Nuveen’s Bob Doll Releases Ten Predictions for 2018
A Look Back at 2017
Nearly everything seemed to go right in 2017. The U.S. economy remained in a slow expansion amid surprisingly tame inflation while the global economy showed signs of improvement with more synchronous growth.
We expected another year of positive equity returns, but were surprised by the degree to which it happened. The equity-friendly environment caused stock prices, as measured by the total return of the S&P 500 Index, to rise for nine consecutive years and increase every month for the first time in history. Non-U.S. equities provided strong returns and in many cases outpaced the United States, especially in emerging markets. Other risk assets, such as fixed income credit sectors, experienced solid returns as well.
The biggest stock market story in 2017 was the string of seemingly never-ending positive earnings surprises, followed by constant upward earnings revisions. Memories of deflation and the Great Recession seemed to keep sentiment cautious and skeptical (if not outright bearish), as investors constantly underestimated earnings results.
U.S. equity valuation levels are being questioned, and while they are high relative to history, we think they remain reasonable versus other asset classes. Bull markets don’t die of old age or over-valuation. Something negative, usually unwanted inflation, becomes the catalyst for a downturn. And serious negative factors seem absent in the 2018 outlook.
Set against this backdrop, Doll presents his Ten Predictions for 2018, followed by his 2017 Scorecard.
2018 Ten Predictions
1. U.S. real GDP reaches 3% and nominal GDP 5% for the first time in over a decade.
The negative impacts from the financial crisis have finally moderated. This backdrop, combined with a significant corporate tax cut and a rising capacity utilization rate, should lead to a return to somewhat more normal growth. Late in 2017, the Leading Economic Indicator series finally rose above its pre-recession level. In the past, this led to on average six more years of economic expansion, with the shortest additional expansion period being four years.
2. Despite ongoing protectionism, the global expansion continues with the fewest countries in recession in history.
We expect global growth to continue increasing at a time when global trade is not expanding. Typically in an expansion, imports and exports are among the fastest growing segments of the global economy. But anti-trade sentiment in the United States and elsewhere has held this back. Investors need to keep a careful eye on protectionist threats to global growth.
3. Unemployment falls to the lowest level in nearly 50 years as wage growth is the highest since the Great Recession.
We expect unemployment to fall again in 2018, dropping to below 4%. Meanwhile, wage growth has remained fairly quiet, but last year wages were slowly starting to rise. We expect that trend will continue as a shortage of workers, robust corporate profits and generally strong corporate conditions manifest themselves.
4. The yield curve flattens (but does not invert) as the 10-year Treasury yield reaches 3% for the first time since 2014.
There are several reasons why rates are likely to increase in 2018, including a pickup in inflation. In fact, we view a rise in inflation as probably the biggest threat to the financial markets in 2018. It is important to note that we expect a flattening yield curve, with the Fed raising rates faster than the curve moves up in yield, but a flattening curve is not a good predictor of equity prices. Equities tend to sag only after a period of time when the yield curve inverts, which we do not expect in 2018.
5. Stocks enjoy longest bull market in history but experience a 5+% correction after the longest period without one.
While we expect the bull market to continue and become the longest in history, we also expect the uninterrupted strings of advances to fade and occasional pullbacks as interest rates and inflation rise. A solid earnings outlook, still-benign inflation and interest rate environments, along with the absence of sentiment or technical warning signs, underlie our generally sanguine outlook.
Volatility is likely to rise, but we still expect stock markets to make modest gains. In this environment, we prefer cyclical over defensive sectors and value over growth.
6. U.S. equity returns lag earnings growth for the first time in six years, the longest streak in decades.
U.S. stock returns have outpaced earnings in each of the last six years, the longest streak on record. The last time equity appreciation exceeded earnings growth for a sustained period of time was 1995-1999. We expect the current streak to end in 2018, meaning earnings will outpace stock market returns. . Earnings expectations for 2018 are now high – justifiably so – but in our view they will be difficult to exceed
7. Equities beat bonds for the seventh consecutive year for the first time in nearly a century.
From 2012 until the middle of 2016, stocks outperformed bonds even though bonds continued to do well. In contrast, since mid-2017 interest rates have been rising irregularly, so the hurdle rate for equity outperformance has fallen. Equities may be vulnerable to pullbacks in response to rising bond yields, but a major decline in stock prices looks unlikely as long as growth and earnings are improving.
