January 2017 Economic Commentary and Capital Market Update
Recap: The financial markets responded positively to President-elect Donald Trump’s surprising victory in November. Stock prices have rallied higher on expectations that tax cuts, increased infrastructure spending and reduced regulation will boost long-term economic growth. Interest rates have also risen. Investors are now anticipating slightly higher inflation, larger budget deficits and, with a stronger-than-previously expected economic outlook, higher opportunity costs.
Labor Market: The U.S. labor market is in better shape now than at any point in the recovery, but many of the longer-term challenges with the work force have remained unsolved (e.g. low participation rate). Even with those challenges however, the latest employment report has continued a long stretch showing steady improvement. The labor market has tightened.
U.S. employers hired at a steady clip in November and the jobless rate fell to its lowest level in nine years. The U.S. added more than 15 million jobs since the labor market bottomed out in early 2010. However, those gains were uneven across the nation and business sectors, pushing swaths of people to the sidelines and by many measures leaving the economy short of pre-recession norms. For example, the mix of new job creation was heavily weighted towards the service sector. Manufacturers shed 54,000 jobs and miners cut 87,300 in the last year alone. Among traditionally blue-collar professions, construction has been perhaps the strongest with 155,000 new jobs in the last 12 months. But the much larger professional and business-services sector has added 571,000 jobs and health care created 407,000 in the same span.
More broadly, wage gains across the U.S. have been outpacing inflation, though they stumbled recently to a 2.5% gain in November from a year earlier.
Housing: The anticipated higher interest rate environment will likely create challenges for the recovering housing market. Housing affordability, while near historic highs, has been falling as home prices have risen much faster than incomes in recent years. The sudden rise in conventional mortgage rates will reduce affordability further in coming months. Moreover, the abrupt strengthening in the dollar, particularly since the Presidential election, will further reduce sales to international buyers, which had already slowed considerably in many East Coast markets.
The most recent housing data has remained encouraging though. There was a huge 25.5% surge in October housing starts, which showed single-family starts rising 10.7% and multi-family starts surging about 69%. Much of October’s outsized gain resulted from milder-than-usual weather, which allowed more construction projects to begin. Starts are now running well ahead of permits, which are less influenced by weather distortions. There has been a subtle shift towards less expensive homes. Builders, particularly in the South, have been focusing more intently on homes priced at or below the median new home sales price, which is currently near a historic premium relative to existing homes. Builders remain fairly optimistic, particularly in the West and South, where sales have remained strong and inventories low. The new administration may eventually find a way to ease up on historically restrictive mortgage rules. Such a move, however, will take time.
Inflation: Higher inflation in the coming months will erode some of the income gains for households, but the overall inflation environment should remain fairly tame. The PCE deflator, the Fed’s preferred gauge of inflation, rose 0.2% in October due to rising energy prices, pushing the year-over-year rate to 1.4%. Core inflation has continued to gradually climb, but at 1.7% also remains below the Fed’s target. The still-benign inflation environment has contributed to gains in consumer confidence. Confidence surged in November with the index jumping to a new post-recession high of 113.7.
US Dollar: The US dollar extended its powerful rally since the election, spurring central banks in developing countries to take steps to stabilize their own currencies. The rise in the dollar should create fresh headwinds for the long-running U.S. expansion.
The U.S. currency moved closer to parity with the euro, its’ longest winning streak against the euro since the European currency’s inception in 1999. The dollar also moved higher against the yen. The gains have been even greater against many emerging-market currencies, prompting central banks in a number of countries, e.g., Brazil, China, Indonesia, Malaysia and Mexico, to intervene slowing the slide.
The currency’s gains have made foreign goods and travel cheaper for U.S. consumers and could give a boost to exports from Japan and Europe into the U.S. But they also have reignited fears that the dollar’s strength could slow U.S. corporate profit growth and intensify capital flight from the developing world, which would complicate the prospects for economic growth.
The strong dollar could be destabilizing for markets, for foreign assets, and for emerging-market nations that pay back their debt in dollars. The dollar’s recent gains have been driven by bets that fiscal spending and tax cuts proposed by President-elect Donald Trump will spur U.S. economic growth, as well as higher U.S. interest rates. Despite measures taken, the power of central bankers to stem the tide of the market moves is limited. There is little any individual central bank could do to halt the slide in their currency while money is flowing into the U.S. dollar and out of their currency.
