- Solid global growth offers support for the bull market to continue in 2018.
- U.S. tax reform may help to lift stocks by encouraging business investment spending.
- The major risk we see is central bank tightening that could become too aggressive.
Can market calm continue in 2018?As we noted in our previous quarterly update, some of the impressive 2017 statistics were driven purely by a solid fundamental environment — a synchronous uptick in global macroeconomic growth and corporate earnings. In addition, it was certainly helpful that some of the more ominous risks that had emerged on the horizon several quarters earlier failed to materialize. Heading into 2017, we had identified populist political movements and the new U.S. administration's campaign platform of protectionist trade policies as risks. In actuality, we saw populist pressures ease in election outcomes and the U.S. administration show restraint, at least temporarily. It is certainly too early to call the all-clear on these issues: Germany's Chancellor Merkel is seeking to form a coalition government that is expected to be much weaker than its predecessor; an imperiled U.K. Prime Minister, Theresa May, is struggling through Brexit negotiations; and the NAFTA renegotiation talks among the United States, Canada, and Mexico are now into their sixth month with no major breakthrough. However, there is evidence that markets are taking them in stride.
At the outset of 2018, two key issues — the effects of changing U.S. fiscal policy and global monetary policies — need to be assessed to determine whether markets can keep rolling.
Will tax cuts stimulate more business investment?Real global growth rates have finally risen to the pace experienced in the mid-2000s. With Purchasing Managers Index (PMI) readings around the world — an indicator of business activity — looking "toppy," and market valuations on the expensive side of fair value, what will it take to boost these real growth rates?
Capital expenditures would seem to be the obvious candidate, and the new U.S. tax policy changes could promote capex. The late December passage of the Tax Cuts and Jobs Act of 2017 allows a five-year period for U.S. corporations to fully expense capital investments in the year in which the outlay is made. Another provision allows a holiday period in which corporations can repatriate cash held abroad from foreign affiliates at deeply discounted tax rates that are even lower than the reduced statutory rate. Supporters argue that the combination of an almost 1% boost to real GDP from immediate fiscal stimulus and a multi-year runway for expensing of capital investment will provide strong incentives for the corporate sector and "unlock" pent-up investment spending.
Analyzing the tax packageThe only relevant recent analogue we have as a basis for comparison with the new tax package is the 2003 Bush tax cuts, which allowed for 50% expensing of capital investment, and then phased out quickly. This example is murky because the U.S. economy at that time was still in the process of emerging from the recession following the bursting of the tech bubble in 2000. Also, the resultant spending by the corporate sector was likely pulled forward by the sun-setting nature of the expensing benefit, having the effect of depressing growth in the further-out years.
While this comparison suggests capital investment will increase, another perspective that focuses on the distinctive characteristics of this cycle is more pessimistic. In this view, global disinflation has kept a lid on the prices of capital goods, so that investment spending is depressed in nominal terms only. When viewed in real (price-adjusted) terms, the recent trajectory of capital expenditures actually looks quite normal. In other words, there is little pent-up investment spending waiting to be released. Adding to this view, in a recent op-ed Michael Bloomberg argued that corporations are already so flush with cash that enticements to invest via these new tax code changes won't matter at all.
We believe that the truth is somewhere in between. We do not dismiss the importance of a large immediate burst of fiscal stimulus to financial markets. And financial incentives are powerful motivators, so CEOs and CFOs will be enticed to maximize the benefits afforded to them by this change in the tax code. However, while risk assets have some incremental upside as a direct result of the landmark GOP accomplishment of 2017, this enthusiasm is tempered somewhat by the knowledge that there remains quite a bit of excess capacity already in the system in the traded goods sector.
What will be the effect of tighter monetary policy?When assessing monetary policy, we must first consider what measure of quantitative easing (QE) matters most for financial markets — the stock or the flow.
The stock refers to the overall size of central bank balance sheets, whereas the flow is the amount of periodic asset purchases. The stock is still large, but the flow is fading, with the Fed now fully engaged in reducing its balance sheet and the European Central Bank (ECB) likely to announce a specific tapering plan in 2018. With the monthly supply of liquidity that markets have become accustomed to now declining, those who believe QE flow matters more anticipate that markets might struggle. This contrasts with a view expressed by many policy makers that the overall size of a central bank's balance sheet is more important.
On this matter, we tend to side with the latter point of view. Earlier in 2017, we had some concern that the Fed's switch from actively buying Treasuries and mortgage backed securities to shrinking its balance sheet might cause an uptick in volatility. This turned out not to be the case, which leads us to believe that the size of the global central bank balance sheet — the combined size of the Fed, Bank of England, ECB, and Bank of Japan (BoJ) — is more important in supporting monetary conditions. Our current view is supported by empirical research, including a paper published by Federal Reserve staff that suggests that the "stock" effect on yields might be as much as eight times as large as the flow effect (D'Amico and King, "Flow and Stock Effects of Large-Scale Treasury Purchases," April 2011).
Since the pace of the decline in the size of the Fed's balance sheet is being offset by continued purchases by the ECB and BoJ, we believe there is still time before global monetary conditions become restrictive.
The market rally is poised to continueWith our answers to these two critical questions, we look rather optimistically toward the beginning of 2018. While risk asset valuations continue to indicate a cap on upside potential, valuation has limited utility in anticipating market corrections. We continue to give the rally in almost everything the benefit of the doubt, but we will be looking for signs of inflation that could cause central banks to tap the brakes a bit more forcefully.
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