Perspectives & Planning: Winter 2017
January 09, 2017
- GDP accelerates to 2.5% in 2017 from 2.0% in 20162
- Inflation rises to just over 2.0%1
- Solid job gains average 150,000 per month1
- Improving growth propelled by consumer near 3.0% gain in consumer spending1
- Modest improvement in global growth as emerging economies benefit from higher commodity prices3
- Favor domestic equities as earnings growth could hit double digits4
- Meager bond returns as 10-year Treasury note yield rises to 2.75% from 2.50% 1
- Continued strengthening of the dollar2
MARKET & ECONOMY
Despite a poor start in 2016, both the economy and financial markets shrugged off a string of major political shocks from Brexit to the election of Donald Trump, and turned in a solid performance for the full year. We begin 2017 on an optimistic note. After barely advancing more than 1% in the first half of 2016, U.S. GDP grew at a robust 3.5% annualized pace in the third quarter and likely increased better than 2% in the final quarter of 2016.2 For the full year, GDP is likely to have grown around 2%, or in line with the trend of recent years.1
Housing is healthy or even frothy in some geographies with supply tight due to an increase in household formation and years of underbuilding. Residential construction grew at a sluggish pace in 2016. As employment has historically been the strongest determinant of housing activity, we expect housing starts will increase 10% in 2017 to 1.25 million units despite higher mortgage rates.1
Even manufacturing and capital spending could pick up with an assist from the energy industry. Drilling activity has steadily increased in recent months albeit from rock bottom, and if oil prices remain above $50 per barrel, this trend will likely remain in place. After flat lining for two years, capital spending is projected to rise 3.5% in 2017.1
Government spending should continue to contribute to GDP. State and local governments will be able to boost spending as tax receipts rise. At the Federal level, the modest relaxation of sequestration is still in effect. As such, the budget deficit increased in FY2016 both in absolute and percentage terms after several years of decline. The election outcome suggests a further widening of the deficit which could nearly double in just two years, based on Mr. Trump’s campaign proposals. Trumponomics should be stimulative, given the President-elect’s advocacy of tax cuts and infrastructure spending. With both chambers of Congress remaining in Republican hands, we presume that significant changes in fiscal policy will be enacted, as divided government and gridlock will end. Nonetheless, considerable debate over the new President’s economic program is to be expected.
While tax cuts are likely to be embraced by the Republican caucus, increased spending could be more problematic. The protectionist trade policy espoused by Mr. Trump may also be controversial within his own party but this is an area where the President has considerable unilateral authority. The imposition of high tariffs or other trade barriers would lead to lower productivity (and hence lower growth) and higher inflation over time but will have little impact over the next year. Similarly, infrastructure spending is unlikely to boost the economy in any measurable way before 2018, especially as policy details are a long way from being worked out.
While globalization seemed to be rejected by voters worldwide time and again last year, the broader global economy was firming as 2016 drew to a close. Absent a full blown trade war, the International Monetary Fund projects an increase in global growth in 2017 to 3.4% from 3.1%.3 With commodity prices improving, a number of emerging market economies should perform better. Brazil, Russia, and Argentina should exit multi-year recessions.3 The Chinese economy appears steady but concerns linger over mushrooming debt and a sagging currency. The developed economies also seem to be holding their own. It even appears that Britain will avoid the worst case scenario after Brexit and avoid recession, although growth will slow.
U.S. investors enjoyed solid returns in 2016 as a post-election rally pushed domestic equity returns into double digits. Value and high dividend stocks outperformed significantly. The S&P 500 returned 11.8% while the S&P Midcap 400 and the small cap Russell 2000 surged 20% and 21%, respectively.3 Despite a second half selloff which morphed into a Q4 rout, fixed income benchmarks still managed to provide positive returns as the Barclays Aggregate gained 2.7% and the Intermediate Government/Credit Index returned 2.1%. Corporate credits performed extremely well and high yield debt delivered equity-like returns of 17%.
FINANCIAL MARKET PERFORMANCE
YTD as of 12/31/16
Our positive economic outlook suggests that improving fundamentals can support continued gains for equities at least in the first part of the year. Stocks only began to emerge from a yearlong earnings recession in the latter part of 2016. A sector by sector earnings forecast for 2017 concludes that 10 of the 11 S&P economic sectors will experience earnings growth with the relatively small utility sector suffering the only decline. Rising commodity prices will power the sharpest earnings gains for energy and materials. The financial sector should also enjoy a double digit increase, aided by rising rates and a steeper yield curve. If capital spending increases as expected, technology will benefit.4
Overall, we project 2017 S&P 500 operating earnings to rise 10% to $132 per share which results in a market multiple slightly above average at 17.0x forward earnings based on the December 30 close. On a trailing GAAP basis, however, the multiple expands to a lofty 25x earnings implying that stocks are not exactly bargains. Our earnings outlook does not incorporate a reduction in the corporate tax rate, which could boost earnings by 5% or more. We are maintaining a 2400 price target for the S&P 500 which implies a 9% total return. Our bullish view is somewhat tempered in that the end of year rally in 2016 may have borrowed somewhat from 2017 and rising interest rates could constrain P/E expansion.
as of 12/31/16
Source: BEA, Washington Trust Wealth Management
Fixed income returns are likely to be meager in 2017. In addition to raising the Fed Funds rate by 1/4% to a range of 0.5% to 0.75%, the Federal Reserve struck a more hawkish tone at its December meeting and projected three rate hikes over the course of 2017. With fiscal policy to turn expansionary and deficits likely to rise, Treasury issuance should increase and could pressure the market. Inflation is also edging higher and we expect the headline Consumer Price Index (CPI) to exceed 2% this year with the Fed at long last achieving its inflation target of 2% for its preferred measure, the Personal Consumption Expenditure deflator (PCE). Deflation fears can finally be put to rest, at least in the U.S. economy.