Emerging markets have issued a record $409 billion in dollar-denominated debt in 2016. For many, that debt will become more expensive to pay back. At the same time, commodities priced in dollars like gold and oil that many developing countries export have come under pressure as the dollar has strengthened. Consequently, many investors are already dumping developing-country assets.
Key Issues for 2017
Tax Policy and Repatriation of Overseas Profits: Part of the $2.5 trillion in profits held overseas by companies could be heading back to the U.S., a move that could further fuel the U.S. dollar’s powerful rally. U.S. corporations have been holding billions in earnings and cash abroad to avoid paying a 35% tax that would be levied whenever the money is brought home. President-elect Donald Trump has said he would propose a one-time cut of the repatriation tax to 10% to attract money back to the United States.
Market optimism that the stimulus plan could generate U.S. economic growth and push interest rates higher has buoyed the dollar against a basket of major trading partners. Now, the prospect of companies repatriating perhaps hundreds of billions of dollars could offer more impetus to the U.S. currency’s rally. When a company repatriates earnings from abroad, it may have to exchange the local currency for the U.S. dollar. Many companies already hold their overseas earnings in U.S. dollar assets, which would mute the demand for dollars. Though companies typically do not disclose the composition of their overseas earnings, the euro, British pound and Japanese yen would come under pressure if repatriations pick up.
A tax cut would probably be the lowest hanging fruit of all the fiscal measures Mr. Trump has proposed. The repatriation tax would be more likely to be passed by Congress as early as 2017, though the impact on the dollar would be relatively modest since companies already hold approximately half of their earnings in U.S. dollars.
Headwinds Facing Market Expectations: President-elect Donald Trump has proposed overhauling the tax code, promoting domestic energy production, rebuilding the nation’s infrastructure, and reducing both the burden of government regulations and the trade deficit. The President-elect’s economic team believes that this will spark a dramatic upswing in economic growth and estimates that his policies could provide average GDP growth of 3.5% a year – a pace the U.S. hasn’t seen in more than a decade. The last stretch of sustained growth above that level ended in 2000.
While tax cuts and infrastructure spending could give the U.S. a boost, especially in the short term, it is doubtful that Mr. Trump can hit his ambitious target for long-run growth. Two very large forces make that a tough assignment: an aging population and stagnant productivity. For years, demographic trends have produced slower growth in the working population. And the U.S. and other advanced economies have grappled with sluggish gains in productivity for reasons that aren’t entirely clear. As a result, long term GDP is more likely to stay in the 2.0-2.5% range. Deceleration in labor-force growth as the baby-boom generation begins to retire and workforce participation declines, plus a marked slowdown in productivity gains since the IT-fueled boom of the late 1990s and early 2000s, would help explain the tepid recent growth trend.
The recovery that began in mid-2009 has been long by historical standards but also weak, with annual growth averaging just 2.1%. There are many forces that have been blamed for that tepidness, from the household-debt overhang after the housing bubble to aggressive regulations. But over the long run, an economy’s potential growth rate all comes down to how much people are working, and how productive they are.
Euro in 2017: Introduced in 1999, the euro has survived a number of tough trials. In 2010, its member countries set aside deep resistance to paying for each other’s debts and bailed out Greece and then Ireland. The next year, Portugal. And in following years, Spain, and Cyprus.
For investors, however, the repeated tests have eroded confidence and reawakened existential questions. And 2017 will pose many more tests. Elections will come in 2017 in Germany, France and the Netherlands. An eventual fracturing of the common currency would likely be a calamitous event for financial markets. Widespread capital controls would be needed to prevent destabilizing rushes of money from countries deemed likely to have a weak post-euro currency to those expected to have a strong one. Huge swaths of financial infrastructure, including derivatives markets and common banking systems, would need to be disaggregated.
Indeed, fears of the chaos even one country’s exit would cause has proved to be a powerful glue holding the euro-zone together during its debt crisis. Since then, there has been a flurry of changes meant to bind it still tighter, most notably, closer and more consistent supervision of banks and tougher fiscal rules.
Yet the work isn’t fully done: The Continent-wide “banking union” is still elusive, and there is little movement toward the more-distant goal of the sort of federal treasury and budget that would redistribute money across the 50 states of the U.S. A host of euro skeptic parties have been making strides in opinion polls, so the prospects for either have receded further.
