As 2017 comes to a close, the U.S. economy looks on track to clock an annual average 2.3% climb for the year—its fastest pace since 2014. Midway through 2018, a stronger-than-expected domestic backdrop should also help ring in the 10thyear of business expansion. However, the question on many investors’ minds: Is there now a risk of slowdown in 2018—or could this expansion see extra innings?
According to a 2018 outlook from Morgan Stanley’s Chief U.S. Economist Ellen Zentner, this cycle may still have room to run. “Though ultra-low unemployment, a positive output gap, and rising interest rates continue to suggest the U.S. is late-cycle, a general lack of overheating in key sectors such as housing, and rising suggest this late-cycle phase is likely to continue throughout 2018.”
In Zentner’s view, the probability of a U.S. recession over the next 12 months lies at about 25%, held down by the delayed promise of tax reform and a strong synchronous global economy. Further, persistently low inflation throughout the forecast horizon may also help stretch the cycle since the Fed may not hasten to hike rates more rapidly.
These combined factors have led Zentner and her team to revise forecasted U.S. GDP growth in 2018 upward to an annual average 2.5% (vs 2.2%, previously) on this strong backdrop.
Contributions to Percent Change in Real GDP
Source: Bureau of Economic Analysis (BEA), Morgan Stanley Research. Note: 4Q17 reflects current Morgan Stanley GDP tracking; 2015, 2016, 2018 and 2019 reflect 4Q/4Q change in real GDP.
In terms of U.S. fiscal policy, Zentner notes that the days of declining deficits may be over. In addition to another round of hurricane funding and an increase in defense spending, moderate deficit expansion from the enactment of tax relief will likely raise the 2018 deficit-to-GDP ratio from 3.2% in 2017 to 3.6% in 2018.
The Days of Declining Deficits Are Over (Deficit, % of GDP)
In Zentner's base case, the delivery of a mildly expansionary tax package in 2018 would be worth roughly $1 trillion over 10 years. This amounts to approximately 0.5% GDP in deficit expansion over the first 4 quarters of enactment, and about 0.1pp of boost to GDP growth.
Ultimately though, Zentner predicts that the true impact of the tax cuts will be determined by the market reaction, the evolution of financial conditions, and the Fed’s response. In terms of rate hikes, Zentner expects the Fed to continue its gradual pace of tightening this month, followed by three hikes placed in March, June and September of 2018.
For U.S. equities, while 2017 delivered exceptional returns—notable for no meaningful drawdowns—2018 will likely see much narrower performance as markets begin to contemplate the peak rate of change on growth and deteriorating financial conditions.
According to Mike Wilson, Morgan Stanley’s Chief U.S. Equity Strategist, “There’s a good likelihood that 2018 will have a few potholes along the way. The recovery will likely become less synchronous and decelerate at some point. I think we’ll also see earnings growth peak in the first half of 2018 which would bring some disruption for investors.”
Wilson comments that while we never saw full blown euphoria in 2017, we did see a significant improvement in sentiment, particularly from institutional investors. What was missing was an absence of strong and persistent retail investor interest, but that may be the final missing ingredient which would conclude the bull market. “We suspect that could happen in early 2018 after a potential tax bill is signed.”