by Bill O’Grady & Mark Keller
- Our baseline forecast for 2018 calls for no recession and real GDP growth of 2.25%, with faster growth in H1. Inflation should remain low, with the PCE staying under 2.0%. Labor markets will remain tight and wage growth will be constrained due to low inflation expectations.
- Monetary policy is poised to tighten next year; we expect the terminal rate for the fed funds target to be 2.25% by the end of 2018. This level of policy tightening could increase the likelihood of a policy mistake. In this expansion, the FOMC has tended to overestimate the degree of tightening but the odds of a policy mistake are elevated with a new Federal Reserve chair and a hawkish voter roster next year. However, it is more likely that the potential policy error will bring this business expansion to an end in 2019.
- Basis operating earnings calculated by Standard & Poor’s for the S&P 500, we expect operating earnings of $129.82 in 2018. We expect multiple expansion next year, with a P/E of 21.1x (again, basis Standard & Poor’s) for a target of 2739.20.
- Although not our base case, an ebullient reaction in equities is possible given elevated sentiment, ample liquidity, tax cut hopes and the extended nature of the business cycle. Based on our trend model, an S&P 500 of 3300 is possible.
- A rising P/E would continue to favor growth over value. We also expect another strong year for foreign assets due to anticipated dollar weakness.
- We estimate a 10-year Treasury yield in the range of 2.25% to 2.50% next year. Curve flattening is highly likely with FOMC tightening. Credit markets are fully valued but we would not expect significant weakness to develop in corporate credit if recession is avoided.
- In commodities, we hold a favorable view toward oil and precious metals, but weaker Chinese growth will tend to limit gains in the rest of the spectrum. And, we expect continued dollar weakness despite FOMC tightening next year. However, a more obvious bear market for the dollar may not develop until 2019.
- Although we expect rather benign macroeconomic and policy environments next year, the current expansion and bull market in equities are aging and late cycle problems could develop. Late cycle investing can be uncomfortable, creating conditions where an investor feels “forced” to participate. It’s important for investors to remain true to their goals relative to their risk tolerance in this environment.
- In addition, during late cycles, markets become vulnerable to “binary events.” Most of these are geopolitical in nature and will be discussed in our 2018 Geopolitical Outlook, which will be published on Monday, December 18.
 The competing provider of operating earnings, Thomson-Reuters, generally calculates higher levels; the Thomson-Reuters estimate would generate S&P operating earnings of $138.29.