29 Jan 2018
U.S. Economic Growth Has Accelerated, but the Potential for Inflation Rearing Is Growing
After the first year ever that saw the U.S. stock market gain in every month (based on the S&P 500), the first weeks of January got off to a bang. Much attention remains on tax “reform”—or better put, tax cuts—and numbers are being crunched by economists and analysts alike to assess to impact on the economy broadly, and corporate earnings specifically.
But the market’s gains, and the enthusiasm around tax cuts, have brought with them elevated investor sentiment. We keep a close eye on the Ned Davis Research Crowd Sentiment Index, which is a composite of seven distinct sentiment gauges. It recently hit an all-time record high (since the data began in 1995); and we have gone a remarkably long time (since November 4, 2016) without a decent-sized pullback (3% or more). Sentiment doesn’t necessarily forecast and we aren’t predicting an imminent correction, but it appears that some of the “cushion” we may have had, should something go wrong, has disappeared. There are any number of catalysts which could trigger the first pullback of some size, and investors need to be ready for it—even if it’s in the context of an ongoing secular bull market. It doesn’t mean making major shifts to asset allocations, but being mindful of staying disciplined around tried-and-true things like diversification and periodic rebalancing. With correlations having come down sharply—both within and among asset classes—and sector rotations occurring more frequently, the benefit of using these disciplines has likely improved.
Technicals, breadth and momentum still offset sentiment concerns
A key reason we aren’t raising more concerns about a major correction at this point is that the aforementioned stock market action has good foundation of support under it. Market breadth remains healthy, momentum remains strong, earnings growth is accelerating further, and financial conditions continue to be loose. And, the economic picture continues to brighten, illustrated by the Citigroup Economic Surprise Index, which continues to show the economy surprising on the upside.
The changes in the tax code on the corporate side have been meaningful: a lower statutory rate of 21%; 100% expensing immediately; territorial tax treatment (companies with earnings overseas will take an initial hit, but then get to bring those assets back to United States tax free). We believe this will result in a decent uptick in capital expenditures (off an admittedly already-elevated level), and at least a modest boost to economic growth.
We also could see some upside surprises to an already relatively solid consumer segment of the U.S. economy. As mentioned, the labor market is tight and we’re starting to see an upward bias in wage pressures. In addition, according to a survey done in late December by Strategas Research Partners, at least 95% of Americans will see larger paychecks as a result of the tax change. Interestingly though, “most” think that their taxes are going up or staying the same; so those folks will be in for a nice surprise come February, when paychecks are adjusted, which could lead to an increase in consumption. That is precisely what occurred when the 2003 tax cuts hit workers’ paychecks. It would serve as a boost to the increase we’ve already seen, as the Mastercard Spending Pulse survey reported that the holiday retail period (between November 1 and December 24) saw a 4.9% year-over-year gain—the best since 2011.
Who’s eyeing the punch bowl?
So what’s there to worry about? For one, as it relates to the consumer, savings rates have dropped even though consumer confidence is quite elevated. Historically when we saw a similar gap, consumption ultimately faltered. And then there are more macro-oriented worries—such as a geopolitical flare-up, more natural disasters, political scandals, elevated trade protectionism, etc. In addition, we think an underappreciated risk is the potential that the Federal Reserve will be forced to live up to former Chairman William McChesney Martin’s famous saying that “just when the party is getting good, the Fed is forced to take away the punch bowl.” With inflation rearing its head, 18 states raising minimum wages (ISIEvercore), a tight labor market (with outplacement firm Challenger, Gray and Christmas recently noting that 2017 saw the fewest job cut announcements since 1990), and rising commodity prices, tighter monetary policy must be taken into consideration.
Tax reform…check! Other major items…in question
Republicans in Washington are completing their victory laps about the tax reform package and now head back to the realities in DC. The markets showed little reaction to a government shutdown and there has been no discernable concern among investors during recent brinksmanship battles. But then there’s the messy process of actually getting a longer-term budget deal done, along with addressing the infrastructure package that President Trump campaigned on; while the Affordable Care Act drama hasn’t had its final act yet either. Although few are relishing the season, we’re in an election year, where Democrats are eyeing both chambers of Congress. Midterm election years have a history of bumps in volatility.
This year seems unlikely to be a repeat of 2017 as volatility should pick up and the possibility of larger pullback than what we saw last year has grown. Investor sentiment—often a contrarian indicator—is extended, which could mean that disappointments or surprises could be met with greater selling than we’ve seen in the recent past. We still believe that the bull has room to run as domestic economic strength is improving and global economies look better than they have in some time, so investors should stay disciplined, diversified and invested.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Ned Davis Research (NDR) Crowd Sentiment Poll is a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.
The Citigroup Economic Surprise Index is an objective and quantitative measures, which show how economic data are progressing relative to the consensus forecasts of market economists.
About the author:
Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist