Stay invested: for 2018 global stock market gains potentially in the double-digits.
Go global: international stocks may outperform U.S. stocks in 2018.
Rebalance: rebalancing back to target allocations is important as 2018 gains in stocks may result in a higher risk asset allocation ahead of a potential recession and bear market.
The exceptional string of month after month gains in 2017 for global stocks raises a concern: have investors become too optimistic about growth? We don’t think so. Global economic growth is also exceptional. Every one of the world’s 45 major economies tracked by the Organization for Economic Cooperation and Development (OECD) is growing this year and expected to post another year of growth in 2018, per OECD forecasts. It has been a decade since the lift to the world economy was this broad.
While risks from politics, central bank policies and military threats haven’t gone away, investors have recognized that the global economy isn’t as vulnerable to these influences as it was during the prior decade. Like a giant cluster of balloons, one or two could fail and the world’s economy would likely remain aloft for 2018.
The broadest global economic growth in a decade likely to keep world economy aloft in 2018
It’s getting late
Global growth is strong and broad, but likely approaching the later stages, according to the global output gap. The output gap is an economic measure of the difference between the actual output of the world economy and its potential output. When actual output is below potential there is excess capacity, typically resulting in prices and wages remaining weak. When actual output is above potential it means excess demand is forcing the economy to run hotter than normal, potentially overworking its resources and often pulling inflation and wages higher.
For the first time in a decade, the global economy has absorbed all of its excess capacity as it heads into 2018, as you can see in the chart below. This is a classic sign we’ve entered the late stages—though not the end—of the economic cycle.
Global excess capacity has finally been absorbed
Source: Charles Schwab, Organization for Economic Cooperation and Development data and 2018 forecast as of 12/8/2017.
There are other key indicators of the later stages of the cycle that have also emerged:
- The low rates of unemployment now seen across the globe. In 2017, the unemployment rate in the Eurozone finally dropped below average, joining other regions with even tighter labor markets.
- Corporate profit margins are now above average in all major regions as they make full use of their capacity. In 2017, profit margins among companies in the MSCI Euro and Emerging Markets indexes finally rose above their 10 year averages, joining those in the MSCI USA and Japan indexes.
The most compelling sign that we’ve arrived at the later stages of the economic cycle is the yield curve. This, the most historically accurate forecaster of the end of economic cycles, is not pointing to an imminent recession over the next 12 months. However, the direction of the yield curve is hinting that a recession may be coming within the next few years, signaling the later stages of the cycle have arrived.
The yield curve measures the difference between short and long-term interest rates. Historically, when short-term interest rates rise above long-term rates, bull markets for stocks have ended and bear markets have soon followed. In 2017, the difference between short-term and long-term interest rates, called the spread, has narrowed in many countries across the globe. When the spread between these rates turns negative, it is referred to as “inverting the yield curve.”
For instance, stock markets in the U.S. and around the world peaked in 2000 and 2007 when the spread between 3 month and 10 year U.S. Treasury yields inverted by about 50 basis points (3 month Treasury yields were about one-half of one percentage point above the yield on the 10-year Treasury note), as you can see in the chart below.
The yield curve: 50 years of accurately forecasting recessions
MSCI World Index began in at the end of 1969.
Source: Charles Schwab, Bloomberg data as of 12/8/2017.
The current yield curve suggests two things:
- No global recession is likely in 2018.
- As the spread narrows toward inversion during 2018, the risk increases of a recession and bear market in 2019 or beyond.
Global economic growth lifting earnings is likely to continue to be a key positive for stocks in 2018. However, if central banks move too aggressively in anticipation of inflation, their actions could invert the yield curve and undermine the bull market.
Takeaway #1: Stay invested
Some investors may want to get out of the stock market early since the yield curve appears headed toward an inversion in a year or so. But, staying invested has actually proven to be the more rewarding approach. Historically, in the year before yield curve inverts global stocks have always posted gains and those gains have almost always been in the double-digits, as you can see in the chart below. Global stocks tended to rise 14% on average in the year before the yield curve signaled a coming bear market and recession.
Index returns shown since date of index inception.
Source: Charles Schwab, Bloomberg data as of 12/8/2017.
These gains have come even though valuations are usually above average (see our take on valuations here: Are Stocks Too Expensive?).
Takeaway #2: Go global
The late cycle gains seen in the year before the yield curve inverted were even stronger in international developed and emerging markets than in the United States, owing to their greater economic and inflation sensitivity.
The table above shows the average return of 21% for developed markets (measured by the MSCI EAFE Index) compared with 9% for the United States. International markets outperformed every period except for the year leading up to the May 1989 yield curve inversion. During that period the dollar rose sharply by more than 10%, weighing on the returns of international stocks when measured in U.S. dollars (measured in local currency, international stocks actually outperformed U.S. stocks).
Takeaway #3: Rebalance
While it is likely to be rewarding in 2018 to stay invested and go global, it may not makes sense to go overweight stocks (even international stocks) given the increasing risk of a recession in the intermediate-term.
As 2018 matures, rebalancing portfolios back to their target allocations will be increasingly important as gains in stocks may otherwise skew portfolios toward a higher risk asset allocation ahead of a potential recession and bear market that could come as soon as 2019.