Fourth Quarter 2017 Market Outlook Kim Huebner, CFA Don Powell, CFA Joseph Styrna, CFA
Economic Outlook Growth Increasing, Spending Modest, Low Unemployment 2017 2016 2015 2014 2013 2012 2011 GDP* Q3: 3.2% Q2: 3.1% Q1: 1.2% 1.5% 2.9% 2.6% 1.7% 2.2% 1.6% Consumer Spending* Q3: 2.2% Q2: 3.3% Q1: 1.9% 2.7% 3.6% 2.9% 1.5% 1.5% 2.3% Unemployment# Dec: 4.1% 4.7% 5.0% 5.6% 6.7% 7.9% 8.5% Payroll Additions# Dec: 148,000 YTD: 2,100,000 2,240,000 2,713,000 2,998,000 2,302,000 2,142,000 2,091,000 * Bureau of Economic Analysis # Bureau of Labor Statistics Economy Continues to Improve; New Tax Law Likely to Benefit U.S. economic growth is improving. Real GDP increased at an annual rate of 3.2 percent in Q3 (versus a 3.1% increase in Q2 and a 1.2% increase in Q1). While some might attribute this strength to the temporary impact of Hurricanes Harvey and Irma, which occurred late August through mid-september, there appear to be other more sustainable growth factors impacting the U.S. economy (e.g. recent tax reform). The increase in real GDP in Q3 primarily reflected positive contributions from personal consumption expenditures (PCE), private inventory investment, nonresidential fixed investment (e.g., equipment), an increase in net exports, as well as federal, state and local spending. Decreases to real GDP in Q3 were due to declines in residential fixed investment (less likely to buy a home during a hurricane). The (Bloomberg) consensus estimate is for GDP growth for the U.S. at 2.3% for 2017 and 2.6% for 2018. On December 22nd, the President signed into law H.R.1., originally known as the Tax Cut and Jobs Act. The new law is the culmination of a lengthy process in pursuit of business tax reform over the past 20 years. The focus of the new law is the permanent reduction of the corporate tax rate from 35% to 21%, the repeal of the corporate Alternative Minimum Tax (AMT), expensing of capital investment, limitations on the deductions for interest expense, as well as, temporary reductions in individual income tax rates and new limits on itemized deductions for individuals. Overall, this is expected to positively impact corporate earnings and future GDP growth. On December 13th, the Federal Reserve raised the Fed Funds rate +0.25% to a range of 1.25% to 1.50%. The effective Fed Funds Rate is currently 1.42%. The Fed will continue to gradually reduce its balance sheet by purchasing less government and agency bonds over the next several years. The Fed is expected to raise the Fed Funds rate 25 basis points (+0.25%) at its March, September and December meetings. By the end of 2018, the Fed Funds rate is expected to increase to between 2.00% and 2.25%, consistent with expectations for inflation. While most economic data and the recent favorable tax legislation supports a continuation of the economic expansion, we continue to monitor economic data closely for signs of a late-cycle slowdown. For example, with the unemployment rate nearing lows of prior economic cycles, we are watching closely for signs of increased inflation, which tends to rise during the later stages of the business cycle. Market Outlook Fourth Quarter 2017 1
Economic Outlook Core Inflation Stable CPI and PPI Up on Rising Energy Prices 2017 2016 2015 2014 2013 2012 2011 Consumer Price Index (CPI)# Nov YOY: 2.2% 2.1% 0.7% 0.8% 1.5% 1.7% 3.0% Producer Price Index (PPI)# Nov YOY: 3.1% 1.7% -1.1% 0.9% 1.2% 1.9% 3.2% Core PCE* Nov YOY: 1.5% 1.8% 1.3% 1.6% 1.5% 1.9% 1.5% Productivity# Q3-17 YOY: 3.0% -0.1% 1.3% 1.0% 0.3% 0.9% 0.1% Unit Labor Costs# Q3-17 YOY: -0.2% 1.1% 1.8% 1.9% 0.9% 1.7% 2.1% Employment Cost Index# Q3-17 YOY: 2.5% 2.3% 2.1% 2.2% 1.9% 1.8% 1.9% # Bureau of Labor Statistics * St. Louis Federal Reserve The Fed