While the prevailing outlook by the big banks for 2018 and onward has been predominantly optimsitic and in a few euphoric cases, “rationally exuberant“, with most banks forecasting year-end S&P price targets around 2800 or higher, and a P/E of roughly 20x as follows…
- Bank of Montreal, Brian Belski, 2,950, EPS $145.00, P/E 20.3x
- UBS, Keith Parker, 2,900, EPS $141.00, P/E 20.6x
- Canaccord, Tony Dwyer, 2,800, EPS $140.00, P/E 20.0x
- Credit Suisse, Jonathan Golub, 2,875, EPS $139.00, P/E 20.7x
- Deutsche Bank, Binky Chadha, 2,850, EPS $140.00, P/E 20.4x
- Goldman Sachs, David Kostin, 2,850, EPS $150.00, P/E 19x
- Citigroup, Tobias Levkovich, 2,675, EPS $141.00, P/E 19.0x
- HSBC, Ben Laidler, 2,650, EPS $142.00, P/E 18.7x
… there have been a small handful of analysts, SocGen and BofA’s Michael Hartnett most notably, who have dared to suggest that contrary to conventional wisdom, next year will be a recessionary, bear market rollercoaster.
And then, there are those inbetween who expect a good 2018, but then all bets are off in 2019. Among them is JPM’s chief economist Michael Feroli who has published a special report, aptly titled “US outlook 2018: Eat, drink, and be merry, for in 2019…”
Here are the seven main reasons why JPM believes that the party will continue until December 31, 2018 or thereabouts:
- Growth momentum at the end of 2017 is solid and global headwinds are unusually mild
- Solid growth should put more pressure on resource utilization for an economy operating at capacity
- Wage growth has already firmed, and unemployment rate is expected to fall below 4%
- Core inflation should approach 2% target rate following surprising weakness early in 2017
- Even with tightening labor markets, subdued inflation expectations should limit upside prices pressures
- The Fed is on track to deliver three hikes this year and we believe will step up the pace to four hikes in 2018
- The year-end period usually contains one wild card; this year it is tax reform
At that point, however, it ends.
Here are the key excerpts from the report:
The prospects for the economy at the end of 2017 look about as favorable as they have at any point in this expansion. The animal spirits of both consumers and businesses appear energized; the ever-present global headwinds of the last half decade have turned to a tailwind; and the domestic fiscal austerity that has acted as a drag on growth since 2011 may now be turning to profligacy. All these factors augur above-trend growth in 2018. The only sticking point is that by many measures the economy already appears to be operating at capacity. This is the fundamental tension in the outlook: does continued above-trend growth tighten labor and product markets enough to threaten higher wage and price inflation or does growth slow enough to limit strains on the rate of resource utilization? Our outlook balances these outcomes. We see growth close to 2% in 2018; while that is somewhat below what we expect will be realized for 2017, it is still about 0.5%-point above our estimate of sustainable, trend growth. This should be enough to push the unemployment rate down into the high 3’s (Figure 1).
Inflation has been mysteriously absent this year, but historically it has not been long before unemployment below 4% began to generate firmer wage and price pressures. We expect that to be the case next year as well. Fortunately for the outlook, this will take place from a starting point in which cost pressures are relatively low, so some firming in inflation trends is not to be feared. Even with core PCE moving only slowly back toward the Fed’s 2% goal (Figure 2), we expect the FOMC will maintain a fairly steady cadence of rate hikes next year. At the beginning of 2017 the Committee’s interest rate forecast “dots” foresaw three hikes this year, and it appears that they will match that forecast. For 2018 the latest dots are looking for another three hikes; this, again, looks like a reasonable forecast to us, though we think the ongoing surprising decline in the unemployment rate means that four hikes next year now look more likely than three.
JPM then focuses on the key drivers of growth in 2018. Below we recap some of the key points”
- Consumer spending energized: Consumer spending has pulled its weight in the first three quarters of 2017, expanding at a 2.5% annual rate, about the same growth registered for the economy as a whole. Looking ahead to 2018, we look for a modest step down to around a 2.2% pace. The prospects for cuts to income taxes stand out as a notable positive for consumers. The principal restraint in the forecast is that we see the recent precipitous decline in the saving rate coming to an end (Figure 3). To understand the importance of the saving rate recall the following identity: the percent change in real consumption = the percent change in real disposable income – the change in the saving rate. Saving is future consumption. Households may see less need to save if future consumption can instead be supported by future income growth, or by present wealth growth.
