Market Outlook:

• High teens earnings growth for the S&P 500 Index in 2018 appears achievable as tax reform boosts after tax earnings³
• Corporate tax reform to add approximately 7% to the S&P 500 Index earnings³
• U.S. equity market valuation challenging on 2018 earnings, but analysts are optimistic on 2019 earnings outlook
• Expect slightly negative 2018 fixed income returns as interest rates and bond yields continue to rise
• Corporate bonds appear richly valued as spreads remain narrow; Treasuries, Government Agencies, and CD’s attractive
• Short to intermediate muni bonds make sense for high tax-bracket investors while TIPS have some appeal as an inflation hedge
• Foreign central banks likely to curtail quantitative easing in latter part of year, removing some liquidity
• Return to normal volatility as rates rise and liquidity reduced (end of financial repression)
• Dollar rallies after a weak 2017 as the Fed tightens and European recovery discounted

Downside Risks:

• U.S. political risk, especially concerning trade policy
• Geopolitical risk is high around the globe; Europe, Middle East & East Asia all vulnerable
• Wage gains accelerate toward 4% (versus current 2.9%) resulting in an even faster pace of rate hikes
• Synchronization of monetary policy; foreign central banks become more restrictive
• Return of market volatility harms consumer confidence and consumption slows
• Increasing supply of U.S. Treasury debt is disruptive to the fixed income market

Upside risks:

• Notable improvement in productivity allows for non-inflationary wage growth and higher profit margins
• Greater political stability in Europe
• Steadier exchange rates and commodity prices
• Trade issues recede on better growth

Fall 2018 Markets & Economy

Despite worries over rising interest rates, a more hawkish Federal Reserve, and continuing trade friction, we are hard pressed to find signs of an imminent economic slowdown in the U.S. GDP advanced at a stellar 4.2% pace in the second quarter, the best quarterly gain since 2014¹. Eliminating a 1% boost to Q2 GDP from a surge in exports to avoid the imposition of Chinese tariffs, the economy seems likely to keep chugging along at a robust 3% clip in the back half of this year. It appears, the 2018 full year growth may even slightly exceed our projected 2.5% - 3.0% range³.

The big economic story this year is the continued strength in the labor market. The unemployment rate of 3.7% is near a 50-year low as are jobless claims, which is a leading indicator of future job gains². The economy added an average of 190,000 jobs per month during the third quarter despite a hurricane-weakened month of September². It appears that the number of new hires in 2018 will easily surpass 2.2 million versus our initial 1.8 million forecast³. To put it in perspective, there are only about 100,000 new entrants into the labor force per month. Given tightness in the labor market, wage growth, while still moderate, is at its best level since the recession a decade ago.

With jobs being plentiful, it is little wonder that consumer confidence surged during August and September to a cycle high and near an all-time record. The U.S. economy is consumer driven and consumer spending jumped sharply in the second quarter, increasing 3.8%, and that pace does not appear to have ebbed much in Q3¹. With incomes rising and confidence high, our assumption is for continued strength in consumption in the current quarter.

Business investment or capital spending has also been a bright spot this year. Capital expenditures surged over 10% (annualized) in the first half of the year¹. For the 12-months ended August 31st, industrial production rose 4.9%⁵. Of particular note is the double digit increase in mining output, which includes energy production. Given the recent upswing in oil prices, capital spending in this key sector is likely to increase at an even stronger pace. Furthermore, overall capacity utilization has increased by 1.7% to 78.1% in the past year⁵. With business confidence high, profitability surging, and labor increasingly more expensive, strength in cap-ex should persist.

Residential investment, however, has been a disappointment in 2018 with housing starts erratic and no clear trend in building permits. Our assumption was that persistent underbuilding and favorable demographics supported by strong employment would keep housing activity robust. Two related factors seem to have conspired against this optimistic scenario. The sharp recovery in home prices has far outstripped wage gains. With mortgage rates on the rise, affordability has diminished. Tight supply is also pushing prices higher and a shortage of construction workers means there is no quick fix to this inventory shortage. On the bright side, strong underlying demand should help support the market, and high prices should bring more inventory on the market. Another housing bubble does not appear to be in the works.

While higher interest rates have hampered the more interest sensitive sectors of the economy such as housing and autos; financial conditions, more broadly, remain supportive of economic growth. Although the Federal Reserve has consistently hiked rates by 0.25% each quarter, the Federal Funds rate at 2.25% remains just below the rate of inflation⁵. In other words, the interest rate adjusted for inflation is still below zero. Credit spreads, despite widening somewhat off of cycle lows during recent market turbulence, are no higher than at the start of the year, indicating credit remains readily available. This relative stability in credit markets is reassuring.

Longer-term bond yields have moved higher as well in response to a strengthening economy. The yield on the 10-year Treasury ended the third quarter 2018 at 3.05% after starting the year at 2.43%³. The yield currently sits at 3.15% and briefly touched 3.25%³. This is very much in line with our forecast for a 10-year yield in the range of 3.0% - 3.25% at year-end 2018. The economy seems to be tolerating the rise in rates well. The Federal Reserve will continue on a path towards interest rate normalization and, with inflation hovering just above the Fed target of 2%, appears to be managing the process well with no need to accelerate its pace⁵.

While we have not formalized our economic outlook for 2019, we acknowledge that there are a number of factors that may lead to a slowing rate of growth by the second half of 2019. The most obvious is that 2018 growth benefited from a large amount of fiscal stimulus. This is unlikely to recur as it would literally take an act of Congress. Higher interest rates will also tend to crimp growth at the margin, although, as we alluded earlier, the impact is unlikely to be severe³.

A shortage of workers is also becoming a concern; job creation cannot perpetually exceed growth in the labor force as it has for the past eight years. Finally, the impact of widespread tariffs is difficult to assess as their imposition is uncertain. Our conclusion is that the costs would outweigh the benefits especially in an economy at full employment. Our hope is that a more targeted approach is adopted in resolving our trade disputes. Despite these issues, the economy will potentially conclude 2018 with considerable momentum. While growth is likely to ease back in 2019 from the current 3% pace, another year of solid growth still appears to be a likely outcome³.

Sources: (1) Bureau of Economic Analysis (BEA); (2) U.S. Bureau of Labor Statistics; (3) Washington Trust Wealth Management; (4) Bloomberg; (5) Federal Reserve Board
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.