In what was possibly the most contentious and emotional Presidential election in recent times, the stage has been set for a new political and economic environment in the year ahead. Populist sentiment led the voting and the results have immediately altered the status quo. Very few Americans did not have a strong opinion about this one. While the election provides ample fodder for a lengthy political debate, as always it is our purpose to focus on the investment ramifications of this event.
The year 2016 was an interesting and turbulent one from a financial market standpoint. It was certainly divided into two parts: before the Presidential election and after. Financial markets started out on shaky footing, with an early sharp, although quickly reversed, stock market correction amid concerns over economic growth in China. Oil prices and interest rates declined to multi-year lows before beginning a gradual upward trend. The “Brexit,” a surprise June vote for Great Britain to leave the European Union, created further uneasiness. The U.S. economic picture was commonly viewed as one of fairly steady, if unspectacular, growth.
Then, the November elections turned conventional wisdom on its head. Donald Trump came from behind to take a surprisingly large electoral college victory, and the Republican party retained majorities in both the Senate and House of Representatives. Financial markets immediately began to discount an environment of faster economic growth, higher inflation, and higher interest rates, although based on little concrete action. Thus, we enter the new year in the most uncertain economic situation since 2008.
In 2017 – THE YEAR AHEAD we discuss this new, uncertain environment. We think that the bull market for stocks will continue, although with possibly even more volatility than in the recent past, and that gradually rising interest rates could be something of a sustained headwind for fixed-income investments. We remind you, however, that while we are attempting to forecast the future, our continued investment success will largely depend on our ability to interpret and adjust to trends and events as they occur and as new information becomes available.
As it has for much of the current expansion, the U.S. economy continued to grow at a below-average rate in 2016, with real Gross Domestic Product (GDP) again up about 2% for the year, at the low end of the range we thought it might achieve. Reasonably strong growth in consumer spending was partially offset by sluggish trends in business and government spending. Employment continued to improve steadily, with the official unemployment rate approaching 4.5%, a level not seen since the last economic cycle peak (the underemployed rate, however, remains higher).
The coming year presents us with a particularly unclear political roadmap. The new President comes to the position with no record in government, and has still not clarified his position on some issues. He will likely be relying heavily on advice from others, some of whose appointments require Senate confirmation. While there is much interest on the Republican side of the aisle in actions that would be perceived as business-friendly, there is also a wing of that party that is very much concerned about already large budget deficits and a high level of national debt. Democratic legislators, while in the minority, could still be a formidable voice if united against particular legislation, or could even form coalitions with some Republicans or Trump himself. However, one thing seems likely: with the same political party in control of both the White House and the Congress, legislation should pass more easily. Both Trump and Congressional leaders have already proposed changes on several fronts, which, if enacted, could provide additional economic stimulus.
Tax reform appears to be high on the agenda for 2017. Proposals have already been floated for reducing both corporate and personal income tax rates, along with simplifying the tax structure through both fewer brackets and fewer loopholes. Repatriation of foreign earnings through some sort of tax holiday may also be likely. Since much of this reform could be hammered out in committee as part of the budget process, it might not need to override any filibuster attempts, thus speeding progress. However, we are reminded that the last major tax reform in 1986 took nearly two years to proceed from the initial outline to final legislation, in spite of the support of the leadership of both parties.
During the campaign, the concept of increased spending on infrastructure received support from both candidates, and the need for improving the nation’s roads, bridges, and production capacity has been obvious for some time. As a source of new jobs, such spending could also improve the lives of some workers who have been left out of the current economic expansion. The effects may not be immediate, though, given the time needed to pass legislation and the logistics of large infrastructure projects. Tax incentives for companies to accelerate their own capital spending could produce results sooner.
A more immediate effect might also be seen from efforts to reduce the levels of business regulation, which Trump has made clear he will work on immediately after taking office. The financial backbone of our economy was re-regulated in response to the last economic downturn, and the banking system has certainly been shored up. Some aspects of the overhaul also put a damper on bank loan growth and the ensuing growth of the economy. Regulation has grown over the years in other industries, which has had some beneficial effects on society, but increased rules have also slowed the speed with which industry can respond to changing environments. Some simplification would likely improve this balance in favor of stronger economic results.
A huge area of concern to investors is the election year rhetoric of protectionism. While some parts of our economy might benefit from less foreign competition, historical evidence is strongly on the side of free trade in improving the overall economic well-being of our citizens. Cooler heads will hopefully prevail here, with any changes in trade agreements made carefully and in consultation with our trading partners.
Whatever progress is made on the government front, it is likely to help increase economic growth at least somewhat from its current 2% pace. If changes are enacted quickly enough, real GDP growth might move toward a 3% annualized rate during the coming year. Consumer spending could be further helped by continued wage growth and lower taxes, while business activity may increase from the benefits of simpler regulation, lower taxes, and infrastructure spending. There is still a lot of pent-up demand for housing, both to rent and buy. Increased U.S. growth will likely push the dollar higher, and it already sits at a multi-year high. Continued strength in our currency could put a brake on the international trade component of GDP growth.
