2018 Schwab Market Outlook

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1 2018 Schwab Market Outlook Schwab Center for Financial Research Schwab s team of market experts share their perspectives and provide investment guidance

2 EXECUTIVE SUMMARY It s getting late YET TO PEAK US Equities Developed International Equities Emerging Markets Equities 10-Year Treasury Yields Cyclical Stocks PEAKING U.S. Earnings Growth Tight Credit Spreads PAST THE PEAK Central Bank Bond Buying Highly Correlated Markets Negative Interest Rates POTENTIAL OPPORTUNITIES Investment Grade Floating-Rate Notes Financial Sector Stocks Healthcare Sector Stocks Technology Sector Stocks Late stages. Going into 2018 global earnings growth continues to be strong, while interest rates and inflation remain low and relative valuations of stocks to bonds reasonable typical of the later stages of a market cycle. We anticipate solid growth in 2018 and don't see a recession on the horizon. However, with markets priced for ongoing moderate growth and low volatility, the risks we re monitoring include the potential for higher inflation and more central bank tightening than expected. Global economic growth lifting earnings is likely to be a key driver for both U.S. and international stocks in Falling correlations across global stock markets bolster the case for diversification. We expect inflation to rise due to a tight labor market and accelerating wage growth. The Federal Reserve is poised to raise rates two to three times in could be the year 10-year Treasury bond yields exceed the three-year high of 2.6% Schwab Market Outlook 1

3 U.S. STOCKS & ECONOMY Liz Ann Sonders KEY POINTS Animal spirits are keeping business optimism alive and well: U.S. growth broadly and capex and productivity specifically should remain healthy in Late cycle tendencies should be on investors radar screen: A tight labor market augurs for higher wage growth, higher inflation and tighter monetary policy. Tax reform would be a plus, but skepticism is warranted: Failure to pass tax reform would dent business and investor confidence, but not necessarily actual growth or corporate earnings. Better late than never U.S. economic growth picked up in 2017, driven by easy financial conditions and surging business capital spending (capex). We expect another healthy year for capex and higher productivity, although the economy is likely in the late stage of its cycle. With a tight labor market, we expect wage growth to accelerate, along with inflation. The Federal Reserve is poised to raise rates at least two to three times in 2018, which is above the market s current expectations. A continued flattening of the yield curve could begin to put the next recession in our sights, although we don t expect a contraction in growth for at least another year or two. Tax reform has the potential to boost economic growth and corporate earnings in Failure would likely dent soft (confidence-based) economic indicators, but not necessarily hard (quantifiable) economic data. This fight won t last forever 2018 Schwab Market Outlook 2

4 U.S. STOCKS & ECONOMY Liz Ann Sonders TAKE AWAYS Discipline is warranted: Tighter monetary policy and rising (but still low) recession risk means diversification and rebalancing will be increasingly important for investors. Valuation risk: Valuation isn t a good predictor of shorter-term stock market returns, but elevated levels are a risk if earnings growth disappoints in Late to the party Stocks tend to correctly anticipate economic recessions, and although we don t see one on the horizon in 2018, a flatter yield curve and tighter monetary policy could bring bouts of volatility and elevated risk. Volatility-linked assets could trigger selling if volatility spikes. Absolute valuations are stretched, but earnings growth has been strong albeit likely peaking. Interest rates and inflation remain low; as such, relative valuations (to bonds) remain reasonable. Large-cap growth leadership should generally persist in 2018 typical in the later stages of a market cycle. Attitudinal measures of investor sentiment are likely to remain in optimistic territory, but could come under pressure quickly with any market pullbacks. We expect behavioral measures like fund flows to finally begin reflecting the length/strength of the current secular bull market, also typical in the latter stages of a market cycle. It s about time: Investors, after years of shunning U.S. stocks (in favor of bonds and international stocks) are becoming more enthusiastic (a blessing and possibly a curse) Schwab Market Outlook 3

5 GLOBAL STOCKS & ECONOMY Jeffrey Kleintop KEY POINTS Broad growth: Global economic growth is the broadest in a decade. Growth trumps politics: Broad growth tends to leave stocks less vulnerable to risks. Inflated risk: If inflation fails to revive in 2018, movements by central banks may be too aggressive. Broadest growth in a decade The exceptional string of month after month gains in 2017 for global stocks raises a concern: have investors become too optimistic about growth? We don t think so. Global economic growth is also exceptional. Every one of the world s 45 major economies tracked by the Organization for Economic Cooperation and Development (OECD) is growing this year and expected to post another year of growth in 2018, per OECD forecasts. It has been a decade since the lift to the world economy was this broad. While risks from politics, central bank policies and military threats haven t gone away, investors have recognized that the global economy isn t as vulnerable to these influences as it was during the prior decade. Like a giant cluster of balloons, one or two could fail and the world s economy would remain aloft for Every major country is helping to lift the global economy Graphic goes here 2018 Schwab Market Outlook 4

