The economic expansion and bull market in US equities is nearly nine years in duration, and it appears as if it will continue through at least October 2018 according to projections. The US Federal Reserve’s desire to increase interest rates and allow maturing assets to mature without reinvestment signals that some liquidity will be slowly drained from the economy. It won’t be much at first but accelerate gradually. Since its October initiation, $4 billion per month has been allowed to run off without reinvestment. It will increase to $8 billion per month in January, $12 billion in April, $16 billion in July, and reach its terminal per month run-off allowance of $20 billion in October 2018. Meanwhile, Japan and the EU are still on zero-rate, QE policies, which will continue to support global asset prices. Global QE on net is expected to expand until early-to-mid 2019. Tightening US policy increases risks and now that tax reform is done in the US, these tailwinds will no longer be available to investors in 2018. Nonetheless, monetary policy takes effect in the economy with a lag to both growth and inflation. Recessions and Monetary Policy’s Role Recession risks for 2018 are low. The main ingredients to watch are wages, inflation, and corporate margins. The case for monetary tightening becomes more pronounced as the first two increase and the latter decreases. If a lack of substitute workers surfaces (“full employment”), current workers have greater bargaining power for higher wages. Corporations largely pass off this cost in the form of higher prices and inflation sets in. Central banks look to balance out this occurrence by raising interest rates, which effectively increases the cost of money and leads to lower levels of investment on aggregate. Inflation is generally targeted at around 2%-ish to incentivize consumers to spend their money (the US economy is 70% consumption), but not so high (or volatile) that it erodes consumer confidence. When the central bank tightens monetary policy, it slows the rate of debt growth in the economy, which leads to a fall in spending and a consequent economic contraction. Recessions end when the central bank begins to ease monetary policy, typically by pushing nominal interest rates below the nominal growth rate such that the economy can grow faster than debt can compound. This reduces debt service costs, makes debt cheaper to help facilitate spending, and will also reflate financial assets by lowering the discount rate at which future cash flows are valued. Higher financial asset prices help create greater wealth among individuals, which ideally funnels down into greater consumer spending. Where in the cycle are we currently? In the US, we are somewhere between the mid- and late-stage of the business cycle. Inflationary forces are still below-target, which generally bodes well for the economy and risk assets. This means that the Fed is likely to remain fairly accommodative as it currently is – a 1.25% lower-bound rate and a $4 trillion-plus balance sheet keeping bond supply constricted and prices high accordingly. But as always the Fed’s actions need to be monitored. So long as low inflation remains, the longer this current economic cycle can likely persist as it limits the ability for the Fed to tighten. As mentioned, it’s important to watch wage growth, monthly inflation figures, and corporate margins. If wage pressures start to build, it’s probably best to start removing risk in your portfolio. Looking at the next 10+ months To look at the future trajectory of the US economy I look at bank debit turnover – i.e., a proxy for transactions velocity in the economy – and form a distributed lag model to project out the next 10-12 months. If credit creation and spending look to be on a positive trajectory over this time, the economy is probably fine as are risk assets. I use two separate but similar models and plot out the US stock market trajectory against them, which is an imperfect substitute for nominal GDP. The orange line – representing year-over-year stock market performance as represented by the Wilshire 5000 index (a group of 3,000+ US stocks) – is expected to roughly follow the blue line in the future and has generally stuck to this pattern in the past. Note that the blue line is a projection of future economic activity in the US rather than an explicit prediction of what the US stock market will do. The stock market is a part of the economy, but not the economy itself. Based on this, it predicts that the stock market will not see the year-over-year returns of recent history following the financial crisis, but should hold relatively stable through at least October 2018 at these lower growth trajectories. Conclusion With high debt, aging demographics, and productive resource underutilization, low inflation remains a structural issue rather than a cyclical one. If this persists, which I think it will, then central banks will have limited ability to tighten their monetary regimes. This keeps discount rates low and allows assets to trade off higher earnings multiples. If interest rates stay where there are currently, I predict forward long-run nominal stock returns to be a little bit under 7% annually. As a base case, I expect the S&P 500 to be up 8%-10% in 2018 to around 2,900, with a bull case of 3,150 and bear case of 2,300. _____ POLL Will the S&P 500 finish 2019 above or below 2,900? Agree = Above 2,900 Disagree = Below 2,900