The euro, as a financial instrument, has declined since early 2014, when it was near $1.40. But that shift has been led by a sharp divergence in monetary policy: The U.S. Federal Reserve is moving away from monetary easing, while the European Central Bank is deep in an experiment of negative interest rates. To a large degree, a weak euro would be a good thing for the euro zone’s efforts to build exports and return ultralow inflation to healthier levels. This monetary-policy split will likely continue to keep the euro depressed, but politics in the region are looming as a force.
Outlook for 2017: There are a few key themes that should increasingly play out in 2017. Overall, 2017 should be a year characterized by increasing emphasis on fiscal policy to stimulate the economy, rising interest rates, continuing U.S. dollar strength, firming commodity prices, and plenty of volatility to go around – both internationally and domestically. What appears certain is that President-elect Donald Trump will inherit an economy that is doing quite well. The U.S. economy grew by 3.5% during the third quarter and is on pace to expand 2% or so in the fourth.
However, this strong pace of expansion is unlikely to be maintained through 2017. Despite one-off export strength last quarter, net exports look to remain a drag on growth during 2017 given the dollar rally. Moreover, dollar strength and elevated uncertainty is likely to weigh on business spending, although the diminishing drag from the energy sector and resilient U.S. consumer should help lift investment in 2017. On a more optimistic note, residential investment should fare well despite higher interest rates, with existing home sales looking to end 2016 with a bang.
Overall, while it is believed the higher dollar and interest rates will take some steam out of U.S. economic growth in 2017, the economic expansion will remain resilient at just above 2%. This will enable the economy to continue eating up whatever slack remains, with the ensuing wage pressure helping lift inflation closer to the Fed’s 2% target. Given the monetary tightening that has already taken place, the Fed is likely to proceed cautiously going forward.
There are a number of headwinds and tailwinds facing the U.S. economy in 2017. Chief among these is the evolution of U.S. fiscal policy. So far, financial markets have focused on the potential upside of the President-elect’s campaign platform, but there are also some downsides. Key platform planks such as tighter immigration or more restrictive trade policies are inflationary, likely negative for growth, especially over the longer-term. Markets have also ignored the potential economic drag from any offsetting spending restraint that may be imposed if Congress won’t tolerate ballooning deficits. Still, one cannot ignore the potential upside from the large package of tax cuts and infrastructure spending that may be coming down the road. Republican tax cuts and infrastructure plans range from 2% of GDP under the House Republican proposals, to 3% under Trump’s platform. Corporate income tax cuts in particular could be an impetus to business spending which has been weak in recent years.
A lower marginal effective tax rate on investment could stimulate investment and thereby lift productivity growth, raising economic growth in both the short- and longer-term. Republicans have also pledged to reduce the regulatory burden on businesses, which could further support investment. Given the orientation of fiscal measures toward tax cuts and their focus on the upper-end of the income scale, the impact on near-term GDP growth would likely be smaller than their total dollar value. And, with a lag in implementation it would likely be 2018 before more material impacts are felt in the economy.
Finally, a number of key elections (Germany, France, Norway and the Netherlands) will be taking place in 2017. Outcomes will further test the recent groundswell of populism that could heighten worries around the sustainability of the euro. Outside the political sphere, there are plenty of economic and financial triggers that could occur, including ongoing concern around Italy’s banking sector, China’s restructuring challenge, and elevated debt in emerging markets; both have the capacity to trigger volatility through a disorderly unwinding and sharp capital outflows.
4th Quarter 2016 Capital Markets in Review
Recap: The S&P 500 Index returned 3.8% in the fourth quarter and finished 2016 with a total return near 12%. Meanwhile, the Barclays U.S. Aggregate Bond Index declined 3% in the final quarter and saw its total return come in near 2.6% for the year overall. Despite all of the eye-popping headlines, unpredictable political twists, and corporate earnings challenges the domestic stock market performed particularly well in 2016. In fact, the results came in much better than had been envisioned at the start of the year. The U.S. economy was expected to continue down its path of slow growth. Primary concerns for the markets included above average equity valuations, declining corporate earnings growth, and the likelihood of interest rates moving higher over the course of the year as the Federal Reserve had set its intentions to possibly raise rates four times in 2016 (something markets overall, did not believe was all that likely given how the global economy was shaping up).
