Stock market returns have exceeded expectations this year, posting the strongest gains since 2013. Are these gains sustainable, or are they a sign of investor speculation? In our view, the positive market trend can largely be explained by three important developments in 2017:
- Global economic growth is picking up. The U.S. economy appears on track to finish 2017 with three consecutive quarters of growth greater than 3 percent. This is a significant improvement compared to the pace of the last several years. Meanwhile, manufacturing activity is expanding in nearly every region of the world, increasing expectations for global growth.
- Profit growth is improving. U.S. corporate earnings have grown at a low-teens pace this year, and foreign profits are rebounding after several years of weakness. Profit growth is a key driver of stock returns over time.
- The likelihood of a corporate tax cut has increased. The recently released Conference Committee Report calls for a reduction in the corporate tax rate from 35 percent to 21 percent in 2018, which would provide a boost to corporate earnings. While the House and Senate still need to vote on final passage, the odds of a tax cut have increased.
While some signs of speculation have emerged this year, strong market returns have largely been justified by improving economic fundamentals. This means positive momentum could continue into the new year.
Most signals indicate the economy is strengthening, meaning a recession is unlikely in the near term. Positive economic and corporate profit trends should support investment returns in 2018. Stocks aren’t cheap, however, so be prepared for more moderate gains. Above-average valuation levels leave less room for an expansion in price-to-earnings multiples. Therefore, stock returns should track earnings growth more closely going forward.
As we enter 2018, here are three important factors for investors to consider:
- Federal Reserve policy – The three Fed rate hikes expected in 2018 could create a headwind for both stocks and bonds. If intermediate and longer-term interest rates hold steady, further Fed funds rate increases could cause an inverted yield curve (when short rates are higher than long rates), a situation that has occurred prior to each of the last five recessions.
- The return of “normal” volatility – While difficult to predict, market volatility will reappear. Volatility is a consistent feature of the stock market, and downside movement often occurs when least expected. This is why investors should maintain a diversified portfolio, even when earning big returns from stocks seems easy.
- Increasing inflation expectations – Inflation hasn’t been a factor for investors over the past several years, running at a below-average pace of 1 percent to 2 percent. With unemployment dropping to 4 percent and global economic growth accelerating, inflation could rise in 2018.
In summary, the investment environment remains positive but continues to evolve. Future recessions and market corrections are a certainty, though the timing is unpredictable. Fortunately, most downturns haven’t been as severe as the last one in 2008 and 2009. For investors, maintaining diversification and investment discipline is the most effective way to navigate changing market conditions and reach a successful outcome.
For more information or if you have additional questions, please contact us.
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC-registered investment advisor offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request