10 Questions For 2018

On Friday afternoon, we brought you “Requiem For 2017: The Year In Charts,” a visual guide to what, by most accounts (double entendre alert), was a stellar 2017 for investors.

At this point, you’re probably exhausted with year-ahead outlooks, forecasts, “top themes”, and the like. Indeed, if you can’t regurgitate the ubiquitous “Goldilocks” narrative off the top of your head, then you’re not in the loop.

Similarly, you should be so well-versed in the prevailing market dynamics that you can list at least four reasons why vol. was suppressed in 2017 even after 8 shots of cheap vodka.


Finally, you should be so indoctrinated with the research that if you were hammered drunk, you would still have absolutely no problem explaining how VIX ETP rebalance risk might interact with model-based selling from systematic strats during a bond tantrum.

If you’ve been following along here at HR all year, then we’re entirely confident in your ability to intelligently discuss these matters whilst completely inebriated. And if we run into you anywhere, we’re going to test that theory.

But on the off chance you needed a little more in the way of 2018 prognosticating, we thought we’d bring you some excerpts from the final note of the year by Goldman’s econ team, which finds Jan Hatizus laying out “10 questions for 2018.”

Via Goldman

1. Will growth remain above the 2.2% average of the recovery so far? Yes. We expect real GDP growth to average 2.6% through 2018, slightly faster than in 2017.

There are three main reasons to expect continued healthy growth:

1) strong current momentum,


2) an ongoing positive impulse from financial conditions,


3) a moderate boost from fiscal policy.


2. Will unemployment fall below the April 2000 trough of 3.8%? Yes. Despite our generally upbeat views on aggregate demand, we do expect a gradual slowdown over the next year. One reason is that we think further cyclical expansion will push the economy beyond its long-term capacity to produce. The most visible sign is likely to be a further sizable drop in the unemployment rate to about 3½% by the end of 2018, levels unseen since the late 1960s.

3. Will (single-family) housing starts rise further despite adverse tax changes? Yes. Admittedly, there are a number of challenges for the housing sector in 2018. But we still expect the housing recovery to continue, at least in the core single-family owner-occupied sector. The biggest positive factor is the continued tightening in the supply-demand balance. As shown in Exhibit 5, the homeowner vacancy rate has fallen significantly further over the past year and now stands at the lowest level since 2001.


4. Will wage growth resume its acceleration? Yes. Wage growth disappointed somewhat in the last year, as our wage tracker—a weighted average of five key series—basically stagnated at 2.6%. However, we think that 2018 will see a renewed acceleration.


5. Will core PCE inflation pick up from the current 1.5%? Yes. Admittedly, there are still some drags on the inflation data that could persist in 2018. The risks to rent inflation, while smaller, are probably still on the downside, and the outlook for healthcare service price inflation is murky. Markets still seem quite focused on these downside risks, and we think the consensus view among investors is probably a sideways move around the current 1.5% core PCE inflation rate. But we see three reasons to expect core inflation to move higher over the next year. First, the price Phillips curve—while generally flat—might be steepening. Second, our analysis shows that the lags between import prices and core inflation can be long. Third, base effects will push core inflation higher in the spring.

6. Will the Fed hike more than the two hikes discounted in current market pricing? Yes. The Fed’s own forecast remains at three hikes, one more than priced in the markets. But even this forecast strikes us as conservative, partly because we think the unemployment rate will fall by significantly more than the 0.2pp projected by the median FOMC participant. It would be surprising to see such a small decline in the 2.5% growth environment that the FOMC is projecting for 2018.

7. Will the Fed adjust its balance sheet normalization plan? No. Currently, the Fed is allowing monthly runoff of up to $10bn from its portfolio of Treasuries and mortgage-backed securities. This number is scheduled to climb by $10bn every three months until it reaches $50bn in October 2018. We are asked quite frequently whether the Fed will adjust this plan in one direction or another. Some think that the committee might decide to suspend the runoff program in response to negative news about the economy. Others wonder whether a new committee with more Trump-appointed officials who have expressed anti-QE views in the past might accelerate the runoff or even turn to asset sales. Both strike us as unlikely.


8. Will market pricing of the terminal funds rate rise? Yes. In 2017, we were surprised that the terminal funds rate implied by a straight read of OIS or Eurodollar futures did not increase, despite strong growth and more actual Fed hikes than markets had priced at the start of the year.

9. Will the yield curve invert? No. Over the past year, the gap between the 10-year Treasury note yield and the federal funds rate has declined from 180bp to 100bp. Many investors have started to wonder about the likelihood and implications of an inverted curve, especially if the Fed continues to push up the funds rate at the current once-per-quarter pace. Whether this happens is closely related to the previous question around pricing of the terminal funds rate. We can think of the 10s/funds spread as the sum of the expected change in the funds rate—or more precisely, the difference between the average funds rate over the next 10 years and its current level—and the 10-year term premium. This means that for the curve to invert, the market must think that the funds rate has overshot its sustainable level, or the term premium must be negative, or both. Conversely, if the pricing of the terminal funds rate increases, either because of higher funds rate expectations and/or a rising term premium, an inverted yield curve becomes much less likely.

10. Will financial conditions ease further? No. Despite three Fed hikes and the start of balance sheet adjustment, our financial conditions index eased by more than 100bp in 2017 as stock prices rose, credit spreads tightened, the dollar weakened, and long-term interest rates stagnated. As shown in Exhibit 9, it now stands at the easiest level of the entire expansion and about 1.3 standard deviations below the long-term average. But we this think this easing has now largely run its course because the Fed will increasingly resist it.



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