Domestic Stocks: The final result of a 12% total return for the S&P 500 Index this past year was surprising and exceeded the expectations of many Wall Street strategists especially considering the declines in quarterly earnings that unfolded for most of the year. Research analysts had begun the year expecting overall 2016 S&P 500 operating earnings to climb 18% and come in at over $125. While final actual Q4 2016 earnings results will not be available for several more weeks, the current 2016 analyst expectations have come down steadily for the year and now stand near $109. However, if earnings do in fact come in near this level it would hallmark a climb out of negative levels. Wall Street strategists had similar optimism for corporate earnings growth, and began the year with an average return expectation near 9% for the S&P 500 (somewhat below the more typical 10% return expectation).
Mid and small-cap stocks surpassed their larger brethren for this past year, particularly following the surprise results from the presidential election in November. The Russell Mid-Cap Index rose 3.2% in the quarter to finish the year up 13.8% for the year overall. The Russell 2000 Index representing small stocks rose 8.8% in the final quarter to mark a banner year total return of over 21%. There was hope that these areas of the market would finally see broader investor interest during the year, after seeing several recent years of underperformance.
Value stocks took the stage in 2016 after trailing Growth stocks by a wide margin the prior year. With markets selling off in the initial weeks of 2016, investors started to show a preference for the defensive characteristics often attributed to Value early in the year. However the focus for the first half of the year was really on high dividend paying stocks and other Value strategies stayed out of favor. Investors’ tastes changed again in the second half of the year as interest rates started to rise globally and dividend stocks (particularly Utilities, Telecom, and REITS) fell out of favor. More traditional Value became more favored, and bank stocks in particular rallied following the election with rising rates and hopes for less burdensome regulatory oversight filling the sails of optimism in the space. Value outperformed across the market cap spectrum although smaller market capitalizations saw greater benefits. For example, the Russell 1000 Value Index returned +17.3% for the year, while the Russell 2000 Value Index returned +31.7%! This compares to the corresponding returns of +7.1% for the Russell 1000 Growth index and +11.3% for the Russell 2000 Growth Index for the year.
Sector performance for the S&P 500 Index was by and large positive for the year. Value sectors dominated overall, with Energy (+27.3%), Telecom (+23.4%), and Financials (+22.7%) taking top performance honors. Health Care was the only negative performing sector, falling 2.7% as fears of greater drug price regulations and uncertainty of potential changes to Obamacare weighing on shares.
Foreign Stocks: Developed equity markets outside the U.S. slipped further in the final quarter of 2016 and trailed U.S. stocks. Performance for the year was also unexceptional. The MSCI EAFE declined 0.7% for the quarter but managed to squeak out a 1% gain for the year. The MSCI ACWI ex USA Index (that has greater emerging markets exposure) was down 1.3% for the quarter and up 4.5% for the year. Foreign stocks had started 2016 on a sour note as markets sold off due to economic and political uncertainty. A stronger US dollar and the combined impacts of refugees, terrorism, and declines in China (as many foreign countries have greater exports to China than the US) carried over from 2015 and weighed heavily on these markets at the start of the year. After rallying back over the first half of the year, a surprising “EXIT” vote for Great Britain to leave the European Union shocked markets once again. This sell off proved short-lived and markets rallied higher until the results of the US presidential election cast additional uncertainty on the geopolitical landscape.
Emerging Markets stocks performed quite well over the course of the year as many commodity markets started to shows signs of stabilizing. Performance results were bolstered further by strong investor flows. Debt investors flocked to the higher interest rates that were available in these countries and equity markets benefited alongside as investors seemed to be drawn to the strong market returns that were seen through the first nine months of the year. However, emerging markets sold off following the US presidential election on fears of a shakeup in globe trading agreements, higher US interest rates, and a stronger US dollar. The MSCI EM Index posted a decline of 4.2% for the quarter, but still managed a respectable total return of 11.2% for US investors for the year.
Bonds: The US 10-Year Treasury closed the quarter and year with a 2.4% yield (up from 2.3% at year-end 2015). Similar 10-Year notes for Germany and Japan posted yields near 0.2% and 0.05%, respectively. The Barclays U.S. Aggregate Index declined 3% in the face of higher rates during the quarter, while the Barclays Global Aggregate ex U.S. declined 10.3%. For the year, these bond indexes returned +2.6% and +1.5%, respectively.
