Stocks benefited from a healthy global economy and growing corporate profits in 2017. Will 2018 be able to follow in the steps of a strong 2017?
Simply Money Advisors answers this question in our 2018 Outlook, which is based on these beliefs:
- By July 2018, the U.S. economy will officially be in its ninth year of growth, making it the second longest economic expansion in U.S. history. Even though this period is longer than normal, Simply Money Advisors believes the U.S. economy will continue to grow throughout 2018.
- With the economy growing, wage inflation will increase slightly more than it did in 2017. The Federal Reserve (Fed), our nation’s central bank, will increase short-term interest rates two or three times in 2018 to keep inflation from rising too much.
- Simply Money Advisors believes stocks will again outperform bonds in 2018 mostly due to low recession risk. However, stocks will likely experience more uncertainty than they did in 2017, which was an unusually calm year.
- The bonds in your investment mix will help your personalized financial plan by generating income and acting as a buffer from any temporary drops in the stock market that may occur.
We are not “due” for a recession.
Some people are worried we are “due” for a recession simply because the economy has been growing for nearly nine years. The problem with this line of thinking is that economic expansions and recessions are not guided by the calendar. An interesting fact is that the current economic recovery has been weaker than normal despite its duration being significantly longer than the average expansion (the average expansion is about six years).
Economists measure the strength of recoveries by looking at Gross Domestic Product (GDP), which is the value of all finished goods and services produced in a country. In the period following the 10 recessions since 1945, the average GDP growth from its high value before one recession to its high value before the next recession has been about 23%, not including the current recovery. This is known as peak-to-peak growth. The U.S. economy has only grown 14% from the GDP peak in December 2007. This means it may have more room to grow before it overheats and falls into a recession.
Economic data will determine when the next recession arrives, not the calendar. Simply Money Advisors carefully studies many leading economic indicators to get a better sense of the likelihood of a recession. These leading indicators tend to move before the economy does. In other words, if these leading indicators weaken too much, it means the risk of a recession has risen.
Your spending and tax reform will carry the U.S. economy in 2018.
Simply Money Advisors expects spending from consumers like you to keep the U.S. economy growing around 2.5% in 2018. Because the job market will continue to be healthy due to low recession risk, consumers will have money to spend. Since spending habits tend to be relatively stable, we expect consumer spending to remain strong. This is important because spending from consumers like you represents about 70% of the total U.S. economy.
The newly passed tax reform bill may result in a one-time increase in spending, but after that jump, growth rates will go back to normal. Two areas where tax reform may result in a one-time increase are consumer spending and business spending. Consumers may end up spending a little more in 2018 because they will have slightly larger paychecks due to less tax being taken out.
Businesses may spend more not only because they will be taxed at a lower rate (the top tax rate was cut to 21% from 35%), but also because they will be able to immediately expense much of their spending on capital investment (e.g. machinery and equipment). This will allow businesses to lower their taxable income and position themselves for future growth. This could also strengthen the job market because there might be an increased demand for skilled workers
There is a chance that business spending will not increase if businesses think tax reform is not permanent. If businesses believe that the next administration might repeal this law, they will be reluctant to increase their spending. Businesses could use this extra money for stock buybacks and extra dividends instead of investing in future growth by purchasing machinery and equipment. Even if this happens, strong consumer spending in the U.S. and demand for U.S. products from the rest of the world will still allow the U.S. economy to enjoy healthy growth in 2018.
The Fed will raise short-term interest rates two or three times in 2018.
The Fed raised the Federal Funds Rate three times in 2017, and this short-term interest rate is now set to a range of 1.25 – 1.50% (the Federal Funds Rate is the overnight interest rate that banks can lend to each other). Even with these three hikes, short-term interest rates are still well below where they normally would be. This is mostly due to inflation and economic growth being much lower than they usually are during economic expansions. The Fed has been worried that if it raises short-term interest rates too much, the economy could stumble.
The Fed is also likely to slowly raise short-term interest rates because inflation is still below its 2% target. If the Fed is too aggressive with short-term interest rates, inflation could fall further and the Fed could induce a recession. That’s the last thing the Fed wants to do.
Stocks should have a good year in 2018, but they will be more volatile than 2017.
Simply Money Advisors is optimistic about stocks in 2018 for many reasons. The main reason is that recession risk is low. Over the past 50 years, all but one bear market (a drop of at least 20% in U.S. large company stocks) occurred along with a recession. This happens because economic recessions cause corporate profits to drop. When profits drop, stocks are less valuable. Because recession risk is very low as we start 2018, we believe any move lower during the year will be temporary and a possible buying opportunity.
A strong economy led by robust consumer spending should translate in corporate profit growth around 6-8% when compared to 2017 profits. The newly lowered corporate tax rate means profit growth should be even higher in 2018, possibly around 15%. This should be good for your stocks because higher future corporate profits have historically resulted in higher stock prices.
Even though we expect higher stock prices in 2018, we also expect an increase in stock market volatility. In 2017, the biggest drop for U.S. large company stocks was a mere 2.8%. This is the second smallest drawdown in a calendar year ever going back to 1928. This tells us that 2017 was not a normal year when it comes to stock market uncertainty. A normal drawdown for U.S. large company stocks is closer to 11%. It’s likely that volatility in 2018 will be more similar to other years than to what it was in 2017.
Bonds will be an added benefit to your diversified investment mix.
Any increased uncertainty from the stock market means that the bonds in your investment mix will continue to add value by acting as shock absorbers. When stock prices fall, bonds usually increase in value because investors seek safety during these periods of uncertainty. Bonds will also benefit you because of the income they generate. These two features should result in smoother returns for your diversified investment mix.
Simply Money Advisors believes the Fed will likely only raise short-term interest rates two or three times in 2018. Bond prices and interest rates typically move in opposite directions. As interest rates rise, existing bond prices can fall since their interest payments are lower than newly issued bonds.
The Simply Money Point
The economy is not constrained to calendar years. As of now, the economy looks strong and our leading indicators suggest growth will continue. However, should the economic data materially change during the year, Simply Money Advisors will – of course – update our view on the economy. But as we start 2018, the economy and corporate profits look strong.