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2018 U.S. Outlook: Ringing in Another Year of Expansion?

As 2017 comes to a close, the U.S. economy looks on track to clock an annual average 2.3% climb for the year—its fastest pace since 2014. Midway through 2018, a stronger-than-expected domestic backdrop should also help ring in the 10th year of business expansion. However, the question on many investors’ minds:  Is there now a risk of slowdown in 2018—or could this expansion see extra innings?

"A general lack of overheating in key sectors and rising productivity suggest this late-cycle phase may continue throughout 2018."

According to a 2018 outlook from Morgan Stanley’s Chief U.S. Economist Ellen Zentner, this cycle may still have room to run. “Though ultra-low unemployment, a positive output gap, and rising interest rates continue to suggest the U.S. is late-cycle, a general lack of overheating in key sectors such as housing, and rising suggest this late-cycle phase is likely to continue throughout 2018.”

In Zentner’s view, the probability of a U.S. recession over the next 12 months lies at about 25%, held down by the delayed promise of tax reform and a strong synchronous global economy. Further, persistently low inflation throughout the forecast horizon may also help stretch the cycle since the Fed may not hasten to hike rates more rapidly.

These combined factors have led Zentner and her team to revise forecasted U.S. GDP growth in 2018 upward to an annual average 2.5% (vs 2.2%, previously) on this strong backdrop. 

A Return to Deficit Expansion

In terms of U.S. fiscal policy, Zentner notes that the days of declining deficits may be over. In addition to another round of hurricane funding and an increase in defense spending, moderate deficit expansion from the enactment of tax relief will likely raise the 2018 deficit-to-GDP ratio from 3.2% in 2017 to 3.6% in 2018.

In Zentner's base case, the delivery of a mildly expansionary tax package in 2018 would be worth roughly $1 trillion over 10 years. This amounts to approximately 0.5% GDP in deficit expansion over the first 4 quarters of enactment, and about 0.1pp of boost to GDP growth.

Ultimately though, Zentner predicts that the true impact of the tax cuts will be determined by the market reaction, the evolution of financial conditions, and the Fed’s response. In terms of rate hikes, Zentner expects the Fed to continue its gradual pace of tightening this month, followed by three hikes placed in March, June and September of 2018.

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The Road Narrows

For U.S. equities, while 2017 delivered exceptional returns—notable for no meaningful drawdowns—2018 will likely see much narrower performance as markets begin to contemplate the peak rate of change on growth and deteriorating financial conditions. 

According to Mike Wilson, Morgan Stanley’s Chief U.S. Equity Strategist, “There’s a good likelihood that 2018 will have a few potholes along the way. The recovery will likely become less synchronous and decelerate at some point. I think we’ll also see earnings growth peak in the first half of 2018 which would bring some disruption for investors.”

Wilson comments that while we never saw full blown euphoria in 2017, we did see a significant improvement in sentiment, particularly from institutional investors. What was missing was an absence of strong and persistent retail investor interest, but that may be the final missing ingredient which would conclude the bull market. “We suspect that could happen in early 2018 after a potential tax bill is signed.”

A More Productive Environment

Equities may also benefit from growing optimism as Americans become more upbeat about labor market and business conditions. A tight labor market and rising productivity have been lifting wages. Additionally, these increases in wealth, as well as the anticipation of higher income via tax policy, may keep consumers spending through 2Q19. Consumer confidence may also hit highs not seen since 2000.

Although average job growth continues to slow, Zentner notes that it should remain strong enough to keep slight downward pressure on the unemployment rate. Zentner expects the unemployment rate to fall to 3.8% by 3Q18, and to remain there through 2019. 

Positioning for 2018

So how should investors play the end of this cyclical bull market?  For U.S. equities, Wilson says investors may want to consider classic late cycle performers like Energy, Tech and Industrials. “All three have been working well lately with capital spending returning and oil prices moving higher, both of which are common late cycle.”  Wilson also still prefers small and mid-caps stocks to large caps.

For fixed income, Morgan Stanley’s Head of U.S. Credit Strategy, Adam Richmond, says investors should expect a bumpier 2018.  “Monetary policy has been massive in this cycle, and extremely supportive for credit markets. But moving forward, Fed policy appears likely to become more restrictive and the shrinking of the balance sheet should turn into a notable headwind for credit.”  In addition, credit markets are even later cycle and valuations are near all-time tights, implying poor long-term return potential. Richmond says fixed income investors should consider staying up-in-quality for 2018 and prioritize quality over yield.

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