Given that the yield on the 10-year Treasury note climbed more than 1% over the back half of 2016, much of the damage has probably been done. Therefore, we expect the yield on the 10-year Treasury to conclude 2017 in a range of 2.5% to 3.0% or not dramatically different from the 2.45% at yearend 2016.1 Rising coupon rates should allow investors to recoup losses from a further slide in bond prices for a slight positive return.
Corporate credit should hold up well in 2017 as economic growth picks up. However, the massive rally in credit that began with the bottoming of energy prices in February 2016 will preclude similar gains in 2017. Corporate spreads are likely to tighten only slightly further. Due to the prospect of cuts in personal income tax rates, municipal bonds sold off sharply late last year. High quality municipal bonds now appear to offer some of the best value in the fixed income market irrespective of the outcome of tax reform.
We retain our overweight position on domestic equities given the improving earnings outlook and the less favorable environment for bonds. An acceleration in GDP should foster outperformance in more cyclical areas as well as financials versus defensive sectors. Stocks with rising dividends should also hold up well under our scenario for a mild increase in inflation. While international and emerging market stocks are relatively inexpensive, we remain underweight due to currency and geopolitical concerns.
Geopolitical risk will remain elevated or even increase in 2017. The political, economic, and military primacy of the West is under assault as traditional alliances fray. Rising powers including China, Russia, and Iran will seek to expand their influence. Elections in France and Germany may have far more impact than the Brexit vote or Italian referendum. Voter antipathy to globalization has yet to play out and the outcome is uncertain.
From a financial market perspective, currency risk remains paramount. Post-election, the dollar resumed its uptrend and rose to 14 year highs after spending much of last year consolidating after a powerful 2 year rally. A stronger dollar tends to reduce earnings for multinational corporations and erode the competitive position of U.S. exporters. It also heightens financial risk in emerging market economies that issue dollar denominated debt.2
An accelerated depreciation of the Chinese yuan remains of great concern even though China has negligible foreign debt. China’s currency has been weakening as its economic growth slows. Market volatility spiked in August 2015 and January 2016 when the dollar value of the yuan was adjusted lower. Despite President-elect Trump’s assertion to the contrary, China’s shrinking hoard of Treasury securities indicates the country is now actually supporting its currency in the face of massive capital flight.
Commodity prices have risen in the past few months which indicates that the stronger dollar isn’t yet much of a threat. However, the divergence in the monetary policy between a Federal Reserve’s tightening and other major central banks’ easing could exacerbate this trend. At a minimum, further modest gains by the greenback are expected.
While markets took the recent rate hike in stride, a faster normalization of interest rates by the Fed than currently indicated could sink investor optimism. There is also the question of the composition of the Federal Reserve Board itself. Two slots on the Board of Governors are currently open while Chair Yellen’s term expires in early 2018. The impact on monetary policy of these nominations could be significant. We think the Fed’s management of the economy since the financial crisis, while not without missteps, has been exemplary especially in comparison to the European Central Bank and Bank of Japan. A break with the Fed’s current philosophy may not be well received.
S&P 500 Actual & Projected Price Range
(projected price range based on 15x-19x p/e range on current year EPS)
as of 12/31/16
Source: Factset, Standard & Poors, Washington Trust Wealth Management
Mr. Trump’s proposed economic policies are also not without risk. We expect that as taxes are reduced and infrastructure projects are undertaken, growth will be enhanced in 2017 and 2018. The main question is whether these policies, once implemented, will prove to be more inflationary than pro-growth. Mainstream economics would suggest that major fiscal stimulus should be initiated when the economy is weak not when the economy is on the cusp of full employment. Our base case is for inflation to remain benign this year. However, should it appear that inflation will accelerate to 3% or higher, it would likely lead to a more aggressive tightening by the Fed and a revaluation of both stocks and bonds lower.
Trump policies on trade and immigration defy conventional economic thinking. Simply put, long term economic growth is defined as the combination of population growth and productivity increases. Lower immigration will limit one factor and restrictions on trade will curb the other. Tariffs are also rather clumsy tools. Trade theory suggests that the advantage to domestic producers from tariffs will be offset by a rising currency. It is little surprise that all the recent talk of tariffs has been accompanied by a renewed rally in the dollar.
Lastly, while Trump plans to rollback much government regulation, his approach seems to be highly interventionist, with government again picking winners and losers but this time with a tilt towards heavy manufacturing and fossil fuels. The irony is that over the past two decades foreigners invested substantially more in U.S. manufacturing than vice versa. However, increased automation has decimated manufacturing employment globally and not just in the U.S. Manufacturing has also steadily migrated from the upper Midwest to the Southern states and to countries south of the border. These trends will not be easily reversed and only time will tell if the Trump cure is worse than the illness. Near term, investors may do well to continue to focus on the pro-business, investor friendly proposals from the incoming administration while keeping a watchful eye on the longer term uncertainty introduced from a very different economic regime.
U.S. Treasury Ten-Year Yields
High-Low Range & Year-End Close
Source: Washington Trust Wealth Management
If you’d like to discuss any of the information contained in this newsletter, please call your relationship team or 800-582-1076. You can also read past editions of our publications by visiting our web site: www.washtrustwealth.com. Weston Securities Corporation is a Broker/Dealer, Member FINRA/SIPC. Securities may be offered through Weston Securities Corporation, which is a sister company of The Washington Trust Company, of Westerly and Washington Trust Wealth Management is a division of The Washington Trust Company, of Westerly.
Sources: (1) Washington Trust Wealth Management; (2) U.S. Bureau of Economic Analysis; (3) Bloomberg; (4) CFRA/Standard & Poors
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation. 01/06/17