Eye on the Markets - 2018


Global Economic Picture Strong

By Ketu Desai

The market finished the year strong behind continued economic strength, low interest rates, and a passed tax cut. Telecom and energy were the worst performing sectors for the year, but performed the best during December. In general, this month, investors sold the best performing sectors for the year, in favor of underperforming sectors. Traditional retail names worked great over recent weeks, as retail sales rose 5 percent, the highest growth rate since 2011. On the flip side, investors took profit on tech names. Optimism on the global economy and a weaker dollar helped emerging markets and oil rally. Gold finished the year with its best since 2010. The Federal Reserve raised rates during the month, but it was widely expected, and was treated as a non-event in the market.

As we go deeper into the year, the global economic picture appears to be strong. The global economy is growing at its fastest pace since 2011. In 2018, most expect the global economy to grow between 3.5 percent and 4 percent. The growth appears to be broad based, as all 45 countries tracked by OECD are expected to grow. Even countries such as Brazil and Japan that have struggled are expected to grow at significantly higher rates than in recent history. India and China are expected to grow 7.5 percent and 6.5 percent, respectively. Europe also appears to have stabilized, and is now showing levels of PMI, confidence, and manufacturing activity that have not been seen in years.

Domestically, we have had two consecutive quarters of 3 percent+ growth, and are on track for Q4 growth of 2.8 percent according to the Atlanta Fed. For 2018, the U.S. is expected to grow 2.5 percent. However, there is some risk to the upside. Take a look at these passages from FedEx and Paychex earnings transcripts from late December. As you will see, growth and earnings estimates could get revised up, as companies adjust to the new rules, and potentially pull investment forward.

FedEx: “Passage of U.S. tax reform could add materially to next year's U.S. GDP forecast. Globally, our world GDP forecast for this year and the next reflects the best growth since 2011 with a synchronized global upturn supporting trade volume growth."
On Capital Expenditures: “So we have a couple of other questions here on CapEx and expensing, and the part that is often missed in the conversation because of the politics involved in this situation is if the tax bill works as anticipated, there will be a significant growth in GDP.

And remember that the Business Roundtable did in a survey prior to this tax bill passing and 82% of the BRT membership anticipated that if it did pass that it would substantially increase their capital expenditures, and 75% anticipated that they would increase employment. Well, they're not making additional CapEx and increasing employment for any other reason than the market is growing.
So if we increase capital expenditures, as Alan said, it will be because the market is growing. We think we can make more money and increase cash flows and so forth. But there's not just any willy-nilly interest in increasing CapEx other than for that except for one thing. In the case of expensing, you increase the net present value of the returns if it is a replacement piece of capital because you get in, in place earlier and you get your money right back.

So to that extent, it would be bringing the money forward and not spending it later. It's the CapEx for GDP growth rates induced by the tax rate that is the important part of any increase in CapEx."

Paychex: “Let's look at the guidance for 2018. It's unchanged from what we've provided last quarter. This guidance doesn't reflect any impact from tax reform legislation. What we try to do in both the press release and you will hear in a second is supreme, what we think the ongoing benefit from tax reform will be for us…We anticipated (the benefit) to be in the range of 10% to 12% on our annualized effective tax rate."

On Capital Expenditures: “there some technology investments that could be made over the next, this fiscal, next fiscal, that while you're getting the biggest benefit of tax reform that we could accelerate those investments to maybe speed that up."

Goldman Sachs expects the plan to boost growth by 0.3 percentage points in both 2018 and in 2019. If growth does continue, the risk then becomes inflation and faster rate increases. Forecasts for Fed rate hikes for 2018 range from 2 to 4, despite inflation being muted, core PCE is up just 1.5 percent on a year over year basis. There are signs, however, of wage pressure, which would boost inflation. One of the key reasons for higher than average equity valuations, has been the low level of interest rates, and the relative attractiveness of equities, and if we start to see inflation and higher rates, then the attractiveness of equites begins to be questioned.

Equity Risk Premium:

Source: i-squared research

As the graph above shows, if rates increase, bonds increase their attractiveness to equities. Further, as rates increase, we could see multiple compressions. With the tax cuts now passed, it is likely that 2018 S&P earnings will be in the $150s, the multiple applied makes a big difference in returns, and rates are a key determinant of the multiple. Multiple compression of a turn or two could mean the difference between a respectable year and a down year. If rates spike, it will also cause repricing in other asset classes such as gold, currencies, emerging markets, and high-yield. As we all wonder, how long the good-times will last, rates and inflation are key fundamental indicators to keep a close eye on