s preferred inflation gauge (Core PCE) was only up 1.5% in November. PCE, including energy and food, rose 1.8%. Inflation by other measures including the CPI (2.2%) and CPI-Core (1.7%) also continue to remain low. At Fed Chair Yellen s Press Conference on December 13th, she stated, Even with a firming of economic growth and a stronger labor market, inflation has continued to run below the FOMC s 2 percent longer run objective We continue to believe that this year s surprising softness in inflation primarily reflects transitory developments that are largely unrelated to broader economic conditions. As a result, we still expect inflation will move up and stabilize around 2 percent over the next couple of years. While Core PCE remains below the Fed s 2 percent target, recent increases in CPI and PPI reflect rising energy prices. Global Growth Continues to Improve According to the European Commission, the Euro area economy is on track to grow at its fastest pace in a decade this year with real GDP growth forecast at 2.2% (versus 1.7% previously forecasted) and remain stable at 2.1% through 2018. On December 8th, Japan posted its strongest GDP report in four years, 3rd quarter GDP growth was revised upward to an annualized 2.5%, but estimates for 2018 remain closer to 1.8%. China and India GDP growth also remain strong. The World Bank raised its forecast for China economic growth in 2017 to 6.8% (from 6.7% this past October), but maintained its 2018 economic growth estimate at 6.4%. India economic growth also expanded to an annualized rate of 6.3% (v. 5.7% in the previous quarter). In December, the JPM Global Composite Purchasing Manager Index (a leading economic indicator) climbed to its highest level (54.4) in 2 ½ years, indicating continued growth. With improvements overseas, and ongoing slow-but-steady US growth, the global economy is expected to grow at 3.5% in 2017 with a slight pick-up to 3.7% in 2018 according to OECD estimates (Organization for Economic Cooperation & Development). Market Outlook Fourth Quarter 2017 2
Stock Markets Quarter: Unprecedented Steady Monthly Gains Lead to Strong 2017 Gains Q4-17 YTD 2016 2015 2014 2013 2012 2011 2010 Returns Returns Returns Returns Returns Returns Returns Returns Returns DJIA 11.0% 28.1% 16.5% 0.2% 10.1% 29.7% 10.2% 8.4% 14.1% S&P 500 6.6% 21.8% 12.0% 1.4% 13.7% 32.4% 16.0% 2.1% 15.1% Russell Mid Cap 6.1% 18.5% 20.7% -2.2% 12.3% 33.5% 17.9% -1.7% 26.6% Russell 2000 (Small) 3.3% 14.6% 21.3% -4.4% 4.9% 38.8% 16.3% -4.2% 26.9% NASDAQ 6.6% 29.7% 7.5% 7.1% 13.4% 38.3% 15.9% -1.8% 18.2% Internat l (Developed) 4.2% 25.0% 1.0% -0.8% -4.9% 22.8% 17.3% -12.1% 7.8% Emerging Markets 7.4% 37.3% 11.2% -14.9% -2.2% -2.6% 18.2% -18.4% 18.9% Bloomberg Stock markets continued to rally in the 4th quarter. The S&P 500 Index advanced 6.6% in the fourth quarter marking the ninth consecutive quarterly increase for the Index. The S&P 500 ended the quarter near a new all-time high. In 2017, the S&P 500 posted a gain in each month (including dividend income) an achievement the Index has never accomplished before. Corporate profits were strong, with 74% of companies beating EPS estimates and 66% beating sales estimates during earnings season. Within the S&P 500, Tech, Materials, and Shown below are earnings growth estimates for the S&P 500. FactSet Qtr1 Qtr2 Qtr3 Qtr4 Year Financials provided the highest yearly returns, whereas, Real Estate, Utilities, and Telecom lagged. Outside of the U.S., Emerging Markets posted the best return for the 4th quarter with a total return of 7.44% and the largest yearly gain as well. According to FactSet, 4th quarter S&P 500 operating earnings are expected to advance 10% year-over-year, compared to an actual year-over-year rise of 6.2% in the 3rd quarter of 2017. For all of 2017, S&P 500 earnings are expected to rise by 9.5% with Energy, Technology, and Materials companies leading the way. Looking farther out to 2018, expectations are for profits to further increase to a year-over-year rate of 11.1%, led by Energy, Materials, Financials, and Technology. S&P 500 Operating Earnings Growth Source: FactSet 2015 1.4% 0.1% -1.1% -2.8% -0.3% 2016-6.6% -2.8% 3.2% 5.1% 1.2% 2017 13.8% 10.3% 6.2% 10.0% 9.5%E Market Outlook Fourth Quarter 2017 3