- Little upside left on housing construction: Despite generally healthy household finances, housing construction has shown signs of outright cooling this year after sluggish but steady growth through most of the recovery. Our 2017 outlook called for modest growth, with real residential investment rising 1.6% (4Q/4Q) and housing starts drifting up to a pace of 1.275 million (saar) by year-end. In fact, the data are on pace to disappoint these modest expectations. We now look for residential investment to decline 1.3% in 2017, and housing starts have managed an average pace of only 1.188 million over the last six months, down from a peak of 1.243 million earlier this year. With supply constraints binding in many areas, continuing sluggish household formation among young adults, and potentially unfavorable monetary and fiscal policy changes on the horizon, we see little reason to expect a return to robust growth in the sector. Our 2018 forecast looks for 1.25% 4Q/4Q growth in residential investment, with housing starts drifting up to about a 1.3 million-unit pace by year-end.
- Capital expenditures send mixed signals: Turning to the business end of the economy, capital expenditures had a weak run from late 2014 to mid-2016, as the sharp decline in oil prices and rise in the dollar pinched profits and spending in industries linked to oil mining or exports. But as these drags abated, many related indicators have been on a strong run since mid-2016. Somewhat puzzlingly, this strength has been much more clearly apparent in equipment spending than in structures investment. There is a possibility that tax reform will further encourage investment spending in the coming year. In fact, as we write, the current version of the Senate tax proposal would maintain the current 35% corporate tax rate in 2018, while allowing 100% deductibility of equipment investment against that high rate. Such a configuration would provide an incentive to pull forward equipment spending from 2019 to 2018 where possible, although evidence on past investment responses to changes in depreciation deduction is mixed at best.
- Fiscal changes afoot: Republican control of the executive and legislative branches of the federal government has yet to produce any material changes in fiscal policy, but our forecast looks for this to change soon. As we write, the House and Senate have each produced their own tax reform bills. In the grand scheme of things—considering the many directions the tax reform effort might have gone—the bills are pretty similar. Notably, they both target a $1.5 trillion increase in total deficits over the next 10 years and would bring the top corporate tax rate down from 35% to 20%. The $1.5 trillion in 10-year deficits includes roughly $500 billion that we would chalk up as the continuation of existing policies (notably in the form of “bonus” depreciation deductions and other “tax extenders” that would likely be preserved even in the absence of a major tax bill). Thus the emerging bills look like a tax cut relative to the status quo of about $1 trillion over 10 years. The exact timing of the cuts remains in flux as the House and Senate debate their preferred method of contorting the plans to achieve the necessary budget score to pass a bill through reconciliation. But if we think of the plan as a net tax cut of roughly $100 billion per year, the economic effects could be viewed as modest. With annual US GDP of about $20 trillion, a $100 billion tax cut represents 0.5% of GDP. If the cuts tilted toward corporations, estates, and high income households who are unlikely to be cash constrained, we would expect the average propensity to spend out of these cuts to be modest. And, as discussed below, we suspect any supply-side benefits from stronger productivity growth will also be limited. On net, we continue to pencil in a 25bp boost to the rate of GDP growth for one year beginning in 2Q18.
- Trade shifts towards neutral: Recent changes in net exports appear to have been affected meaningfully by fluctuations in the value of the dollar (Figure 19). The dollar started appreciating significantly in the middle of 2014 and the trend in real exports weakened shortly afterwards; as a result, net exports persistently dragged on growth from late 2014 until the end of 2016 (Figure 20). More recently, however, the dollar has depreciated throughout much of 2017, and the trend in exports has been stronger than that of imports, leading to a contraction in the trade deficit. Changes in the dollar can have long-lasting impacts on the trade data, and we think that the earlier strengthening in the dollar can still be weighing on the trade deficit even with the partially-reversing depreciation from more recent months. Following the earlier swings in the trade deficit, we expect net exports to be close to neutral for growth in 2018 with exports increasing 3.7% and imports up 1.5% saar (4Q/4Q).
