We’ll miss you, Goldilocks. For the stock market, the fact that the economy was less than robust for many years was OK. It was the Goldilocks economy—not too hot and not too cold, helping the bull market reach its ninth birthday in March. But this year, the economy will start to get much hotter, thanks to factors ranging from tax cuts to wage increases. Although those factors are helping support tremendously higher growth in corporate earnings and further drops in the already low unemployment rate, says top economist Allen Sinai, it also will lead to higher inflation and interest rates, making for much riskier times for investors.
Sinai tells Bottom Line Personal that the Dow Jones Industrial Average can gain another 11% this year, including dividends, to reach record highs, and the bulls can keep running through 2019 and into 2020. He adds, however, that investors must be prepared to endure much higher levels of volatility along the way, including sharp corrections.
Here’s what Sinai sees ahead for the rest of 2018 and beyond and how it could affect you and your investments…
Boom and Bust
I’ve often fretted about the disappointing economic growth that the US has experienced since the 2007–2009 recession. Growth in gross domestic product (GDP) has averaged an anemic 2.2% per year, compared with a historical average of 3.2%. But it turns out that this slow-motion expansion served to keep inflation at bay and short-term interest rates near zero for nearly a decade. By the end of 2018, it’s likely that these unusual conditions will have helped spawn the longest bull market in US history.
At the same time, investors should be aware that we already have moved into a new phase of the economic expansion and bull market that I call “boom and bust.”
The boom: Rising GDP growth will likely hit 3% for 2018 and could approach 4% by 2020, a level not seen since 2000. That should happen in large part because of President Donald Trump’s probusiness agenda including…
Massive tax cuts. Economic growth will accelerate in the rest of 2018 as businesses and individuals feel the impact of the administration’s 10-year, $1.5 trillion income tax reductions and start to spend more.
Much higher federal government spending. The new federal budget increases discretionary spending
by $300 billion over the next two years. In addition, the US economy and multinational companies will
receive a boost from increased economic growth in a number of countries around the world. For example, the eurozone, with minimal inflation, should produce GDP growth near 2.5% for 2018 and higher in 2019 despite political and economic turbulence in Italy and Spain.
As a result of all this, the Standard & Poor’s 500 stock index could hit 3,000 in 2019, compared with 2,674 at the end of 2017. That’s because sharply higher corporate earnings will fuel stock price gains despite higher interest rates.
The bust: Unfortunately, when an economy that is in the late stages of an expansion does extremely well, spending and borrowing can get out of hand, igniting higher inflation and resulting in sharp market pullbacks…and then a recession. The dark side of the boom and bust likely will look like this…
Stocks get even more volatile. Over the next 18 months, we are likely to see various pullbacks and corrections of the type that sent the market dropping 10% in the first quarter of 2018. Investors should hang in and use the volatility as a buying opportunity because robust corporate earnings will continue to push the stock market to new highs. But conservative investors who feel too uncomfortable with sharp market drops should consider moving some or all of their stock allocations into short-term bonds or cash.
Inflation jumps. Tight labor markets will ignite wage growth and stoke inflation. Global economic growth means greater demand and higher prices for basic commodities such as crude oil. US benchmark oil prices should rise to nearly $80 per barrel, up from $60 early this year. By next year, I expect the average price of gasoline in the US to hit well over $3.50 per gallon, the highest since 2013. The economy will begin running too hot, with excessive amounts of spending and borrowing leading to unacceptable levels of inflation.
The Federal Reserve raises interest rates to cool inflation. This strategy should work well in 2018 and 2019. After that, I expect that a further rise in interest rates will cause consumers and businesses to pull back spending so much that the economy will suffer.
Economic growth slows dramatically in 2020 and 2021. That means corporate earnings gains will slow, and we could even enter a bear market—a sustained drop of 20% or more in stock indexes.
Key Economic Indicators
Here’s what I see for the key measures of the economy this year and beyond…
GDP: I expect to see the robust growth we have historically experienced in previous economic expansions. GDP likely will grow by 3% for 2018. For 2019, I expect it to grow by 3.5% or more.
Unemployment: The jobless rate, which was 3.8% in May, should fall to 3.6% by the end of 2018 with an average gain of 150,000 to 175,000 jobs a month. By the end of 2019, the rate should be around 3%, the lowest since the 1950s. That comparison is a little misleading, since the US economy is fundamentally different now, with a much higher number of part-time workers and the retirement of many baby boomers. But the tighter labor market will boost wages, which have been growing by around 2% a year over the past several years. Wage growth should jump to 3% by the end of this year and 3.5% by the end of 2019.
Inflation: As measured by the Consumer Price Index (including food and energy), inflation likely will be significantly higher for 2018, around 2.6%, and 2.9% in 2019.
Outlook for Stock Indexes and Sectors
The S&P 500 should gain 13% for all of 2018, including dividends. That will be driven by very strong corporate earnings. In the first quarter of 2018, earnings for companies in the S&P 500 were more than 20% higher year-over-year, the strongest gain in more than seven years. Corporate earnings should rise 17% in 2018 and 12% in 2019, allowing the stock market to keep reaching new highs before turning down in 2020. Best stock sectors now…
Information technology. These companies will be the biggest beneficiaries of stronger business and consumer spending. But investors should be valuation-conscious and look past the exorbitantly priced FAANG stocks (Facebook, Amazon, Apple, Netflix and Google parent Alphabet Inc.).
Energy. Higher oil prices and beaten-down stock prices make this sector attractive.
Financial services. This sector will benefit from strong loan demand and rising profit margins.
Health care. The aging US population and technological advancements will help drive these stocks.
Sinai’s Outlook for Bonds
Rising interest rates are likely to result in losses for most bond funds in 2018 and 2019, and for individual bonds that are sold before maturity. But it’s OK to invest in individual bonds if you can hold them to maturity.
For investors who do not want to be in the stock market because of the increasing volatility, the most attractive fixed-income option now is six-month US Treasuries, recently yielding 2.1%, which is higher than comparable yields for most bank deposit accounts or certificates of deposit (CDs).
I expect that the Federal Reserve will lift short-term interest rates a total of four times in 2018, and three times in 2019, to tamp down inflation. I forecast that 10-year Treasuries, recently yielding around 3%, will reach 3.75% by the end of this year and well over 4% by the end of 2019. Because of that, as short-term Treasury notes mature, you should be able to keep rolling them into similar notes with higher yields.
Important: Avoid long-term Treasuries and other long-term bonds because they are not yielding enough to make it worth locking in your money for an extended period.