Year Ahead 2018 regional outlook: U.S.
29 November 2017
This article is part of the UBS House View Year Ahead 2018, our yearly outlook on markets. You will find investment ideas and portfolio implications in the full report.
The US economic expansion has now spanned 101 months, making it the third longest of the postwar era. Meanwhile, the 350% cumulative total return for the S&P 500 generated thus far during this bull market represents the third highest in history. There are many who now openly question just how much longer each can endure.
While there is no shortage of factors that will likely affect the outcome, both the durability of the US expansion and the sustainability of the current bull market will depend, to a large degree, on the three themes that loom large in this edition of the Year Ahead: politics, policy, and profits.
Seldom has politics played such a prominent role in discussions about the outlook for economic growth and financial market returns. On the geopolitical stage, escalating tension on the Korean peninsula, ongoing Middle East unrest, a surprising crackdown on alleged corruption within Saudi Arabia, increasingly contentious trade negotiations, and greater assertiveness on the part of China all pose challenges for US policymakers. The unconventional manner in which the current administration conducts foreign policy suggests that flare-ups in geopolitical hot spots and/or rising trade tensions could threaten both the economic outlook and market return prospects.
But domestic political dynamics may present an even less welcome development. Recent local election results hint at a backlash against the Trump administration. While care must be taken not to over-interpret these results, Republican congressional leaders are increasingly wary about their ability to maintain majorities in both houses of Congress in the upcoming midterm elections.
Markets rallied sharply following President Donald Trump’s victory last November amid a shift in expectations of what was now possible in Washington. To the extent that the prospect of a divided government after the midterms threatens the pro-growth agenda, they could well come under some short-term pressure.
However, political events alone are unlikely to materially alter the market outlook, and the US economy is showing little evidence of the sorts of imbalances and excesses that typically mark the terminal phase of the business cycle. The executive branch will likely continue to make progress on its deregulatory push, regardless of the makeup of Congress. Should political events impact economic or market return prospects, they most likely will do so by markedly shifting either monetary or fiscal policy dynamics.
The Federal Reserve is two years into the process of resetting interest rates. It has also taken its first tentative steps toward normalizing its balance sheet. All this is occurring amid the most significant turnover of the central bank’s leadership structure since the 1930s. In addition to a new chairman and vice chairman, three governors are likely to be appointed to fill currently vacant seats, and the replacement for outgoing New York Fed President Bill Dudley, who is retiring early, will be named.
These changes, coupled with the regular rotation of regional bank presidents, mean that there could be as many as nine fresh faces among the twelve voting members of the Federal Open Market Committee, a leadership shift that could well trigger uncertainty about the direction of monetary policy and begin to weigh on markets. But any ratcheting up of market volatility associated with a leadership transition at the Fed is apt to prove temporary. Jerome Powell, tapped by President Trump to replace Janet Yellen as the next Fed chair, is a seasoned central banker whose policy views are very similar to Yellen’s – although perhaps a bit more lenient on regulatory issues.
What’s more, the Fed has evolved from a “majority of one” into a more deliberative and consensus-seeking body over the years. Since much of the expertise has become institutionalized within the Fed ranks, we look for steady stewardship and policy continuity.
As monetary stimulus wanes, many see a more expansive fiscal policy mix as filling that void. Congress is still putting the finishing touches on a tax reform plan that provides more targeted tax relief to corporations and middle-class taxpayers while likely also raising overall government debt by about USD 1.5tr. As it stands now, the tax package will only marginally improve growth prospects – perhaps boosting GDP by an additional 0.2% in 2018. Instead, it is the impact that tax cuts might have upon the corporate profit picture that represents the biggest potential benefit to investors.
US earnings growth reaccelerated in 2017 amid improved global growth dynamics, a softening dollar, and a rebound in depressed energy sector profits. Although the tailwinds from the weaker greenback and firmer oil prices may fade, leading indicators suggest that earnings are still on track for solid gains this coming year thanks to healthy consumer demand and a revival of non-energy-related capital spending. Somewhat higher rates and greater lending activity should also create a more favorable environment for bank earnings.
But tax reform could well determine the difference between a solid year for earnings growth and a stellar one. We estimate that tax reform could lift S&P 500 earnings per share (EPS) by about USD 10. The combination of lower corporate income tax rates and the repatriation of nearly USD 1tr of overseas cash would provide a significant earnings boost.
Whole new year
Two of these three P’s – politics and policy – could threaten the economic expansion and bull market in 2018, but the profit picture remains a formidable obstacle to that happening. What’s likelier is that financial markets will experience greater turbulence and perhaps more corrections than their tranquil journey in 2017. Politics and policy may not have acted as market tailwinds this past year, but they wound up being benign sources of risk. But even though the year ahead may prove more eventful amid policy shifts and political realignment, we retain our positive view on risk assets overall – at least for a while longer.