Stock Markets Outlook: Higher, With Higher Volatility Looking ahead, stocks should move higher for the following reasons: Corporate earnings are expected to continue to rise in 2018. As mentioned above, 2018 earnings are expected to rise at a doubledigit pace. The Tax Reform impact for small caps is expected to be even larger, as small caps typically have higher effective tax rates. The global economy continues to expand, and is expected to accelerate in 2018. An improving global economic environment remains a positive for corporate profits. The corporate tax cuts allow for further increases in stock dividends, stock buybacks and merger and acquisition activity. In addition, the immediate expense provision can be a positive for corporate spending, allowing for a continuation and potential acceleration in Cap-Ex spending. The U.S. Federal Reserve is expected to increase rates in 2018, but also in a manner that is data-dependent, cautious, and transparent. Trade policies could come to the surface again as the political season moves along. The Trump Administration has threatened protectionism since the early days of the campaign. If threats translate into actual economic policy, in the form of tariffs, sanctions, or withdrawing from trade deals, then the flow of goods, services, and supply chains could be disrupted. Consequently, markets would be negatively impacted. Monetary policy will continue to be a focus. The Fed has already raised rates 5 times, and more hikes are expected in 2018. If the Fed increases rates too quickly, this could choke off the ongoing expansion, resulting in a policy error. Furthermore, there is a change in Fed leadership as well as new voting members resulting in a less experienced FOMC than years past. Only 3 members remain from the FOMC that initiated Quantitative Easing in 2008. However, stock markets may experience volatility from a number of potential catalysts. Geopolitics are always a concern for investors, and unfortunately hard to predict. Any number of short-term unexpected headline risks could include tensions in the Middle East, the Korean Peninsula or overseas election results in developed and emerging market countries. Although nearly a year away, mid-term U.S. elections could be a concern for investors. With the president s low approval ratings and initial low ratings for the tax plan, voters may seek to make a change at the ballot box (resulting in market fluctuations). Market Outlook Fourth Quarter 2017 4
Interest Rates Quarter: Lower 12/31/17 QTR YTD 12/31/16 12/31/15 12/31/14 12/31/13 12/31/12 12/31/11 12/31/10 Yields Returns Returns Yields Yields Yields Yields Yields Yields Yields 3 Mos T-Bill 1.38% 0.28% 0.85% 0.50% 0.17% 0.04% 0.07% 0.04% 0.01% 0.12% 6 Mos T-Bill 1.53% 0.27% 0.96% 0.61% 0.48% 0.12% 0.09% 0.11% 0.06% 0.18% 2 Year Treasury 1.88% -0.34% 0.18% 1.19% 1.05% 0.67% 0.38% 0.25% 0.24% 0.59% 5 Year Treasury 2.21% -0.71% 0.71% 1.93% 1.76% 1.65% 1.74% 0.72% 0.83% 2.01% 10 Year Treasury 2.41% -0.29% 2.06% 2.44% 2.27% 2.17% 3.03% 1.76% 1.88% 3.29% 30 Year Treasury 2.74% 2.99% 9.03% 3.07% 3.02% 2.75% 3.97% 2.95% 2.89% 4.33% 2-10 Year Spread +53 +126 +122 +150 +265 +151 +164 +270 Bloomberg Bond