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Special report: Outlook 2018

Looks like all blue skies, unless ...

Joachim Fels said momentum is good and all indicators point to a solid year.

Using terms like "benign" and "Goldilocks" to describe their economic forecasts, economists and chief investment officers predict 2018 will be a year of sustained GDP growth and manageable inflation in the U.S. and worldwide.

"There's good momentum" for the next six to 12 months, said Joachim Fels, a managing director and global economic adviser for Pacific Investment Management Co. LLC, Newport Beach, Calif. "Economic indicators are above expectations."

Worldwide economic growth looks "healthy and strong" for 2018, said Isabelle Mateos y Lago, the London-based chief multiassetstrategist for BlackRock (BLK) Inc. (BLK)

U.S. growth prospects appear "benign" and "inflation is not threatening," she said. And the eurozone has "exceeded expectations" by being "very strong."

However, being true to their nature, economists — "on the one hand, on the other hand" is their profession's unofficial motto — also mentioned a few dramatic possibilities that could alter their predictions.

A recent PIMCO forecast, for example, said its "Goldilocks-extended" forecast could be jolted by a "zombie apocalypse or a sudden spontaneous collapse in asset prices."

Mr. Fels defined the economic version of a zombie apocalypse as a war with North Korea, a "major explosion" in the Middle East leading to an oil supply shock or China changing its policy to allow its currency to depreciate.

To Ms. Mateos y Lago, U.S. retrenchment on the North American Free Trade Agreement would be "a step back and quite detrimental" to the U.S. and world economies. "There could be concern than the U.S. wouldn't stop at NAFTA and could escalate trade tensions," she said.

Protectionist trade policies by the U.S. remained a potential disrupter of forecasts by many interviewees.

"There always will be political risk, and you have to build that into your investment strategy," said Celia Dallas, the Arlington, Va.-based chief investment strategist of Cambridge Associates LLC.

Her forecasts could be upset by "a major war," Middle East turmoil affecting oil supply and prices, trade tensions between U.S. and China and "significant" protectionist policies by the U.S., she said.

Still, a recent analysis by Ms. Dallas noted that investors should "expect more of the same" in 2018 because "many of the factors that drove risk assets higher this year are still in force" even though 2018's gains might not be as great as those in 2017.

"For the first time in about a decade," all components of the MSCI All Country World index "are in expansion mode," said Ms. Dallas, citing these results as a source for her optimism.

Cannot be complacent

Still, she warned that investors cannot be complacent about inflation. Her recent analysis cautioned "the party cannot go on forever, as we are closely watching central banks for signs they might remove the punch bowl faster than markets anticipate."

The interplay of inflation, employment rates, economic growth and wages ranks high on the radar of economists as they try to predict how these forces affect each other.

The current U.S. unemployment rate of 4.1% is below the Federal Reserve's long-term non-accelerating inflation rate of unemployment at 4.65% — an indicator that wages should have room to rise. NAIRU is the rate of unemployment arising from all sources except fluctuations in aggregate demand, according to the U.S. Congressional Budget Office, which notes "estimates of potential GDP are based on the long-term natural rate."

However, recent wage growth has been modest. Economists said they believe wages will grow at a greater rate in 2018 vs. 2017 — but not at a pace that would trigger significant inflation.

In the U.S. "we are at full employment, and we are now entering a time for higher wages," said Joseph Davis, global chief economist for Vanguard Group Inc., Malvern, Pa. "We look for 3% wage growth. I would be shocked if it goes higher."

Like other interviewees, Mr. Davis said technology has played a prominent role in recent years to keep wage growth modest in relation to declining unemployment rates. Another damper on wage hikes is the retirement of many baby boomers, who are replaced with lower-salaried younger workers.

"Just because you have full employment, it doesn't mean wages will rise," he said.

Inflation triggers

Responding to a tight job market and relatively low inflation, Mr. Davis said, presents a delicate balancing act for central banks that must deal with several paradoxes — low growth and full employment; low unemployment and low inflation; and low growth and high valuations in the equity markets. "All of these shouldn't co-exist," he said. Vanguard forecasts a U.S. jobless rate of 3.5% to 3.7% next year.

The worldwide suppression of strong wage increases has many sources, added Robert Sierra, the London-based director of sovereigns for Fitch Ratings Inc. They include the globalization of workforces, so employers aren't relying solely on local workers, as well as technology advances that cut down on labor costs, such as robotics.

Adding to pressure on strong wage growth are the facts that older workers might stay in their jobs longer, valuing job security over significant wage increases, or that millennials might prefer jobs with a better work-life balance vs. big boosts in pay, he added.

Re-evaluating relationships

These factors have contributed to re-evaluating the forecasting power of the Phillips curve, a 60-year-old economic concept showing an inverse relationship between unemployment and inflation. "The Phillips curve hasn't disappeared," said Mr. Sierra. "The relationship is weaker."

For 2018, Fitch forecasts "synchronized global growth," reflecting a tightening of labor markets and "the erosion of slack," especially in the U.S., Mr. Sierra said. "There's still some slack in Europe, but on the whole slack will disappear."

He said wage increases should rise next year as the U.S. unemployment rate drops to 4%. The firm is predicting four separate federal funds rate increases of 25 basis points each by the Federal Reserve Open Market Committee next year, reaching 2.5%. BlackRock (BLK) officials are expecting three increases of the federal funds rate — each at 25 basis points next year — with a fourth possible "if the Fed expects tax cuts to raise inflationary pressures," the firm's 2018 economic outlook report said.

PIMCO executives are predicting the FOMC will raise the federal funds rate three times, putting the rate at 2% to 2.25% by the end of next year. Vanguard estimates a fed funds rate of 2% by the end of 2018.

Members of the FOMC recently forecast three increases in 2018 and two more in 2019.

PIMCO expects worldwide GDP growth in the 3% to 3.5% range, U.S. GDP growth at 2.25% to 2.75%, and China GDP growth at 5.75% to 6.75%.

Fitch has forecast 3.3% worldwide GDP growth in 2018, with the U.S. advancing by 2.5% and China gaining 6.4%.

One benefit of greater growth should be more capital expenditures, said Mr. Sierra of Fitch Ratings.

"The conditions are ripe for 'cap ex' to increase and continue increasing," he said. "The cost of borrowing is low and access to credit is plentiful."

In recent years, capital expenditure growth was held back because "there was a high degree of uncertainty in the world economy," he added. "But the uncertainty is gone."