The long-anticipated market correction finally arrived. Equity markets began to falter in late January, entering a full-blown correction phase in February.
Rather than a mere 5 percent dip, it has been a more meaningful correction with the S&P500 down by over 10 percent from the January. Expect more as markets still appear quite nervous and unsettled. While we suspect that the worst of the correction is behind us, one cannot be sure.
For 2018, we think global equities can deliver high single-digit returns, possibly a bit more, accompanied by a modest contraction in valuation or P/E ratios. In short, there is nothing in the recent market correction that makes us want to abandon our generally positive 12-month outlook. After such a long run of uninterrupted monthly gains, a pullback in equities was long overdue.
There are good reasons not to turn bearish about what lies ahead, since fundamentally not all that much has changed. We still focus on three fundamentals.
• Global growth remains robust. The global composite purchasing manager index (PMI) in January, for example, was at its highest level in over three years. Europe’s growth conditions are particularly good.
• Earnings are still strong. Global earnings for the fourth quarter of 2017 have been robust in all regions, beating estimates by a wide margin. The consensus forecast of 11-12 percent earnings growth in 2018 looks achievable.
• Financial conditions remain benign despite the upward shift in interest rate expectations and bond yields, if judged by the various indicators of financial and monetary conditions. Monetary conditions will not tighten much in 2018; 2019 will be the year when quantitative easing starts to unwind more rapidly.
To argue that the US stock market faces a deep and sustained correction in what looks set to be the best year for the economy since the global financial crisis strikes me as too bearish. We believe that investors may be well served to take advantage of the volatility that has presented itself since the fundamentals globally continue to be very strong. A temporary shakeout is more likely than an equity bear market.
Recession in the US is not imminent; however, investors should still watch the trend in inflation. This is now on every investor’s radar screen. There are clear signs that the trend in inflation will move up a notch this year. We forecast headline CPI inflation to rise to 2.5 percent, or just above, by December.
It would probably require inflation to move above 3.0 percent to trigger a major adverse reaction from markets, not to mention the Fed. On balance, there are few signs at present that point to a rising US recession risk within the next 12 months.
Of all drivers, US wages pose the biggest risk to inflation in 2018. Higher wage inflation would see the Fed respond by raising interest rates more aggressively. Wage costs are now the most important labor market indicator to focus on in 2018.
But all we are seeing so far is a continuation of the very gradual uptrend in US wages that has been visible since 2016. With unit labor costs flat year on year, it is much too soon to declare that we have a wage inflation problem. Not until wage inflation exceeds 4.0 percent can we expect some pressure on corporate profit margins.
If inflation this year begins to accelerate sooner and by more than we are forecasting, investors will face a dilemma. Under a strong inflation trend, equities and bonds would become positively correlated, with negative prospective returns for both asset classes. Although we are not in the high inflation camp, February’s market correction is a reminder for investors to stay vigilant on inflation as the year unfolds.
From our perspective, the long-anticipated market correction is not the start of a protracted bear market. Indeed, economic fundamentals, such as global growth, market liquidity, and robust earnings remain firmly in place.
Our expectation is still for positive returns from global equities in 2018. However, while investors should remain calm they should not return to the complacency evident in January. The trajectory of wage inflation, bond yields and interest rates in the United States plus movements in the US dollar should be watched closely to gauge market sentiment moving forward.
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