Outlook for 2018

By Mark Bern, CFA

First of all we can expect continued volatility for at least another month and possibly into the early stage of quarter three.  Why? 

It’s simple really.  The full impact of tax reform won’t show up in corporate financial reports across the board until the Q2 earnings season.  There were a lot of mixed messages coming out of Q1 reports as corporate leaders tended to provide conservative guidance.  I think that is primarily driven by the questions surrounding trade talks and the possibility of a trade war with China. 

What to expect from the Trade Tirades

As I have stated before I realy don’t think it will come to that.  Both sides need to avoid an all out trade war and both want to announce a victory to their respective audiences.  That cannot happen as a result of a trade war and both side understand it.  The desired result only comes from a negotiated settlement. 

Trump needs to be able to announce a win before the mid-term elections and a better trade deal with China that estimates a reduction of our annual trade deficit with China of $100 billion or more would do the trick. 

Trump also wants to be able to announce a negotiated end to the nuclear program in North Korea.  And he wants it done, once again, before the mid-term elections this fall.  Such expedience by government would have been unheard of under any previous administration, Republican or Democrat.  I am on the fence as to whether the President can achieve such momentous milestones in such a short time.  If he is successful, the Democrats will be hard pressed to make much headway toward gaining control of either chamber in Congress.  My only hope is that in rushing to get things done the Administration does not make any major mistakes.

Before anyone gets overheated just let me say I am not taking political sides.  While I would like to have real headway in these areas I don’t care who gets the credit as long as the results are good for the American economy and its citizens. 

Stocks are in a consolidation phase

From a technical perspective the markets appear to be healthy with no signs of rolling over just yet.  Take a look at this video for a better understanding of what I mean.  The video from a week ago is 42 minutes long and the introductory information, while good, may be boring to many so if you just want to get to meat of the current day analysis skip on ahead to about the 27 minute mark for the punch line. 

If you need additional confirmation of the health of the market take a look at this video from the same source published yesterday.  There are none of the tell tale signs of a coming bear market yet.  Of course, this could change in just a few months but as of today we are still in growth mode.

Taking a look at charts from a longer perspective we see that the market has broken out of a very extensive range bound box dating back to before the dot com crash.

Again, this picture could change, but the current prognosis is that the upward trend appears to still be intact.

Potential drags on economic growth

Everything is not roses, though, as there are sectors of the economy that are likely to keep the economy from growth above 3% in 2018.  The biggest concern at this point is the auto industry.  The peak in new car sales appears to be in the rear view mirror now.  I have been predicting this for about six months now but, barring any other natural disasters, major acts of Congress or a miracle, I believe we have actually seen the peak. 

I was early, even though the signs were showing up, back in October last year.  But then the hurricanes hit Texas, Florida and Puerto Rico and replacement of damaged vehicles helped boost car sales for several months. 

Then came the tax reform bill which allows corporations to write off 100% of equipment purchases instead of depreciating those assets over several years.  This provided a boost to sales of light trucks ande SUVs in Q1.  It may continue throughout the year but I suspect that it the pace will slacken because of trade worries.  So, now that those major positive catalysts are mostly behing us the natural cycle trend will again be the overriding force.  And the cycle trend is down.

There are several reasons:

1.      All of those who had put off a purchase after the financial crisis of 2008 have finally upgraded.

2.      Credit for new car purchases is tightening because the default rate on subprime loans is rising.

3.      A impending flood of low mileage used cars are beginning to hit the market as the surge in leasing that begain 3-4 years ago are coming in off lease in record numbers.  The dealers are going to need to sell these cars and, with so many available, prices will come down creating better deals for buyers and competing against new car sales.

Last year new car sales were 17.2 million in the U.S. and in 2016 there were 17.5 million sold.  Predictions for 2018 range between 16.2 and 16.8 million units, depending on the source.  I think that since we had a better start in Q1 and because tax reform will continue to help some the most likely sales level will be close to 16.5 million.  Were it not for those two factors I would expect sales to be closer to the bottom of the range as forecast by Toyota.

Rising interest rates will dampen growth somewhat but not kill the goose from laying a few golden eggs this year.  Housing prices have continued to rise and, when coupled with rising interest rates on mortgages, will make home purchases less affordable.  Home prices have surged by 6.8% on average in the 20-city Case Shiller Home Price Index.  Those who want to buy are trying to get it done before interest rates rise further and pushing prices higher.  I don’t know when the tipping point will come but at some point, possibly in the second half of this year, demand could begin to slow as fewer households will be able to afford the house they want.  Until then, though, demand could remain strong and add to growth prospects.

The other potential drag could end up being corporate spending because of the uncertainty about trade.  Company executives often become more conservative when the future becomes unclear which ends up creating a less vibrant economy.  If trade issues are cleared up I would expect the economy to pick up steam and grow above 3% for the remainder of the year.  If not, we could see growth of about 2.8% for 2018.  Still, not a bad pace considering the average GDP growth since 2009 has been relatively tepid around 2%. 

On the positive side of the equation

Corporate earnings should come in consistently higher for the remainder of the year.  That should boost stocks as the EPS (earnings per share) and other valuation multiples come down.

Respectfully and Candidly,

Mark Bern, CFA