yields rose during the quarter. The yield curve shift was a Bear Flattener as the shorter term rates rose faster than the longer term rates. Three month to 2 year Treasury yields moved higher by 34 to 40 basis points. The 5 year yields moved up 27 basis points and the 10 and 30 year rates rose 8 basis points each. Consequently, the yield curve continued to flatten, as measured by the 2-10 year spreads. The spreads went from 85 basis points on 9/30 to 53 basis points on 12/31. The shift is not surprising given 1) the Fed executed its 3rd anticipated rate hike on Fed Fund rates on December14th to 1.25% - 1.50%. This followed 2 previous 25 basis point hikes on June 14th and March 15th. 2) On December 21st, final GDP estimate for the 3rd quarter came in at 3.2% which was followed by a 3.1% increase for the 2nd quarter. By any reasonable account, the economy appears to be on solid ground and anticipated negative effects of hurricanes appear to be overdone. 3) The Fed began reducing its balance sheet in October by withdrawing $10 billion per month through December. It will increase this amount by $10 billion per month, per quarter until it reaches $50 billion per month and continue to the end of 2020. The Fed has essentially reduced demand and, in theory, rates will drift higher. 4) The tax cut legislation is likely to modestly increase inflation expectations toward the Feds 2% target. As inflation expectations move higher, rates will follow. Corporate bond spreads continue to narrow to levels last seen in 2007. Investment grade spreads narrowed by 7 basis points from 106 basis points on September 30th to 99 basis points on December 31st. Conversely, Junk spreads widened by 5 basis points from 353 basis points on September 30th to 358 basis points on December 31st. In spite of this, Investment Grade Corporate Bonds and High Yield bonds posted the best returns for the year with 6.5% and 7.5% respectively. Other fixed-income returns are posted below: Market Outlook Fourth Quarter 2017 5
Interest Rates Q4-17 2017 YTD 2016 2015 2014 2013 2012 2011 2010 Returns Returns Returns Returns Returns Returns Returns Returns Returns Treasuries 0.1% 2.4% 1.1% 0.8% 6.0% -3.4% 2.2% 9.8% 5.9% Agencies 0.0% 2.1% 1.5% 1.0% 3.4% -1.8% 2.4% 5.3% 4.6% Mortgages (Agency) 0.1% 2.5% 1.7% 1.5% 6.1% -1.4% 2.6% 6.1% 5.7% Corporates 1.1% 6.5% 6.0% -0.6% 7.5% -1.5% 10.4% 7.5% 9.5% Municipals 0.8% 5.4% 0.4% 3.3% 9.1% -2.6% 6.8% 10.7% 2.3% High Yield 0.4% 7.5% 17.5% -4.6% 2.5% 7.4% 15.6% 4.4% 15.2% Outlook: Moving Higher Interest rates may increase by year end due to the following: The Fed began executing the plan to reduce its balance sheet in October, 2017. The Fed (and Market) continues to be committed to 3 to 4 rate hikes in 2018. Tax cut legislation is likely to be moderately inflationary. Bullish sentiment toward the US dollar continues to wane due to stronger global growth. Concerns that may change this projection and add volatility to credit markets include: Deterioration of foreign relations: North Korea, Iran, etc. Continued gridlock in Washington, DC. Midterm election outlook and the prospect of a Democratic majority in the House and/or Senate. With consideration of the above, bond portfolios will continue to focus on quality, duration (maturity) management, and issue structures for added safety (TIPS, floating rates, and call features). Past performance is no guarantee of future results. This commentary has been prepared for informational purposes. Information and opinions expressed herein reflect our judgment and are subject to change. Wealth Management services are offered through First Midwest Bank. Most wealth management products are not FDIC insured. Market Outlook Fourth Quarter 2017 6