Investors Set to be Surprised Again in 2018

Investors have been surprised by 2017.

We’ve had stronger-than-anticipated global growth. Earnings growth exceeded expectations and interest rates haven’t increased as much as forecast.

Global stock prices rallied beyond most projections, and bond prices recovered from their lows. Yet, markets indicate investors continue to expect weak growth in the economy, along with earnings growth and stable interest rates. Investors are signaling they believe deflation is more probable than higher inflation.

I think it’s more likely the economy and earnings will continue to outperform expectations, and that should be good for global stocks.

Growth in the United States and many other countries looks sustainable. While central banks plan to tighten monetary policy, they don’t plan to tighten more than their economies can tolerate. There continues to be more potential outside the United States.

The United States is later in the business and economic cycle than the rest of the world. The Fed stopped quantitative easing in 2014. Unemployment is very low, and there are pressures for higher wages. As the economy grows, businesses will have to hire additional workers. That should lead to higher wages. The higher labor costs should result in some combination of higher inflation, as businesses try to pass costs onto consumers, and lower profit margins.

Also, investors aren’t giving the European economy enough credit. It is growing at its fastest rate since the financial crisis. The European Central Bank (ECB) will provide whatever stimulus the economy needs. The elections and other political risks people were so worried about a year ago are mostly in the past.

I don’t want to understate the risks in Europe. The continent continues to depend on both strong stimulus from the ECB and continued growth outside Europe. Many European economies still are at depression levels, and there is too much debt. Inflation remains very low. Even so, the potential growth for the next year or two is higher than in the United States.

In addition to underestimating the global economy, investors probably will be surprised by interest rates. Real interest rates (market rates minus inflation) remain near historic lows, despite higher economic growth and the Fed’s tightening. If growth continues at recent rates (or accelerates), there should be inflation pressures and markets will push long-term rates upward. In this post-financial-crisis period, we have to balance the traditional economic and business cycle with the long-term credit cycle.

In the United States, we’re late in the traditional economic and business cycle. That’s when growth typically is strong, the labor market is tight and inflation pressures develop. Normally, central banks tighten policy to slow the economy.

But we’re still in the liquidation phase of the long-term credit cycle that peaked with the financial crisis. Much of the debt overhang from the credit boom is affecting the economy by putting downward pressure on growth and inflation. That leaves the economy in a precarious state and it’s why the greatest risk is central banks tightening too much.

The central bankers don’t have all the tools they used to have to re-stimulate the economy if it falters, so they must be cautious. So far, the Fed and other central banks have done a good job of not overreacting to the business cycle by tightening too much. As long as that restraint continues, this phase of the business cycle should continue for a while.