Outlook 2018: Entering the Third Period

By Craig Fehr January 02, 2018

hockey player on ice

We think 2018 will add another year to this longer-than-average bull market, but we believe we are moving to the third period of this cycle. As in hockey, the third period means there is still sufficient time left on the clock. But as the game extends, conditions change and it's a period when star players can carry the load while fatigue causes mental mistakes and greater swings in the action.

In our view, persistent economic growth and rising corporate earnings can lead markets to further gains. But fatigue, in the form of rising policy risks and extended valuations, will drive greater volatility, including a higher likelihood of a short-term market correction this year. We expect more frequent leadership rotation among investment categories, which we believe can help reward proactive portfolio rebalancing and broader diversification.

A more balanced matchup of tailwinds and risks

Positive Forces
Signs of Fatigue
Improving U.S. economy – Low unemployment, better wage growth and improving business investment could spur GDP growth to its fastest pace since 2014. While we think legislative execution will fall short of original expectations, President Trump's pro-growth agenda has the potential to extend the current economic expansion.
Consumer debt and housing – Elevated household debt threatens future loan growth, which, combined with muted domestic wages, could drive slower personal spending. Additionally, we expect softer housing market conditions in response to higher regulation and rates. With housing and consumers accounting for two-thirds of GDP, this poses a challenge for the Canadian economy.
Rising profits – Sustained economic growth provides support for faster revenue growth. While profit margins are likely to compress, corporate earnings should rise at a mid- to upper-single digit rate, setting the pace for equity market returns.
Monetary policy changes – With monetary policy providing a cushion of safety for the equity markets in recent years, we anticipate the gradual withdrawal of stimulus this year to likely prompt greater volatility in response to disappointing data or headlines.
Faster global growth – World GDP is poised to accelerate for the second straight year, helped by increased output in the U.S. and Europe, less drag from slower growth in China and improving global manufacturing and trade activity.

Full valuations – Canadian and U.S. equity markets are trading at above-average valuations, while strong performance has also lifted overseas valuations. Though not in bubble territory, full valuations leave less margin for error and suggest more moderate gains moving forward.

Rebounding exports – Stronger growth in the U.S. and a favourable (low) loonie set the stage for a helpful lift in domestic exports, which account for more than one fifth of domestic GDP.
Geopolitical disruptions – Given higher valuations and less help from central banks, we think the market may have sharper reactions to geopolitical shocks, including tensions with North Korea, drama in Washington, disruptions in Brexit negotiations and policy changes in China.

We don't see a recession emerging in 2018 nor do we think equity markets are exhibiting signs of euphoria typically associated with market tops, suggesting the final buzzer isn’t about to sound. However, 2018 brings the shift toward tighter monetary policy (albeit very gradually), domestic economic imbalances, heightened political risks and above-average valuations across many asset classes.

Key views

  1. Equities post further gains – The fundamental foundation of economic growth and rising corporate profits should support higher stock prices. That said, we think this bull market’s largest gains are behind it, and in the latter stages of this expansion we expect more moderate returns from equities, compared to the average annual return of 14.9% since this bull market began.1
  2. A correction emerges – It’s been nearly two years since the last 10% correction, and there have been only two 10% pullbacks since 2011. We think the balance of headwinds and tailwinds raises the potential for a temporary correction in 2018.
  3. International equities outperform – Slower domestic economic growth and range-bound oil prices could restrain TSX earnings growth relative to foreign markets. Faster growth in the U.S., along with ongoing monetary policy stimulus in Europe and Japan and relatively lower overseas valuations present compelling opportunities for international allocations.
  4. Bank of Canada pauses, Fed continues rate hikes – After multiple rate hikes in 2017, we think the BoC will move to the sidelines as domestic growth slows and higher rates begin to influence the housing market. We believe the Fed will be persistent but gradual in raising rates and reducing the size of its balance sheet.
  5. Oil treads water a bit longer – OPEC production adjustments and global demand offers support while elevated inventories and shale production growth could limit the upside for oil prices.
  6. The loonie lingers in the '70s – We think the CAD's 2017 surge to US$0.83 was overdone. A widening interest rate gap versus the U.S. and the absence of a lift in oil prices will, in our view, keep the loonie in the mid- to upper-70-cent range.
  7. NAFTA is adjusted, not scrapped – The breakdown in NAFTA negotiations is discouraging, but we don’t expect the trade deal to be completely abandoned. Instead, we anticipate adjustments that will likely involve some concessions from Canada and Mexico.

Talk with your Edward Jones advisor today about opportunities to position your portfolio for the year ahead, and strategies to keep you on track toward your goals well beyond 2018.

Important Information:

Sources: 1. Morningstar Direct, 9/30/2017. Average annualized return between the S&P/TSX Composite and the S&P 500 Index since 3/9/2009. Returns expressed in local currency and include reinvested dividends.Past performance is not a guarantee of how the markets will perform in the future.

Equity investments carry risk, including the loss of principal. There are special risks inherent in international investing, including currency fluctuations and political, social and economic risks.

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