Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
A confluence of factors is coming into play in the financial markets as the year draws to a close and we move into 2018. An acceleration of economic growth has occurred with the second and third quarters recording 3+% annualized gains. Moreover, an improving consumer environment and an uptick in capital spending, particularly equipment, highlights the shift in growth to productivity enhancing factors. The ISM Surveys for Manufacturing and Non-Manufacturing continue to suggest that the economic expansion is on track, and 2018 is shaping up to be a constructive year. Moreover, economic growth in Europe, Japan, and China are providing the basis for a synchronized world-wide expansion. India, Australia, Canada, and parts of Latin America are adding to the upturn.
Worldwide economic growth has fostered a revival in revenue and earnings growth beyond expectations and has set the fundamental background for higher market valuations. Moreover, fiscal policy in the form of tax reform has recently taken center stage. As the probability of passage rose, the equity market responded positively. This response is not surprising, given the low expectations of several months ago. Additionally, the aggressive effort toward deregulation should not be overlooked as an important constructive factor.
On the monetary front, the testimony of Mr. Powell, the Fed Chair nominee, provides comfort to market participants that continuity will be maintained. The low level of unemployment does not appear to be a policy problem as inflation remains the focus.
As 2017 draws to a close, seasonal factors come into play and selling pressure should diminish. Given the markets performance this year and the implementation of tax reform, 2018 should see increased volatility and a change in the character of the market.
The level of interest rates will be critical in determining market valuations. The Federal Reserve’s decision to raise the Federal Funds Rate to 1.25% – 1.50% on December 13, 2017, was highly anticipated and three rate increases in 2018 was reflected in its forecast. From the economy’s and the market’s perspective, the relationship between short-term rates and inflation is particularly important. Maintaining short-term rates below the inflation rate is simulative and is likely to persist well into 2018 and maybe 2019. Even the three rate increases that are anticipated for next year should keep the rate near, but not above the inflation rate. Moreover, there is no guarantee that there will be three increases. At the December 13th Federal Open Market Committee Meeting, two members voted against the increase.
Another element in the monetary equation is the European Central Bank (ECB). The ECB remains committed to quantitative easing, although monthly bond purchases have been reduced. Given Europe’s improved growth rate, continued monetary accommodation through next year should foster improved growth in 2018 and 2019. A synchronized worldwide economic expansion provides the fundamentals for sustained revenue and earnings growth.
The administration’s tax reform should provide a boost to corporate earnings, estimated to be in the 7 – 9% range. This impact would reduce the S&P 500’s price/earnings ratio by .5 to 1 point, thereby producing an 18 to 18.5 multiple on 2018 estimated earnings and a 4+% earnings yield.
As we have indicated in the past, a key element to the valuation equation is interest rates. Despite rising economic growth, stimulative fiscal policy prospects, and a less accommodated Federal Reserve, the 10 Year Treasury yield has changed little over the last year. One of the more puzzling factors the Monetary Authorities have struggled with is the notion that given current economic conditions, inflation remains low thus leading to low long-term interest rates. It appears that the excess liquidity and excess capacity on a worldwide basis (the supply chain) continue to be reflected in the rate structure: a 30 basis points yield on 10-year German bonds and a near zero yield in Japan. Moreover, Italy and France have 10-year yields below the U.S. The normal or neutral interest rate that is often discussed, may well be illusive and low.
As we move into 2018 and even 2019, central banks will attempt to extricate themselves from the aggressive monetary policy that the financial crisis produced. However, given the experience of the last decade, they are likely to be in inexplicably integrated into the world economy as never before. Those forecasters who think we are going back to policies that preceded 2008 are likely to be very disappointed.
In this setting, the equity market will be wrestling with valuation in an interest rate environment that is changing, but heavily influenced by central banks around the world. At the same time, the economic expansion (which is driving revenue and earnings) will be assessed and reassessed as the new year progresses. Sector emphasis and stock selection are likely to come into greater focus.
It is imperative that investors ignore the noise; there will be plenty. The pundits will be prognosticating many scenarios, and some will be quite scary. Please ignore those scenarios and stay committed to concentrating upon the fundamentals. Liquidity, interest rates, and financial stress will be the important drivers of the market into the years ahead. When they change so will the market. Stay tuned!!!
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, or firstname.lastname@example.org or
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com.
© 2017 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.