Interest rate activity was anything but quiet over the course of the year. The first half of the year saw a dramatic decline in global interest rates that culminated near the Brexit decision at the end of June. The US 10-Year Treasury rate bottomed near 1.36% on July 5 following this market disruption. Many developed market bond rates went into negative territory over the first half of the year as countries continued efforts to stimulate economic growth. However, rates marched steadily higher over much of the second half of the year as investors grew increasingly comfortable with higher risk investments like stocks. This year finally seemed to mark a turning point for interest rates, and likely an end to the over 30 year bull market run in domestic bonds.
The high yield bond market stole the show the entire year as investors flocked to the space for higher incremental income, despite potential risks that might be present. For the quarter the Barclays High Yield Corporate Index was up 1.8%, to finish out the year up over 17%! The asset class certainly benefitted from improving stability in energy markets and decreased likelihood of sharp rise in default rates of those borrowers. But for income investors the spread differentials proved too hard to pass up and high yield markets outperformed most other debt investments by a wide margin.
Non-Traditional Investments: Commodity-related investments recovered over the year with greater stability in many underlying commodity prices, particularly in energy markets. MLPs investors experienced bouts of volatility over the year, but with headline grabbing output cuts by OPEC on the horizon, the final quarter saw the Alerian MLP Index climb 2% to close the year up 18%.
Real estate investments also saw periods of volatility over the year as investors wrestled with rapid moves in interest rates, along with the addition of a separate Real Estate sector in the S&P 500 Index sector groups (GICS). Rising interest rate environments can stoke investor concerns of negative impacts to property values. However, often times these fears prove short-lived, particularly in markets with positive fundamentals and rental rates adjusting higher. Real estate markets saw this type of sell off in the final quarter as the FTSE NAREIT Equity REIT Index declined 2.9%, but still provided a positive 8.5% total return for the year overall.
Investors continued to see a steady flow of new alternative investment vehicles brought to market in 2016, although perhaps this drive is starting to fade somewhat as the financial crisis falls further from investors’ memories. Many of these strategies have lacked proven investment expertise, operating histories through several market cycles, are focused on unique investor situations or goals, maintain above-average fees, and often times are not appropriate for inclusion in mainstream diversified portfolio structures. This reinforces the need for persistent due diligence in order to research viable options and product appropriateness for clients.
Outlook: It is appropriate to reiterate that strategic investors should keep their focus on maintaining a disciplined long-term positive perspective on capital markets. Attempts to make substantial portfolio adjustments as markets ebb and flow for all kinds of reasons are not likely to prove fruitful. Preference should be placed on meaningful and purposeful strategic allocations to client portfolios and adjusting them modestly from time to time as needs arise or conditions change.
At the same time, it is prudent to be mindful of the many potential risks that could hinder positive outcomes over shorter periods. The list of potential risks in 2017 results include (in no particular order): the new Trump Presidency and any associated upheavals in both domestic and foreign policies, a swath of elections and referendums across Europe and a potential growth in populism (and related impacts to the European Union and euro), potential impacts from rising interest rates, more aggressive interest rate actions from the Federal Reserve than perceived, impacts from a stronger US dollar, relatively high domestic stock market valuations, and inevitably the persistent threats from geopolitics, terrorism, and other “black swan” events.
The S&P 500 now trades at 19 times forward earnings according to the Wall Street Journal, above long-term averages. Market valuations increased over the course of 2016 as investors looked favorably toward many statements made on the Presidential campaign trail. The election has been decided, but budgetary constraints and the will of Washington DC politicians to go along with so many initiatives will certainly be tested. Domestic stock markets are not cheap, but Wall Street strategists have been implying (based on their low forecasted returns) a decline in valuations based on lower market return expectations alongside earnings growth near 20%. With those domestic stock market and earnings forecasts in mind, it is difficult to get overly excited about the prospects for outsized returns for the S&P 500 in 2017.
In other areas, developed foreign equities may appear more attractive based upon more favorable valuations, earnings potential, dividends, and stimulative government activities, however political uncertainty drives more conservative expectations. As interest rates move higher fixed income investments face sizable headwinds, although there certainly will be periods of stability.
Based on recent economic and market trends and forgoing a significant change to current inflation trends, the Federal Reserve is targeting 2-3 interest rate hikes in 2017, slightly more than the market feels is appropriate at this time. With relatively reasonable market expectations, diversified portfolios should continue to provide investors an appropriate balance of risk and return.
Index Performance as of 12/31/16
Sources: Department of Labor, National Association of Realtors, the Conference Board, Department of Commerce, Barron’s.