Inflation, Interest Rates, and the Bond Market
Inflation remained moderate in 2016, although, as we expected, it began to tick up later in the year toward a 2% annual rate. A bottom and recovery in energy prices began adding rather than detracting from overall price levels, and helped to offset continued low food inflation. Wage growth has also begun to accelerate, to a rate of more than 2% per year. More fiscal stimulus is likely to cause further wage inflation, and, along with higher energy prices, should push overall price inflation toward 3% for the coming year.
Interest rates in the bond market also appeared to go through a bottoming process, as the yield on the benchmark ten-year U.S. Treasury note declined from about 2.25% at the beginning of the year to less than 1.4% in the summer, a level breaking the low of 2012. This decline was followed by a gradual increase up to Election Day as investors began to assume a one-quarter percent increase in the Fed Funds rate by the Federal Reserve, in response to an improved labor market and gradually increasing inflation.
Investor surprise over the election results precipitated an additional spike in all bond rates as the year drew to a close. Looking forward, more government spending will likely produce bigger budget deficits, at least initially, and stronger economic growth will further push up the price of both goods and labor. These factors would in turn push interest rates higher, and investors are trying to guess ahead of time how much economic strength should be priced in. The Fed, meanwhile, has clearly signaled its intent to increase the Fed Funds rate in quarter-point increments two or three times in 2017, depending on how concerned it becomes about inflation. Even though the longer trend is now higher, it seems to us that the initial move in bond rates may be getting a bit overdone in the short run. It remains extremely unclear how quickly any governmental changes may be implemented.
If the ratcheting up of bond rates has gotten ahead of itself in the near-term, this spike may provide an opportunity to put some cash into good quality bonds of short and intermediate maturities. Corporate bonds do not currently provide as much additional yield over U.S. Treasury securities as previously, but selective buying can still provide decent returns. If Treasury yields were to continue to rise, we might also be active buyers of U.S. government bonds for the first time in several years. Tax-exempt municipal bond rates have risen the most during the recent move, to the point where they actually yield as much as Treasury bonds, a highly unusual situation. This may be due in part to an expectation that the tax-exemption on their interest will not be worth as much if tax rates are lower, but is mostly the result of a large amount of panicky redemptions from muni-bond funds, forcing the sale of bonds to buyers like us at lower prices.
The Stock Market
After a rocky start, 2016 ended up being a pretty good year for the stock market after all, thanks to the strong rally in prices post-election, which contributed more to the year’s results than the previous ten months put together. This move allowed the major market indexes to exceed our expectations for high single-digit investment returns. Energy stocks, among the hardest hit in 2015, rallied strongly as energy prices recovered. Financial stocks also performed well based on expectations of improving earnings in a higher interest rate environment. In contrast, many sectors that tend to go up in a slow-growth world, such as utilities and consumer staples stocks, lagged after a strong start to the year. Surprisingly, healthcare was the weakest area as increasing concerns about pricing power and healthcare system modifications offset the positive structural tailwind of the aging baby boomers. Market participation broadened to include many medium- and small-cap stocks as well.
A stronger economy, aided by government fiscal policy, should enable stocks to generate positive returns again in 2017. The rate of corporate earnings growth should improve over the low single-digit rate of the past year. Monetary policy, while starting to become slightly less accommodative, will still be a positive factor. Offsetting these pluses will be valuations that have moved up to more expensive levels thanks to the year-end rally.
Before the election, earnings growth for the coming year was already set to accelerate a bit. Continued real GDP growth of 2% would be enough to support single-digit revenue growth, and the rebounding of the energy and industrial sectors should add a bit more. Any positive effects from fiscal stimulus, possibly before year-end, could contribute to both increased revenue growth and improved profit margins. For example, a reduction in the corporate tax rate, if enacted in 2017, could be retroactive to the beginning of the year. If the dollar continues its appreciation against other currencies, this could once again become a headwind. And, wage inflation could put some pressure on margins. Even so, these offsets will probably not be enough to keep overall U.S. corporate earnings growth from approaching a high single-digit pace.
Stock dividends are likely to grow at a pace in line with earnings. Company cash flows and balance sheets remain strong overall, and higher stock prices may mean that companies will focus more on dividend increases than stock repurchases.
A counterweight to better earnings and dividend growth is that, after the recent market run, the average price-to-earnings ratio of the companies in the S&P 500 Stock Index currently stands at around 18 times analysts’ consensus earnings forecasts for next year, a higher-than-average level. While accelerating earnings growth could support this optimistic valuation, any obstacles to increased government stimulus could cause disappointment and a possible pullback in valuations. In addition, higher interest rates tend to lower P/E ratios, as future earnings are worth less when discounted back to the present at higher rates.
