A year ago, the Dow Jones index received a boost from the US election, though it was unable to break above 20,000 before New Year’s Eve. Surrounding the election of an inexperienced President was a growing concern that stimulus policies would get bogged down in what appeared to be a weekly dramafest. This week, the Dow was headed towards 25,000 on passage of the tax reform bill, but are we indeed over the wall of worry?
If we break down the roughly 25% gain in the Dow this year, most would attribute at least half to the expectation of tax cuts and infrastructure spending. The remainder would come from improved economic growth and corporate earnings—both of which we saw over the course of the year. These two factors are important as were key to the acceleration in equity valuation growth this quarter, as investors were treated to back-to-back quarters of 3%+ GDP growth in the US. To put this in perspective, the advance in the Dow this quarter of just over 10% was more than double any other quarter this year (Q1 gain was 4.5%, Q2 gain was 3.3% and Q3 gain was 5%).
Looking ahead into 2018 there is anticipation of a further acceleration in growth based on the tax cuts in the bill, but I wouldn’t hold out much hope for a massive move higher. Indeed, year-over-year growth in the US is still just above 2% even with the ramp-up this year. The peak growth rate this cycle was a little under 4% and that was back in 2015. Keep in mind also that we are in the late stages of the economic cycle. Going back over the past 40 years, the time in between economic troughs has averaged 8-1/2 years. The shortest gaps were 7-1/2 years (1975-82 and 2001-09). The longest gap was in the 1990s at 10-3/4 years—coinciding with the record long equity market rally.
The last trough in year-over-year growth was back in the second quarter of 2009 and, assuming we end 2017 with positive growth, this will be exactly 8-1/2 years since that bottom. Taking the consensus view that growth in 2018 will at least remain positive, this would put us at 9-1/2 years this time next year and applying the record cyclical gap would be the first quarter of 2020. That is interesting math, but the key takeaway is that these are gaps between cyclical troughs, meaning that even if we hit the record this would entail a slowdown/recession in 2019.
Financial markets can sometimes be viewed as irrational and overly exuberant, like the bubble in bitcoin or a 46% advance in US defence and aerospace shares since the US election of 2016. The stock market can also be a decent indicator of what the economy will look like down the road. If indeed, the probability of a slowdown in 2019 is high, then stocks will start to reflect this at least six months before. There are a few factors that could cause this shift in market opinion. One is that further rise in US interest rates and bond yields and the much flatter yield curve we have today versus the start of 2017.
The other factor is the increased debt load among consumers, businesses and the government. Note, much of the expansion in the US economy since 2009 has come from the consumer and it is by far the largest component of the economy. Experts are mixed at best in terms of how much of a benefit tax reform will be for households and it is further unclear as to whether the more significant tax cuts for businesses and high net worth individuals will counter a gradual fatigue among the majority of consumers. Put it all together and 2018 is not a slam dunk in terms of continued progress in equity markets and caution still has a role to play in terms of portfolio construction and strategy.
I usually end the last newsletter of the year with a Christmas carol parody, but we are breaking with tradition to use this space to thank all of our clients for their trust in us as their wealth custodians. 2017 marked another year of growth and milestones, but it was also a year where we said farewell to those who were taken from us way too early. Our thoughts and prayers go to all those who have experienced loss this year, and The Pyle Group wants to express our wishes for a happier and healthy New Year.
Upcoming events: Dec 26th to Jan 5th
Canada: Leading indicator, producer prices, merchandise trade, employment
US: Consumer confidence, pending home sales, Chicago PMI, construction spending, ISM manufacturing, vehicle sales, ADP payrolls, non-farm payrolls, trade, factory orders
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