6 GLOBAL STOCKS & ECONOMY Jeffrey Kleintop TAKE AWAYS Rebalance: The increasing risk of recession and bear market beyond 2018 make portfolio rebalancing important. Go global: The riskreducing advantages of broad global diversification may offer the most benefit in 20 years. Stay invested: Global stocks have produced double-digit returns before leading indicators signal a recession. Best diversification in two decades Our view is that a global recession is not on the horizon in the next 12 months, based on historically reliable leading indicators including the yield curve. Global stocks (MSCI World Index) have posted double-digit gains, on average, in the year before the yield curve signals a recession. However, the intermediate-term risk of a recession and bear market means rebalancing portfolios is important. Global economic growth lifting earnings is likely to be a key positive for stocks in But if central banks move too aggressively in anticipation of inflation, their actions could undermine the bull market. The return to the lowest average correlation across stock markets seen in 20 years implies globally diversified investors may benefit from less volatility without sacrificing return on the path to their financial goals in essence decreasing risk without decreasing return Schwab Market Outlook 5

7 FIXED INCOME Kathy Jones KEY POINTS Past the peak of central bank stimulus: Led by the Federal Reserve, major central banks are poised to reduce the amount of monetary stimulus flowing to the global economy. Deflation fears are easing, with interest rates slowly moving out of negative territory in Europe and Japan, a trend we expect to continue in Central bank tightening may awaken bond bears 2018 could be the year that bond bears finally awaken from their long slumber, sending 10 year Treasury bond yields above the three-year high of 2.6%. Economic growth is picking up both globally and domestically and fiscal policy is becoming more expansive. Most importantly, the era of extremely easy money is coming to an end. The Federal Reserve is tightening monetary policy through rate hikes and balance sheet reduction. The European Central Bank (ECB) is planning to gradually reduce its bond buying program. Even the Bank of Japan (BOJ) is seeing some success with positive inflation while focusing on keeping 10-year bond yields at zero or above. As the easy-money era gradually recedes, we see more upside risk in yields than downside. Bond bears awakening Potential inflation surprise: Stronger economic growth, a tight labor market and the prospect of tax cuts could mean that inflation in the U.S. hits or exceeds the Federal Reserve s 2% target in Markets appear complacent: With rates low, a flattening yield curve and tight credit spreads, fixed income markets aren t priced for higher inflation or volatility Schwab Market Outlook 6

8 FIXED INCOME Kathy Jones TAKE AWAYS Short-to-intermediate duration: For Treasuries and investment grade bonds, we suggest keeping duration in the 3-7 year range to mitigate the risks of rising rates. Investment grade floating-rate notes should benefit from further Federal Reserve tightening. Stay up in quality: Corporate bond credit spreads are near the post-crisis lows and well below their longterm averages, offering little compensation for their additional risks. Even a modest rise in the yield spread likely due to increased volatility - could result in disappointing returns for lower-rated bonds. Bond markets are highly valued Most segments of the fixed income markets appear expensive relative to long-term average valuations. Yields in the corporate and municipal bond markets are low compared to Treasury yields, providing little reward for added risk. With the economic outlook positive, we don t anticipate a major increase in yield spreads, but there simply isn t much room for further narrowing. Since risks rise as credit quality declines, we are most cautious about lower credit quality bonds like high-yield corporate bonds could be a year when the income generated by bonds is the major source of return rather than price appreciation. With markets priced for ongoing moderate growth and low volatility, the risks we are monitoring include the potential for more central bank tightening than expected and the potential for fiscal stimulus from tax reform. International: Low yields and the potential for tighter monetary policy make international and emerging market bonds less attractive. Municipal bonds: Valuations are high for short-term maturities but near longterm averages for longer maturities. Credit quality remains high in general. 5-8 year durations offer better risk/return characteristics Schwab Market Outlook 7

9 Predictions we are willing to make You ll notice our market outlooks don t include specific forecasts for the major market indices. That s because we don t have a crystal ball (no one does!), and for most investors, we don t think it s particularly useful to focus on where indices might be at mid-year or yearend. However, there are some things outside the realm of markets and investing that we thought we d take a stab at projecting just for fun Schwab Market Outlook 8

10 OUR TEAM Schwab s Market Experts 2018 Schwab Market Outlook 9

11 Important Disclosures Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request. All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. Specific names/titles are for illustrative purposes only. Indices are unmanaged; do not incur management fees, costs, or expenses; and cannot be invested in directly. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met. International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. obtained from third-parties and Schwab does not guarantee its accuracy. Taxexempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax. High-yield bonds and lower rated securities are subject to greater credit risk, default risk, and liquidity risk. Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Index and Term Definitions S&P 500 Index is a capitalizationweighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares. The MSCI All Country World Index (ACWI) captures large and mid-cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. With 2,484 constituents, the index covers approximately 85% of the global investable equity opportunity set. The Nikkei-225 Stock Average is a priceweighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)- denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg). The Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index is part of the Barclays U.S. Corporate Bond Index. Securities are classified as high-yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors. The Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component. The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USDdenominated, non-investment grade, fixedrate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Bloomberg Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB) or higher using the middle rating of Moody s, S&P, and Fitch. This index is part of the U.S. Aggregate. The Bloomberg Barclays EM USD Aggregate Index includes USDdenominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. As with other fixed income benchmarks provided by Barclays, the index is rules-based, allowing for an unbiased view of the marketplace and easy replicability. The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar (USD)-denominated preferred securities issued in the U.S. domestic market. Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security s taxexempt status (federal and in-state) is The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USDdenominated, non-investment grade, fixedrate, taxable corporate bond market Charles Schwab & Co., Inc. All rights reserved. Member SIPC. ( YX)