- Solid demand, meet weak supply: With consumption and business investment expanding at a healthy pace, housing construction and government spending growing more modestly, and international trade about neutral, we look for 2018 real GDP growth to average just under 2.0%. Translating this demand growth into its implications for jobs and the labor market requires an assumption on productivity growth, as each quantum of increase in output will need more (less) job growth when productivity growth is slower (faster). So far in this cycle, productivity growth has been extremely weak, necessitating a relatively firm pace in hiring. Recently, however, there have been hints of a pickup, with nonfarm business sector productivity increasing 1.5% in the four quarters ending in 3Q17. This is modestly higher than our 1.25% estimate for trend productivity growth and well above the -0.1% growth registered in the prior four-quarter period.
- Productivity pickup will probably pass: We tend to think we are likely still in a slow productivity growth regime, consistent with our 1.25% trend estimate. Since 2004, nonfarm productivity growth has been stuck in the slow lane, averaging 1.3% annualized growth over those 13 years. The 1.5% growth seen over the last year looks more similar to that period than to the high productivity growth period that preceded it. In fact, besides recessions, productivity growth as weak as 1.5% was rarely seen outside the original Great Productivity Slowdown period, which lasted from 1974-1995 (Figure 21). The NY Fed maintains a productivity regime-switching model which estimates that, even with the 3Q17 data, there is a 94% chance we are in a slow productivity growth regime (which the model defines as 1.3% annual productivity growth).
- Labor market to get even tighter: With GDP expanding and productivity growth set to remain soft, our 2018 forecast looks for another decent year of job gains. Although the trend for job growth has moderated in each year since the 250,000 average monthly pace reported for 2014 (Figure 27), the latest figures still have been strong enough to push the unemployment rate down by 0.7%-pt over the most recently reported 12 months. We think that job growth will continue to slow somewhat over time, but that it should remain above the pace needed to keep the unemployment rate steady. For the last several years, we have been forecasting that the national labor force participation rate would remain about flat on average, as drags from an aging population are roughly offset by the pull of a tight labor market. This forecast has performed well, as the participation rate currently stands at the same level as it did in December 2014, despite some volatility along the way and some surprises within individual demographic groups. Our models continue to predict more of the same— population aging should continue to subtract 0.2%- to 0.3%- pt from the participation rate each year, while low unemployment and rising wages pull some younger workers back to the labor force. On net, we look for the participation rate to be roughly unchanged a year from now.
- Profit margins to get squeezed, not pinched: Firming compensation trends are the number one headwind for corporate profits. Typically, profit margins narrow as the cycle matures and labor costs begin to firm. That pattern has played out this cycle. Profit margins for the nonfinancial corporate sector peaked in 2014. Profits did get a lift in the second half of 2016 as energy prices firmed, though have exhibited less growth in 2017 (Figure 30). In 2018 we expect profits will grow 1.5%, which is less than our anticipated 4.0% growth in nominal GDP. The reason for the shrinking share of profits in GDP is that we expect labor to take an increasing share. Two other mature cycle phenomena should also pose headwinds to profit growth. First, the normalization of capital spending levels means the depreciation expenses will command a larger share of revenue; depreciation expenses began accelerating in 2016 and have recently been increasing at a 4.6% growth rate. Second, as interest rates go higher, interest expense begins to take a larger share of operating surplus.
