a realization among investors that more aggressive monetary policy normalization could be on tap. In mid-December the domestic Treasury market was priced to reflect less than two Fed rate hikes for the upcoming year, versus the Fed’s interest rate “Dot plot” which showed most FOMC members forecasting three rate hikes. Moreover, it is generally anticipated that the Fed’s planned reduction in the size of its balance sheet will act like an additional rate hike. At the same time, both Japanese and European officials are likely to temper the amount of stimulus they are providing to the capital markets. Likewise, the stronger economic growth may signal a bottoming in input costs and, with signs pointing to stronger business capital expenditures as well as higher wage and benefit costs, inflation is likely to accelerate modestly in 2018.
Signs to Watch
In the upcoming year we will watch factors that impact these conditions carefully. Our concern is that the smooth sailing we have seen the last two years may face turbulence ahead. The result could be a shift from a galloping equity market to a grinding equity market, whereby total returns moderate to be in-line with our five-year projections for mid- to upper-single digit gains. Strong near-term earnings and cash flows from tax cuts are likely to be partially offset by a modest compression in the price to earnings ratio.
As we first showed two years ago and reiterate in the chart below, equity returns in a rising interest rate environment, defined as periods when the Fed is tightening monetary policy, have generally been positive. Since 1958, we have had 15 such periods and gains have been recorded in 13 of the 15 periods, including the current one. However, with equity returns since the start of the latest tightening cycle in December 2015 running at close to a 20 percent annual pace, or more than seven percentage points per year above the norm, some reversion to the mean is likely in the year ahead.