2018 Outlook: An object in motion…

Executive summary:• U.S. economic momentum, already positive, will increase further due to the tax package

• Interest rates are likely to rise throughout the year posing a headwind for longer duration core bonds

• Equity valuations are underpinned by the interest rate and macro environment, but continued valuation increases would become more concerning if inflation makes a comeback

• Europe and Japan are also gaining momentum and are earlier in their economic cycles, contributing to the global synchronized growth

• Individual risks are moderate, but collectively could pose a challenge, particularly in the second half

U.S. economic backdrop: the big moThe combination of solid consumer spending and accelerating business spending that prevailed in 2017 looks poised to continue into 2018. Unemployment hovering around 4% doesn’t just embolden consumers, it also drives companies to seek efficiencies through technological improvements rather than additions to headcount. Up until 2017, business spending had been restrained for a couple of years, so a combination of pent up demand plus a tax package that provides for five years of immediate capital expenditure expensing should also add to strength in business spending. Survey measures of future capex, which our analysis indicates has reasonable correlation with actual future expenditures, also point to continued strength in business spending.

For consumers, the Tax Policy Center estimates that the middle household income quintile will benefit by over $900 per year from the tax package. That’s a substantial amount, and the concern that the individual tax cuts are set to expire after 2025 is misplaced. At most, that’s a consideration for future years. The Tax Foundation estimates that over 80% of the Bush 2001 tax cuts were ultimately made permanent, so that propensity is a reasonable baseline if we want to think that far out. The almost certain addition to the deficit is a valid concern, but also a long-term one that is unlikely to have any bearing on 2018. For now, unemployment is low, confidence is high, interest rates are not restrictive, and wage growth is above inflation.

BMO Wealth Management JANUARY 2018

Continued

Percent Change in After-tax Income by Income Quintile

Source: Tax Policy Center

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%Lowest Quintile

Second Quintile

Middle Quintile

Fourth Quintile

Top Quintile

2018 2025

Survey of Future Capital Expenditures Diffusion Index (Philly District)

Source: Federal Reserve

40

35

30

25

20

15

10

5

0Dec 09

Dec 10

Dec 11

Dec 12

Dec 13

Dec 14

Dec 15

Dec 16

Dec 17

Interest rates: a 2018 inflection,finallyThe Fed is set to continue marching short-term interest rates higher in 2018, with its baseline expectation of three rate hikes bringing the Fed Funds Rate to a target range of 2.00% to 2.25% by year end. At present, the yield on the 10-year treasury, currently around 2.55%, is at a level last seen only briefly in March of 2017 and before that in December of 2016. The recent move higher looks decidedly sustainable compared to those head-fakes of 2016 and 2017. While more yield curve flattening is possible, and even likely, we do expect some upward response on the long end of the curve. U.S. economic momentum should support this, and the expectation that the ECB will wind down its bond buying program around the end of 2018 may also provide an interest rate inflection point later in the year for global rates. The almost legendary demand for U.S. long-dated paper is on course to collide with increased bond supply in 2018. Bloomberg reports that Treasury borrowing is set to increase almost 70% in 2018 compared with 2017 and continue on an upward trajectory in the following years as well. It’s difficult to divine the demand schedule of the marginal buyer, but consensus forecasts for the year-end 10-year Treasury yield are in the 2.75% to 3.00% range. The high end of that range, which we see as more probable, would create a strong headwind for longer-duration core bonds in 2018.

U.S. equities and the valuation questionMomentum in the economic backdrop along with robust earnings growth should provide a favorable environment for equities. Our equity valuation models indicate that 10-year U.S. Treasury rates could rise 75 basis points before any meaningful dent was put in our expectations for equity returns. The recently passed corporate tax cuts are expected to add about 7% to 8% to S&P 500 earnings. While the imminent tax benefit moderates forward P/E estimates, 2018 could get increasingly uncomfortable from a valuation perspective if the equity markets continue to ramp. Valuations, however, cannot be considered in a vacuum. The prospect of tactical changes in 2018 will be more dependent on how the risks outlined in the final section below take shape and the extent to which interest rate increases are more driven by inflation expectations rather than growth. That is, whether there are signs of overheating.

