Market Voice: What Will be Ringing in The New Year?

For the first edition of 2018 we will look at how we expect the key themes of last year to play out in 2018. Probably the most critical issue is if and when inflation will emerge and what this means for the stock and bond markets. The second is whether crude oil prices will finally break out of the five-year old range. Finally, will 2018 be a positive year for the dollar?

A Watched Pot Never Seems to Boil

The tax package enacted in December has arguably made the market see inflation as a serious risk for the first time since the financial crisis. This is not surprising given that tax cuts are projected to add around $1.5 trillion in deficit spending to an economy that is already operating at low levels of unemployment. 5-year Treasury bond rates surged in the fourth quarter; gaining about 50 basis points to the highest level since 2010 and the Fed Funds futures market increased expected tightening in 2018 by 10 basis points (i.e., almost a 50% chance of an additional hike). The bond market speculative indicators suggest a renewed piling into one of the biggest pain trades of the past decade – shorting long duration.

We believe inflation pressures are on the rise but it will take a long time for the pot to come to a boil. We established in last  June’s Market Voice that the historic link between unemployment and wage gains – and ultimately inflation – had broken down. And as was shown in  last month’s edition, the link between deficit spending and inflation is also weak. Although there is anecdotal evidence that employers are increasingly having difficulty hiring in certain job sectors, this has yet to show up in any meaningful way in the broad wage data; both the quarterly Employment Cost Index (Q3) and the monthly average salary data (December) show labor costs rising steadily in rough alignment with inflation.

Capacity Utilization and CPI Inflation

Source: Refinitiv Eikon

The breakdown of the relationship between labor market conditions and wage rates, at least in part, reflects the historically high proportion of the population that has dropped out of the workforce. This pool of idle potential workers may mean labor conditions are not as tight as the unemployment rate suggests. Capacity utilization rates support this picture of ample capacity. Capacity utilization is shown in the chart above as a 12-month moving average to sync with year/year inflation. While current capacity of 77 is a bit higher than the moving average, it is still a level more akin to the early stages of recovery from recession rather than the late stages of a business cycle. Inflation, while still low compared to history, actually looks overdone given the low level of utilization. We think core inflation is not likely to move materially higher until utilization moves north of 80 or there is clear evidence that wage rates are gaining upward momentum. Even if the tax package provides stimulus, it will probably be well into the second half of 2018 before this works through the economy and begins to affect output and wages. With inflation likely to remain benign for the next few quarters, the move higher in bond yields is also probably overdone and 2018 will see a ringing in of the old; shorting the bond market will yet again be a pain trade.

Will 2018 be a Year of Pain for Long Equity Holders?

One of the ongoing themes we pushed in 2017 was that while outright equity price/earnings (P/E) ratios were high by historic standards they were not nearly so extended when scaled by the low 10-year bond rates. Most recently in  the November Voice we showed that the SPX bond-adjusted P/E ratio was near post financial-crisis highs but remained well below pre-crisis levels. The recent bump in yields was concentrated in the front end and the 10-year rate finished

2017 mid-range so there has been no appreciable change in adjusted P/E ratios since November. We believe scaled equity valuations are above average but they are far from levels that could be termed a “bubble market”. The implication is that there is no basis to view equity markets as vulnerable to a major sustained downturn purely on the notion of being expensive.

Real Interest Rates, the Yield Curve and Equity Market Downturns

Source: Refinitiv Eikon

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Many events have been attributed as the specific trigger for prior plunges in equity prices but there are some common themes that typify the onset of a bear market As shown in the chart above, since the mid-1950s the onset of a bear equity market trend – here defined as two or more consecutive months of at least a 5% SPX year/year price decline – has generally occurred with the real (deflated by prior year CPI inflation) 3-month interest rates above 1% and, since 1980, the bear market onset required a real rate in excess of 3%. The only clear exception to this 1% real rate condition is the 1976 decline which was triggered by an oil crisis. With real short-term interest rates rising but still below zero, the Fed would have to hike substantially more this year than the 50 to 75 basis points expected by the market to create the backdrop needed for a major market decline. A rise in bond yields would not be the basis of a bear market if it steepens the curve. Major market declines have almost always emerged in an environment of a flat to inverted yield curve so while the curve became flatter last year, there is also much more work required to create the conditions for a major market decline.

Given high valuation, it is difficult to make a case that 2018 will match the equity gains of last year even with the positive impact of the recent tax package. A rally market will be dependent on the economy delivering solid growth with relatively benign inflation. So our bias is the bull market will continue at a modified pace with risks for a downturn increasing late in the year. A double negative whammy for the markets would be if growth slows with an inflation rate high enough to make the Fed reluctant to cut rates.

.Global Oil Supply/Demand Balance and Crude Oil Prices

Source: Refinitiv Eikon, International Energy Agency

The Oil Picture is Prettier than the Prospects

Oil prices closed 2017 with a solid uptrend finishing the year testing USD62/bbl, near the post-collapse high. The rise in prices represents both push and pull. The pull comes from the 2017 pickup in global activity. The IMF is estimating global growth reached 3.6% in 2017 up roughly half a percentage point from the prior year. Expanding economic activity stimulated energy use with oil demand closing the year at 98 million barrels per day (bbd) up about 3% since 2015. The push comes from the recent announcement that OPEC will continue to restrain production in 2018 and supply closed the year up only 1% during the same period. As shown in the chart above, the relative pickup in demand has closed the supply overhang that emerged in 2015 abetting the sharp decline. So could surging oil prices be a trigger for an equity bear market?

While the picture for oil is no longer clearly bearish, it would be a mistake to read too much upside in the current environment. Despite OPEC restraint, oil supply remained firm in 2017 as shale oil producers amped up production in response to firming price. And while the supply overhang has disappeared, continued upside price momentum requires a steady net demand pull that has yet to emerge. And more ominously, global inventories surged more than 10% in 2015 hitting record highs. Despite the pickup in demand, inventories have only come off marginally from the record highs suggesting an additional overhang for prices. So even if, as the IMF projects, global growth maintains its current faster pace this year, unless there is a major supply disruption, oil prices should struggle to break through $65/bbl. Any price response to the unusual US cold spell should prove to be temporary.

Dollar’s Outlook for 2018 Tied to Relative Equity Gains

In addition to the potential stimulus to growth and equities, the Tax Package creates incentives for a substantial – perhaps $1 trillion plus – repatriation by US corporates of overseas holdings (note much of the repatriated funds may already be held in USD so dollar buying will likely be a – still sizable – fraction.) A similar repatriation during Bush’s presidency was accompanied by solid dollar gains so the early months of 2018 should see the dollar remain firm. However, as shown below, the trade-weighted USD is already

relative strong both in nominal and real terms. So while some USD gains should be expected, last year’s highs should continue to be strong resistance. More importantly, the longer term USD trend has been strongly linked to US equity performance relative to local-currency equity gains in other countries. As discussed above we are confident in extension of the US bull market into the second half of 2018 but the picture could turn problematic late in the year. So keep an eye on relative equity performance as a bellwether for a turn in the dollar.

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