Photo: Dave Meier. Source: Picography
On its face, next year looks a lot like this year, just starting from a higher level. The economy – already growing well – should accelerate. A coordinated global expansion is currently underway. This will lead unemployment to fall and wages to rise. That will push inflation marginally higher, but not too high.
The Fed will respond with a couple of rate hikes, but new Fed Chair Jerome Powell will have his hands full. Inflation remains stubbornly low, restrained by demographics, technology, and global trade. Interest rates are already close to their neutral level, known as r-star among central banks. (When global central bankers get together, all the cool kids know what their r-star levels are.) There were two dissents from the latest Fed rate hike. The unofficial rule at our collegial Fed is: more than three dissents and any rate move is out.
The markets should respond to an environment with low interest rates, a stable economy, and low inflation the same way seeds respond to moisture, warmth, and darkness: they grow, potentially in the double-digits. Our stable economy creates strong revenues; these revenues pass through to earnings; tax reform increases returns on investment; and higher investment flows should lift wages without sparking more inflation. The strongest sectors should be financials and cyclical stocks, but the growth darlings will also do well, unless they become too highly valued.
And make no mistake, we’re in a highly-priced market. The Buffet Ratio, which is the ratio of the market value of US equities divided by the US economy, is now at levels last seen in 1999. That wasn’t an auspicious time for stocks, but there are some major differences between then and now. Back then, business plans with no revenues or profits still received sky-high valuations. Now, whatever your feelings about Amazon, Facebook, and Tencent, they have solid earnings and earnings growth. In fact, they dominate every area of the market where they choose to compete. That’s why Amazon doesn’t do many acquisitions: it’s easier for them to beat their competitors than to buy them.
Valuation is a concern, as is the growth of credit around the world, especially in China. But even if China’s economy falters, their authorities have so many resources – with a huge economy growing more than 6% per year and foreign reserves exceeding $3 trillion – that they should be able to stave off any local crises. And it’s not like they just ship their problems overseas. China is highly integrated into the global economy. Our problems are their problems.
Like this year, next year is looking good. The trend is still our friend. Until it ends.
Douglas R. Tengdin, CFA