In many ways 2017 was one of the most surprising years in recent memory. Back in January there were few optimists around. After all, the economic expansion and bull market had gone on for almost nine years, making it one of the longest on record, and all good things come to an end sometime. Investors were worried that a hard landing in China would result from the huge build-up in debt there, a large portion of which was believed to be non-performing. The decision by the United Kingdom to leave the European Union made many investors nervous about the ability of the alliance to continue. Perhaps most important, investors didn’t know what impact a Donald Trump presidency would have on the financial markets or the world economy.
The year turned out better than almost everyone expected. Real growth finally reached 3% in the United States both in the second and third quarters after being mired in the 2% range since the recession. Inflation remained below 2% as measured by the Consumer Price Index and the ten-year U.S. Treasury yield stayed below 2.5%, while unemployment dropped to 4.1% and looked like it was headed into the 3% range. To be sure, average hourly earnings were increasing by only 2.5%. Nonetheless, household net worth reached an all-time high and so did the Standard & Poor’s 500. The mood in Washington shifted to pro-business, leading to expectations of less regulation and lower taxes. China continued to grow at an impressive rate, and Europe and Japan were doing well. We all worried about a military conflict with North Korea and continued fighting in the Middle East, but on the whole it was a very good year.
Every year I prepare a list of Ten Surprises that I believe have a greater than 50% probability of happening, but which the average professional would only assign a 33% chance of taking place. This is the 33rd edition of The Surprises, which began in 1986 when I was a strategist at Morgan Stanley. The idea derived from my realization that my best investment ideas were generally non-consensus observations that turned out to be right. The Surprises are designed to stretch my own thinking (and hopefully yours) about the outlook for the year ahead. I don’t prepare the list to achieve a high score. Usually I get five or six of the Surprises more or less on target. I’ve had a number of years when I achieved seven, and one (2009) when the score was nine right.
Every year in my January essay I review the previous year and list the Ten Surprises for the year ahead. In my first Surprise for 2017 I said that Donald Trump would move away from many of the extreme positions he took during his campaign for the presidency. He didn’t tear up the Affordable Care Act on his first day in office, but allowed modified parts of it to be incorporated into the tax bill. The NAFTA Trade agreement is under negotiation rather than being trashed. He didn’t denounce China as currency manipulator during his recent trip there; he complimented the Chinese leaders on their negotiating skills. Generally he has found that extreme positions may appeal to voters, but they are hard to implement in the real world.
In my second Surprise, I said that the Trump administration’s pro-growth policies of cutting taxes, dismantling regulation and spending money on infrastructure would result in 3% growth in the United States and that is where we are in spite of the administration having passed only the controversial tax bill during its first year in office. A number of regulations have, however, been eliminated.
My optimism on S&P earnings and the performance of the equity market was borne out, validating the third Surprise. Earnings will come in well ahead of my $130 estimate and the market exceeded my S&P 500 target of 2500.
I ran into trouble on my fourth Surprise. I thought the strong U.S. economy coupled with a rising stock market would attract investors and the dollar would appreciate against the euro and the yen. It turns out that there is a high degree of correlation between the presidential approval rating and the performance of the U.S. currency. Trump’s low approval rating, possibly rooted in his unpredictability, may be behind the poor performance of the dollar this year.
I didn’t do much better in the fifth Surprise, where I thought inflation would rise because of a tight employment market and higher wages, and the 10-year Treasury yield would approach 4%. Inflation stayed below the Federal Reserve’s target of 2% and the yield on the 10-year Treasury remained a modest 2.4%.
In the sixth Surprise, I said the populism that had brought Donald Trump to the presidency and led to the United Kingdom leaving the European Union would spread to the continent, resulting in unexpected political outcomes in France and Germany. Angela Merkel’s failure to win enough seats to guarantee a coalition government is definitely a result of the populist phenomenon. Voters throughout the world believe that governments have failed them and they want change. I expect this trend to continue, resulting in immigration reform and less bureaucratic meddling.
At the beginning of 2017 many thought the price of oil would rise sharply as a result of increasing world demand and cuts in production by OPEC. In the seventh Surprise I thought the price of West Texas Intermediate crude would remain below $60 and it has, although it has rallied recently.
While I expected China to grow at an impressive rate and not have a hard landing, I did think the renminbi would depreciate toward eight to the dollar (from near seven) as China allowed the currency to decline to stimulate exports. That was my eighth Surprise. The yuan, however, appreciated to 6.60 to the dollar.
My ninth Surprise was that Japan would prove to be a good place to invest in 2017 and that one really worked out well. As I traveled throughout the world last year I found that investors were almost universally underweighted in Japan, yet the earnings of Japanese companies were increasing impressively. The overall economy was growing at 1.5% real, unemployment was low, deflation had ended and consumer and business confidence was high. As a result, the Japanese market and its currency did well last year.
Finally in the tenth Surprise, I anticipated a cooling down of the turbulence in the Middle East with a greater Russian presence and fewer U.S. troops. Syria is still a serious geopolitical and humanitarian problem, and there is a general belief that if the United States were not involved in Afghanistan and Iraq, the Taliban and Al Qaeda would take over immediately. But there is a growing conviction that ISIS has been defeated. The situation remains uncertain, with no resolution in sight.
