Cautious Optimism

Mark P. Bernier |
Posted on Jan 01, 2018

I have used the phrase "cautious optimism" many times during my career; I have used it several times in the last eighteen months. For investors, cautious optimism could be described as being risk-aware (notice that I did not use risk-averse). 2018 will provide plenty of arguments for being cautiously optimistic and risk-aware. I offer the following thoughts from our investment team at ACNB Bank as arguments for both this year.

Caution: Valuation

At the time of this writing, it has been over two years since the beginning of the last market correction (defined as a sell-off of 10% or more). Many of you may remember that between January 1 and February 11, 2016, the Dow Jones Industrial Average and S&P 500 fell -10.13% and -10.51%, respectively. Stretched stock valuations (price compared to earnings) and low levels of market volatility increase the probability of a market correction, in our opinion.

Caution: Global/Domestic Political Climate

Tensions on the Korean peninsula have been high for months and the potential for escalation seems omnipresent. Tensions and uncertainty caused by numerous other geopolitical events (Russian sanctions, protests in Iran, response to the President's stance on Jerusalem) could trigger a correction. Domestically, developments in or outcomes of the Russian election collusion investigation, threats of a government shutdown, and unexpected outcomes from the mid-term elections would likely be catalysts for a market pullback.

Caution: Federal Reserve Monetary Policy

One of our primary near-term concerns is a policy misstep by the Federal Reserve. As you may know, the Federal Reserve has two mandates: (1) full employment and (2) price stability. With already tight labor markets, the Fed's primary concern has shifted to inflation. Ironically, inflation has been relatively tame, as core inflation (excluding food & energy prices) remains below the Fed's long-term target of 2%. The Fed presented its forecast for three rate hikes in 2018 based on its assessment of the economy and the potential for inflationary pressures to increase. At the time of this writing, the markets are expecting only two rate hikes in 2018 (based on Fed Funds futures markets). Though new Fed leadership is largely expected to maintain the current rate policy trajectory, a more aggressive Fed could cause a sell-off in stocks and longer-term bond investments.

Optimism: Corporate Earnings

Corporate earnings growth for the fourth quarter of 2017 (as measured by the S&P 500) is forecast to be 11.9%, according to data recently published by Thompson Reuters I/B/E/S, continuing the trend we saw for all of 2017. With the new tax law in effect as of January 1, 2018, it is our expectation that corporate earnings will continue to show strength, reflecting positive trends in global domestic and global economic activity.

Optimism: Economic Activity

The U.S. economy is likely to have grown by over 3% again in the fourth quarter of 2017, driven by one of the strongest consumer spending periods in years. Manufacturing activity, too, has seen strength. The ISM Manufacturing Index, last reported at 58.2, has been well above the 50 level (the dividing line between growth and contraction) for all of 2017. Several components of the index have indicated continued gains (new orders, production, and backlog) based on the most recent readings. Labor markets continue to be strong, if not tight, as we now enter a phase where employers may begin competing for new hires with higher compensation. Housing remains strong, aided by a lack of inventory and accommodative mortgage rates. Even the energy sector has seen a boost, driven by greater efficiencies in exploration and production processes and higher crude and natural gas prices.

Optimism: Innovation

One of the truly unique facets of our country is the freedom to turn ideas into reality. Innovation and entrepreneurism have been the backbone of our economy since its inception. While innovation is certainly a longer-term source of optimism, the pace of innovation seems to continue to shrink, and it is a primary driver of investment. The World Wide Web was invented in 1990; the first smart phone was introduced in 1994. It's almost difficult to remember how the world functioned without these technologies; what new innovations will we see or have the ability to invest in this year? As investors, we are always assessing how innovation continues to shape our lives and redefines our needs.

As we begin 2018, cautious optimism is our theme: cautious of near-term influences, optimistic for long-term opportunity. I hope your holidays were filled with joy and wish you a Happy New Year. Thank you for the opportunity to serve you.

Mark P. Bernier
CFA, Senior Vice President/Wealth Management Officer