International developed markets: change is at the marginEurope and Japan, both equity market winners in 2017, look economically well-positioned into 2018. In Europe, growth is accelerating, deflation risk is gone, political risks have abated, and the ECB is still in accommodation mode. It’s hard to argue with that list. German manufacturing PMIs, data points shown to have predictability for the future economic activity, recently recorded the strongest readings since the data started being tracked in 1995. In Spain, exports and growth have had a strong ramp in the past few years and the unemployment rate is down about 10% from its 2013 peak. Recent labor reforms in both Spain and France should have a positive effect on these economies. These developments may not have the flair of a trillion dollar tax cut, but change is at the margin and should be given its due. Reasonable valuations, continued earnings growth, and expanding profit margins should provide a tailwind for European equities in 2018.

Japan’s manufacturing PMIs, while not quite as stellar as Germany’s, are themselves hitting multi-year highs. The Bank of Japan remains accommodative, valuations are attractive, and shareholder reforms are slowly taking hold. We expect Japanese equities to have another leg up in 2018. Overall, the synchronized and relatively stable world growth reinforce the positive trends in these individual countries.

Continued

JANUARY 2018

Source: Blue Chip Economic Indicators

GDP Growth Forecasts

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%U.S. eurozone Japan China

2.4%2.7%

2018 2019

1.9%2.2%1.1%1.4%

6.1%6.3%

Risks look tilted to the 2nd halfFirst, what the risks are not. The U.S. economy does not have near-term unsustainable excesses or misallocations of resources that pose a risk of unwinding. What we do have is a list of moderate risks that individually look manageable and contained, but if a few or more develop in concert they could pose a challenge to equity markets that is greater than the sum of their parts. The nature of that set up tilts the risks toward the second half of 2018 as some of the risks possibly gain traction throughout the year. Those risks include inflation, which is unlikely to accelerate meaningfully but still has the potential to surprise to the upside. Even moderate inflation could lead to increasing Fed hawkishness. By the end of 2018, we will most likely shift from accommodative monetary policy to neutral monetary policy with the prospect of 2019 bringing in mildly restrictive monetary policy. China is clearly slowing down and burdened with bad debt, but the state’s vast resources should still allow for orderly growth without a sharp downturn. A more pronounced slowdown, however, remains a risk. U.S. trade policy with China and NAFTA also remains a wildcard, although our base case is for only limited trade disruption. The U.S. personal saving rate just fell below 3% for the first time since 2007. If 2018 sees a consumer spending boom, then toward the end of 2018 the saving rate could get down to a concerning level. Tax cuts will provide a reprieve so this risk may be more distant than the numbers indicate. We expect wage inflation in 2018 to stay below 3% and profit margins to stay firm, but profit margin health is also influenced by our forecast of improved productivity.

Finally, political turmoil, a frequent feature of early 2017, is likely to return in 2018 as Special Counsel Robert Mueller pushes forward his investigation into obstruction of justice and collusion by President Trump. We could well reach the end of 2018 with only one or two of these risks coming to the fore and the economy and equity markets generally pushing past them. But, if four or five of these risks take hold in 2018, that could bring an end to the animal spirits with which the year has begun. Newton’s First Law seems to apply well enough: an object in motion stays in motion … unless acted upon by an unbalanced force. We believe that 2018 calls for vigilance, but not skittishness.

Yung-Yu Ma, Ph.D., is the Chief Investment Strategist with BMO Wealth Management.

Yung is responsible for performing macroeconomic analysis, valuation modeling,and market analysis across asset classes to guide strategic and tactical asset allocations for client portfolios.

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U.S. Savings Rate and Revolving Credit

Source: Federal Reserve

13.0%

11.0%

9.0%

7.0%

5.0%

3.0%

1.0%

Savings Rate (left) Credit ($B right)

Dec 89

Dec 93

Dec 97

Dec 01

Dec 05

Dec 09

Dec 13

Dec 17

$1,100

$900

$700

$500

$300

$100