8. Corporate capital expenditures increase at the expense of share buybacks.
We think the chronic underinvestment in capex this business cycle, strong profitability, the low cost of capital, improved economic confidence, lowered corporate tax rates, the repatriation of foreign earnings and the expensing of capex in the new tax bill will combine to show an increase in business fixed investment by maybe 6% or more in 2018. At the same time, tax changes that limit interest expense deductions should curtail share buybacks.
9. Telecommunication services, information technology and health care outperform utilities, energy and materials.
The technology sector features companies with strong earnings and solid balance sheets. Health care looks to be the best positioned among the defensive growth sectors. We are including telecom services as a projected outperformer for its outsized yield, reflecting its out-of-favor sentiment. In contrast, utilities are not cheap and have poor growth prospects, while the deeper cyclical sectors of energy and materials appear expensive with mixed supply/demand fundamentals.
10. Republicans lose the House, retain the Senate and further distance themselves from President Trump.
The long list of Democrats up for reelection in states where President Trump won by a wide margin provides some hope for the Republicans that they will retain the Senate, but the poor polling of the president and the Republican Congress means the Democrats may well retake the House. Whatever the outcomes, we expect many congressional Republicans will further distance themselves from the president. For markets, it probably means little, if any, significant legislation after the tax bill.
Bob Doll’s 2017 Predictions Scorecard
1) U.S. and global economic growth improves modestly as the dollar strengthens and reaches parity with the euro.
2) Unemployment drops to its lowest level in 17 years as wages increase at the fastest pace since the Great Recession.
3) Treasury yields move higher for a third consecutive year for the first time in 36 years as the Fed raises rates at least twice.
4) Stocks hit their 2017 highs in the first half of the year as earnings rise but price/earnings multiples fall.
5) Stocks outperform bonds for the sixth year in a row for the first time in 20 years while volatility rises.
6) Small caps, cyclical sectors and value styles beat large caps, defensive and growth areas.
7) The financials, health care and information technology sectors outperform energy, utilities and materials.
8) Active managers’ performance improves as flows into equities rise.
9) Nationalist and protectionist trends rise as pro-domestic policies are pursued globally.
10) Initial optimism about the Trump agenda fades in light of slow legislative progress.
Score: 7 out of 10
Outlook 2018: A Slightly More Difficult Climb
We’re constructive toward equities as we enter 2018, but we think conditions will become less perfect than 2017. We are calling for an environment of low inflation and interest rates, good earnings and earnings growth and solid economic growth. The effects of the recently passed tax reform bill should be a positive as well. Having said that, we think the environment is moving from nearly perfect to less perfect.
What might such a transition look like? In 2017, economic growth was good and markets anticipated acceleration in 2018. In 2018, growth will likely remain good, but investors may anticipate deceleration in 2019. Inflation and bond yields might move from very low and flat to low but rising. Earnings growth surprised to the upside nearly nonstop in 2017. Expectations for 2018 are higher and likely to be met but not significantly exceeded. Investor sentiment and confidence is shifting from skepticism to optimism. The political backdrop may move from messy to messier. However, as long as economic growth and earnings are relatively good (which is likely), equities should be fine. It may be difficult to advance at the same strong, smooth pace as 2017.
We also see possible risks for the markets. Although we don’t expect inflation to rise significantly this year, we expect it to climb. A key warning sign for a more adverse outlook would be an inverted yield curve and rising credit spreads that accompany rising inflation. Such concerns are probably premature but bear close scrutiny. Rising anti-trade protectionism would be a significant concern as well, especially if it could disrupt global economic growth.
Equity valuations are rising, but we don’t expect that to be an issue in 2018. Overall fundamentals remain strong, which should help equities make additional gains. Though valuations tend not to matter as much in the short term, they matter significantly for long-term returns. Therein lies the challenge. As the economic cycle progresses and the bull market continues, investors will inevitably experience more mediocre returns. For now, we are enjoying the upward momentum of the stock market, but we remain vigilant.
Key Themes for Investors
We believe investment selectivity is likely to grow in importance as volatility rises. With that, we’ll focus on the following characteristics when evaluating companies in the year ahead:
- Free cash flow that can provide flexibility to raise dividends, buy back shares and reinvest in the business
- Companies with the ability to generate unit growth may be advantaged over those that lack pricing power
- Economic sensitivity and above-average secular growth that may help insulate against market fluctuations
For more detailed information on Bob Doll’s 2018 Ten Predictions including full commentary and a point-by-point examination of his 2017 predictions, visit Ten Predictions 2018. To learn more about the strategies managed by Bob Doll and team, click here. Those interested in receiving Doll’s weekly commentary and special market reports can subscribe via the following link: Bob Doll Weekly Commentary. Follow Bob Doll on Twitter.