By Paul Hoffmeister, Chief Economist
After such a good year, a common question we’re hearing is, can the good times last in 2018? For the most part, we believe they can.
To put today’s market into context, we believe the strong U.S. equity market returns of the last year were primarily driven by supportive monetary, fiscal, and regulatory policy. And, the nearly unchanged yield in the 10-year Treasury (2.40% at year-end 2017 versus 2.44% at year-end 2016, according to Bloomberg) was mainly due to declining inflation and the resistance by some Federal Reserve officials to raising the federal funds rate aggressively.
One of the big stories of the last year was the historically strong risk appetite in stock and bond markets. Based on our calculations, the average daily VIX level in 2017 was 11.1, the lowest average for a calendar year since 1990. And today’s around 72 basis point spread between medium-grade Baa and high-grade Aaa-rated corporate bonds is less than 25 basis points from its post-1990 low.
Looking forward to 2018, business-friendly regulatory and fiscal policy will likely continue. It appears that the regulatory rollback instituted since January will remain. And of course, Congress just implemented $1.5 trillion in fiscal stimulus, of which the signature feature is a permanent corporate tax cut.
Rather than having the world’s fourth highest statutory corporate income tax rate, as it was last year according to the Tax Foundation, the US rate will now be fixed almost two percentage points below the world average of 22.96%. This bodes well for U.S. competitiveness.
With these tailwinds, we are forecasting approximately that the S&P 500 to reach 2959 at the end of 2018, and the 10-year Treasury yield to rise to 3.00%, as real GDP accelerates to 3.0%.
Also we approximately expect unemployment to fall to 3.8% and core PCE inflation to grow 1.7% by year-end 2018.
Among the myriad risks that exist to our base case forecast, we foresee the top risks to be overly aggressive monetary policy, political uncertainty, and geopolitical instability associated with North Korea as well as Iran-Saudi Arabia.
We are particularly concerned that in 2018, the strong risk-taking environment along with accelerating GDP and rising inflation will compel some monetary policymakers to advocate aggressively tighter monetary policy. To us, this would be misguided given years of dollar strength and the shift by other major central banks toward tighter policy.
But if Fed officials take a ‘do no harm’ approach and allow for the full effects of fiscal and regulatory relief, 2018 could be another very good year for most stock and bond investors.