- Still holding out for higher inflation: Arithmetically, firmer growth in unit labor costs means either less growth in non-labor payments—much of which are profits— or faster growth in output prices. We believe both of these outlets will reflect some of the firmer wage growth next year. The link between wage pressures and price inflation is quite loose, but our forecast has nonetheless looked for the tightening labor market to put gradual upward pressure on price inflation. We were thus surprised by the moderation in core consumer price inflation in the second half of this year. Core inflation had been firming and was close to the Fed’s 2% target late last year and early in 2017, with the core PCE deflator—the FOMC’s preferred measure of underlying inflation— up 1.9%oya in many months between August and February. But an unusually large drop in core inflation in March followed by some other soft readings have been weighing on year-ago inflation rates since then—the core PCE price index was up only 1.3% oya in September. The downshift in inflation has occurred despite reasons for inflation to firm. Pricing for many types of services tends to respond to changes in slack, but core services inflation has cooled this year even with continued labor market tightening. And core goods inflation has remained persistently weak even as the decline in the value of the dollar this year has pushed up import prices (Figure 33). It is therefore hard to use the economic backdrop to explain the recent inflation disappointments. It does appear that part of the softening was related to special factors that were likely one-time events, including a substantial decline in pricing for cell-phone services back in March.
- A Fed in motion tends to stay in motion: With the labor market continuing to tighten and inflation drifting up, we look for the Fed to stay on the move. At the beginning of 2017 the oft-derided FOMC “dots” indicated the Committee anticipated hiking three times this year. With many Fed speakers leaning toward a mid-December hike, they look quite likely to have hit their forecast. If one counts the September balance sheet normalization announcement (discussed more below) as a form of tightening, then they will have delivered four tightenings this year: once a quarter at the press conference meetings. We anticipate the Fed will hike the funds rate four times next year for the same reason they tightened policy four times this year: with labor market slack diminishing faster than they (and most others) anticipated, concerns about being behind the curve will keep them on a fairly steady path back toward a more neutral policy setting. With an unemployment rate that may soon fall below 4%, leaving the real policy rate in neutral territory, may strike many on the Committee as improper risk management. Two more hikes next year—in March and June—would bring the interest on excess reserve (IOER) rate back to 2.0%, and the real policy rate close to zero. Hikes in the second half of the year should be more data dependent. However, even if inflation runs modestly below the Fed’s 2.0% goal, we believe most Committee members have more faith in the Phillips curve than the market does, and that solid growth would be enough to warrant hikes in September and December.
Those are all the positives. However, then comes 2019, and as JPM concludes, “Eat, drink, and be merry, for in 2019…”
We conclude our discussion of Fed policy, and the 2018 outlook more generally, with a few thoughts about monetary policy beyond next year. If recession risks are indeed nontrivial in 2019 or 2020, then it could well be that the Fed enters that situation with the funds rate not much above 3.0%. This would limit the amount by which the Fed could cut rates before running back into a zero lower bound situation. This problem could be exacerbated by limited space or willingness to employ countercyclical fiscal policies. The deficit next year will already be one of the largest for a full employment economy. Moreover, after the 2009 Recovery Act, the appetite for counter-cyclical fiscal policy has waned in Washington.
Given the largely successful experience with negative rates abroad, one may wonder whether the zero lower bound is the effective lower bound. Apparently, the Fed remains reluctant to explore this issue, in part because of questions around whether the Federal Reserve Act allows the Fed to take its administered rates into negative territory. The issue regarding negative rates is emblematic of the main challenge the Fed may face with the next downturn: the political constraint that Congress may exert on the Fed’s creativity. Currently, some of the more academically minded Fed officials have been musing about reinterpreting the Fed’s price stability mandate. For example, raising the inflation target or moving to pricelevel stability have been suggested as alternative operating frameworks that may lessen the severity of recessions in a low real interest rate world.
However, the Fed needs to tread carefully. The decision to interpret the Federal Reserve Act’s price stability mandate as 2% inflation was made in the late 1990s, when the institutional prestige of the Fed on Capitol Hill was enormous. Now, with the Fed serving as Congress’ favorite whipping boy, any further innovation in interpreting the Fed’s mandate risks the wrath of lawmakers. In all likelihood, the Fed will enter the next recession with the same meager zero-bound toolbox it had in the last recession: forward guidance and balance sheet expansion.
And the punchline:
In the aftermath of the last recession nothing was done to enhance the country’s ability to conduct countercyclical policy; perhaps the pain of the next downturn will motivate reconsideration of fiscal and monetary policies.
But why prepare for a recession, a crash or even a modest correction when the market no longer has an even 1% drop? Until it does of course, which is after the next downturn, expecting a rebound may be generous…