Assessing the results I think I got six of the Surprises essentially right and four wrong, which makes 2017 an average year, but I did well on some of the more important investment-related entries.
Every year I seek help from many sources in preparing the Surprises. George Soros reviewed my ideas as he has since they began back in the 1980s. Gideon Rose and Dan Kurtz-Phelan of the Council on Foreign Relations gave me their thoughts on the geopolitical Surprises. My Third Thursday group of former research directors provided their annual observations and many friends and associates at Blackstone and elsewhere contributed their ideas. In the end, however, the Surprises are mine and I am accountable for the results. Now on to 2018. I will discuss them in detail in my February essay.
- China finally decides that a nuclear capability in the hands of an unpredictable leader on its border is not tolerable even though North Korea is a communist buffer between itself and democratic South Korea. China cuts off all fuel and food shipments to North Korea, which agrees to suspend its nuclear development program but not give up its current weapons arsenal.
- Populism, tribalism and anarchy spread around the world. In the United Kingdom Jeremy Corbyn becomes the next Prime Minister. In spite of repressive action by the Spanish government, Catalonia remains turbulent. Despite the adverse economic consequences of the Brexit vote, the unintended positive consequence is that it brings continental Europe closer together with more economic cooperation and faster growth.
- The dollar finally comes to life. Real growth exceeds 3% in the United States, which, coupled with the implementation of some components of the Trump pro-business agenda, renews investor interest in owning dollar-denominated assets, and the euro drops to 1.10 and the yen to 120 against the dollar. Repatriation of foreign profits held abroad by U.S. companies helps.
- The U.S. economy has a better year than 2017, but speculation reaches an extreme and ultimately the S&P 500 has a 10% correction. The index drops toward 2300, partly because of higher interest rates, but ends the year above 3000 since earnings continue to expand and economic growth heads toward 4%.
- The price of West Texas Intermediate Crude moves above $80. The price rises because of continued world growth and unexpected demand from developing markets, together with disappointing hydraulic fracking production, diminished inventories, OPEC discipline and only modest production increases from Russia, Nigeria, Venezuela, Iraq and Iran.
- Inflation becomes an issue of concern. Continued world GDP growth puts pressure on commodity prices. Tight labor markets in the industrialized countries create wage increases. In the United States, average hourly earnings gains approach 4% and the Consumer Price Index pushes above 3%.
- With higher inflation, interest rates begin to rise. The Federal Reserve increases short-term rates four times in 2018 and the 10-year U.S. Treasury yield moves toward 4%, but the Fed shrinks its balance sheet only modestly because of the potential impact on the financial markets. High yield spreads widen, causing concern in the equity market.
- Both NAFTA and the Iran agreement endure in spite of Trump railing against them. Too many American jobs would be lost if NAFTA ended, and our allies universally support continuing the Iran agreement. Trump begins to think that not signing on to the Trans-Pacific Partnership was a mistake as he sees the rise of China’s influence around the world. He presses for more bilateral trade deals in Asia.
- The Republicans lose control of both the Senate and the House of Representatives in the November election. Voters feel disappointed that many promises made during Trump’s presidential campaign were not implemented in legislation and there is a growing negative reaction to his endless Tweets. The mid-term election turns out to be a referendum on the Trump Presidency.
- Xi Jinping, having broadened his authority at the 19th Party Congress in October, focuses on China’s credit problems and decides to limit business borrowing even if it means slowing the economy down and creating fewer jobs. Real GDP growth drops to 5.5%, with only minor implications for world growth. Xi proclaims this move will ensure the sustainability of China’s growth over the long term.
Every year there are always a few Surprises that do not make the Ten because either I do not think they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”
- Investors recognize that the earnings of companies in Europe, the Far East and the emerging markets are growing faster than those in the United States while the price earnings ratios in those regions are lower than those in America. Global investments become more broadly represented in institutional portfolios.
- The Mueller investigation of the 2016 presidential election fails to implicate any members of the Trump family in collusion with Russian operatives.
- Artificial intelligence gains visible momentum. Service sector jobs are automated, particularly clerks in legal and finance professions, as well as workers in fast food outlets and healthcare. Economists begin to question the unemployment data because the rate drops below 4% while so many people still appear to be out of work and seeking government assistance.
- Cyberattacks become more prevalent and begin to affect consumer confidence. A major money center bank suspends deposits or withdrawals for three days because its system is penetrated. Numerous retail organizations report that customer personal information has been obtained by hackers. Those invading corporate information systems appear to be smarter and more innovative than the internal employees protecting the computer data, suggesting that the systems themselves need to be upgraded.
- The regulatory authorities in Europe and the United States finally get concerned about the creative destruction of Internet-related businesses. As a result of pressure from retailers and traditional media companies, they begin an investigation of anti-competitive practices at Amazon, Facebook and Google. The public begins to think these companies have too much power.
- The risks in Bitcoin are so great that regulatory authorities restrict trading. Among their concerns are: no regulatory oversight; no safety and soundness measures; no recourse in the event of mistaken or miscalculated transactions; high cyber risk; no deposit insurance. (Risk source: Morgan Stanley.)
So there they are: The Ten Surprises of 2018. Now let’s see how the year plays out.
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