Putting these factors together–high single-digit earnings growth rates, plus a current average dividend yield of about 2%, offset by some possible P/E contraction–will likely produce mid-single-digit stock market returns for the year as a whole.
As we have said before, the coming year presents us with a higher level of unpredictability than we have seen in a while. Such environments tend to lead to more volatile markets. We expect this will be true for stocks in 2017 as well. While the end result is still likely to be a higher market by the end of the year, there may be twists and turns along the way.
Within the equity markets there has also been a lot of sector rotation toward various industry groups seen to be beneficiaries of the new environment and away from those that might not fare as well. Financial stocks have shot upward since the election on the perception that a higher interest rate environment, less regulation, and faster economic growth would help their business. Industrial and energy stocks would likely benefit from infrastructure spending, a better economy, and higher commodity prices. Conversely, the stocks of consumer companies have lagged as investors look for faster-growing cyclical opportunities. Utilities typically suffer in a rising interest rate environment, which makes bonds an increasingly attractive alternative.
While we think that most of those initial trading moves are rational responses to perceptions of a changing economic environment, some of these reactions seem overdone to us in the near term, given the uncertainty around just how much improvement we will see and how soon. Thus, we are generally not chasing stocks of the perceived beneficiaries, but are looking to add to them if they pull back from the initial trading euphoria. We also think that, while the defensive sectors of the market have likely seen their best days for this cycle, the initial sell-off was an overreaction, and so we would not be in a rush to dump them immediately. We see housing-related real estate investment trusts as one interest-sensitive area that still might do relatively well in response to pent-up demand in this sector.
Healthcare stocks continue to be odd-man-out as concerns have mounted over potential pricing pressure for pharmaceuticals and other healthcare products and services. The Affordable Care Act is likely to be revamped, although with great uncertainty about what successor legislation will look like. The demographic imperative for increasing use of healthcare remains unchanged. This demand, combined with inexpensive valuations for many of the stocks in the sector, means likely profitable investment opportunities. The technology sector, while having performed reasonably well over the past year, has still not fully participated in the post-election rally. Many of these companies could benefit from increased capital spending, and technological advancement continues, but a strong dollar and protectionist rhetoric are negatives for the sector.
We have continued to focus our investing in stocks of U.S.-based companies, as our country’s economy has continued to grow faster than many others, and protectionism might hold back some emerging economies if trade slows. A number of our clients’ stock holdings have some international exposure already. As fiscal stimulus boosts growth in our economy, other countries are also finally beginning to look at increasing fiscal stimulus. There may come a time when growth is picking up enough overseas to warrant renewed emphasis. We’re still not sure that time is here yet, however, and a stronger dollar would offset some of the benefit of any price increase in foreign stock holdings.
The overall investment picture for 2017 does not look bad, on balance, to us, although there remains an unusually large amount of variability around the most likely outcomes given the changing political environment. We see continued–and maybe increasing–economic growth, with gradually rising interest rates. We think that this will provide a moderately positive environment for the U.S. stock market, but with higher volatility. Higher interest rates could also improve opportunities to pick up return in the bond market, and even short-term cash investments may provide a positive yield in the near future.
The near-term fly in the ointment is that the recent rally in stocks has already priced in at least some change. Any delays in implementing improvements in the economy could lead to possible corrections in the stock market. We would likely be buyers of stocks on any hiccups that might occur. Some mention has also been made in the financial press of the venerable Dow Jones Industrial Average approaching the 20,000 level. Often, when the Dow has hit a large, round number, traders have used the opportunity to take profits, which could mean a near-term ceiling for stocks until trading action subsides.
The current bull market for stocks has been underway for over seven years, but we remind our readers that economic cycles usually do not die of old age. Rather, it is an overheated economy, with rising inflation, that typically leads to tighter monetary policy followed by economic slowdown. While unemployment has continued to decline, it is not yet at a level low enough to produce a major Fed response. The Fed will be monitoring employment and inflation, and, while it would like to continue to “normalize” interest rates, it should be content to follow, rather than lead, the economic indicators. Will a stronger economy over the next year or two pull closer the time when it is more overheated and inflationary, with a subsequent recession? Or, will a more efficient business climate foster a wider and deeper economy that can grow larger before bumping up against its bounds? Only time will tell.
While this past year has been reasonably successful for long-term investors who look for fundamental investment value, much public attention continues to be focused on both unmanaged index funds and short-term trading strategies. Over time, we think that both will prove to be riskier than many think, and that a longer view, based on an objective analysis of business value, will continue to demonstrate its merit over market cycles.
We wish all of our friends and clients peace, joy, health, and prosperity in the New Year, and for many years to come.