U.S. Outlook: Strong Economy, Expensive Markets | American Funds

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2018 outlook

U.S. Outlook: Strong Economy, Expensive Markets

Key Takeaways

  • Soaring consumer confidence, a healthy jobs market and improving retail sales are giving the U.S. economy a further boost.
  • Tightening labor markets and faster wage growth will eventually lead to higher inflation, but generally favorable conditions will likely persist in 2018. 
  • After years of solid market returns, valuations for most U.S. assets are at or near multiyear highs, so at this stage of the cycle a measure of caution is warranted.
     

U.S. Economic Engine Reaches Higher Gear Consumer Strength, Modest Inflation Point to an Extended Expansion

LI49 - Chart 1

Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Thomson Reuters. GDP growth is the year- over-year growth in 3Q16 and 3Q17. Inflation and retail sales growth are year-over-year changes on 9/30/17, and 9/30/16. Inflation uses the change in the consumer price index. Jobs added is the monthly change in the payroll survey as of 10/31/17, and 10/31/16. Manufacturing activity is the manufacturing component of the 9/30/17, and 9/30/16, Institute of Supply Management (ISM) Purchasing Managers’ Index (PMI) reports.

When it comes to the U.S. economy, good news seems to be getting better. Growth hasn’t been robust during the current cycle, but it has been steady. And it appears to be entering a new phase of self-sustaining equilibrium. GDP rose at a 3% annual rate in the third quarter of 2017, the second consecutive quarter of 3% growth. At more than 100 months old, the expansion is mature, but the absence of notable imbalances indicates it can continue for some time. But markets have been soaring of late and valuations are high across asset classes, pointing to the importance of selective investing.

U.S. growth appears poised to strengthen further, thanks largely to consumer health. The jobs market is solid, consumer confidence is soaring and retail sales growth is picking up. The U.S. unemployment rate fell to 4.1% in October, a 17-year low. As a result, wages have also been picking up, rising 2.4% in October. Thus far, wage growth has been subdued, helping keep a lid on inflation. But given the improving jobs market and strengthening economy, wage inflation is likely to rise later in the year.

Consumer spending on durable goods rose at an 8.3% annual rate in the third quarter, and capital expenditures rose 7.4%, providing an additional tailwind to the economy. In addition, corporate profits rose 5.8% in the third quarter. On the policy front, the prospect of corporate and personal income tax cuts could propel the expansion further.

With consumer spending healthy and wages rising, consumer-facing businesses have the potential to do well in the next phase of the economic expansion. Companies across a wide variety of industries are exposed to rising consumption, including home improvement retailers such as The Home Depot, online retailer Amazon and shopping mall developer Simon Properties, which could benefit from higher traffic at traditional retailers.
 

But U.S. Assets Have Gotten Expensive Research Is Critical to Uncover Value in Soaring Equity Market

LI49 - Chart 2

Sources: Bloomberg Index Services Ltd., MSCI, RIMES, Standard & Poor’s, Thomson Reuters as of 9/30/17. Large-cap and small-cap equity valuations provided by IBES, for the S&P 500 Index and Russell 2000 Index, respectively. Investment-grade and high-yield corporate bond valuations are option-adjusted spread to Treasuries provided by Bloomberg Index Services Ltd. For the Bloomberg Barclays Corporate Bond Index and Bloomberg Barclays High Yield Corporate Index, respectively.

U.S. equity markets have been soaring. Since 2009, total returns for the S&P 500 have averaged nearly 19.2% annually through October 2017. As a result, equity markets have touched all-time highs and valuations are quite elevated. But stocks aren’t the only expensive asset class. High-yield and corporate bond returns too have been robust, leaving credit spreads at their tightest levels in years. Conditions remain favorable and markets tend to climb a wall of worry, so the rally could continue. But the rising tide can’t lift all ships forever. At this stage of the cycle, caution and selectivity are essential.
 

Dig Deeper to Uncover Potential Value A Look Beneath Market Averages Reveals Differentiation

LI49 - Chart 3

Sources: RIMES, Standard & Poor's as of 9/30/17.

The U.S. stock market has soared since the end of the global financial crisis, reaching its prior peak in 2012 and more than doubling since then. But not all areas of the market have reached elevated heights at the same time. The stunning gains of a number of the largest technology and consumer discretionary companies, such as Alphabet, Amazon, Apple and Facebook, have gotten much attention - gains that can be partly justified by dominant competitive positions and robust growth rates.

Financials recently reached its prerecession peak after 10 years and energy has returned to 2007 levels. The global financial crisis generally hit financials stocks the hardest, and the sector declined nearly 80% following its peak in May 2007. Given the sector’s slower recovery, it may still have more room to run. Further Fed rate hikes could provide another boost to the industry. With respect to both financials and energy, select companies are likely to fare better than others, so fundamental research will be key to identifying potential winners.

The potential for credit growth driven by solid consumer fundamentals, and the prospect of rising interest rates, could help drive profit growth for banks. Regional bank PNC Financial Services and conglomerates JPMorgan Chase and Wells Fargo are examples of companies that have strong credit card and commercial banking divisions.


What This Means for Portfolios

With most asset valuations near multiyear highs, volatility at multiyear lows and profits near record levels, a measure of caution is important. Maintain a core allocation of U.S. equities, but invest selectively, focusing on companies with attractive valuations in areas where value is unrecognized by the market. Consider rebalancing toward international and emerging markets equities. Go to our Portfolio Playbook for more detail.

 


 

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