2018 Outlook: Tax Reform Bill Will Push the US Dollar Up Further

in #money6 years ago

It is not well known, but one of the worst asset performances for 2017 was the US dollar. The dollar fell almost 10% in 2017.

We expect the dollar to have an up year for 2018 for a couple of reasons. The United States is now leading the world in raising rates; higher interest rates in a country will generally push the currency higher. The Federal Reserve has been raising the Fed Funds Rate throughout 2017 and the dollar has declined. This is very unusual.

The new Tax Reform Bill signed by President Trump should also be bullish for the dollar. Over two trillion dollars are parked overseas by American companies. The tax changes are designed to bring a good amount of that money back into the United States. Companies converting the local currency to dollars and moving the dollars back to the United States should cause a shortage of dollars overseas, pushing the dollar higher. The bottom line look for a stronger dollar for 2018. Investments that will profit from a strong dollar should do well.

The Tax Reform Bill is bullish for the US economy. It will increase US borrowing and likely push up longer-term rates. I think one of the surprises of tax reform will be that S&P 500 companies put more of the tax savings into wages than expected. This will likely happen because of political pressure from the Trump Administration in combination with a tight labor market. Therefore, I do not believe the earning of the S&P 500 will be helped by tax reform as much as expected.

We are likely to see higher inflation this year as the result of higher wages and commodity prices and the economy gaining momentum. I expect gold and silver to move higher because of inflation, industrial demand and a very unsettled geopolitical outlook. The idea of higher rates, higher dollar and a higher gold price is somewhat counter-intuitive. This should happen because of the unique combination of the tax bill, stronger economy, higher rates in US currency and a very fragile geopolitical world.

The stock market has moved higher on the expectation of a stronger economy. The outlook for 2018 earnings has helped the stock market hit record highs. The problem is that on a valuation basis it is very expensive. Looking at valuations based on the Shiller CAPE (P/E ratio), Price to Sales ratio or Total Market Cap to GDP of the stock market, the valuations are closer to 1929 and 1999 than normal. We wrote about this here

Looking at the chart below of the two-year Treasury Yield and the S&P 500 Dividend Yield, we can see that for the first time in a long time the two-year yield is above the S&P yield.


We have two major trends working against the stock market, one is some of the highest valuations in history and the other is rising interest rates. I cannot see how interest rates fall before the stock market does. Over the last couple of years, the stock market has already priced in much of the expected economic recovery.

It is hard to predict when it will happen but we should see a substantial correction in 2018 as record high valuations and rising interest rates catch up with the markets.

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