The post-election rally in U.S. equities took a breather at the end of December, but stock prices bounced back strongly in the first trading week of 2017. The same factors that have driven prices higher since November — enthusiasm over President elect Donald Trump’s legislative agenda and stronger economic data — boosted equity prices last week, with the S&P 500 Index rising 1.7%.1 Looking ahead, we expect the tailwind from improved economic growth should continue through this year, while the positives from the political backdrop may be tested.
Improving economic growth in both the United States and around the world should help equities in 2017, but we also acknowledge that markets face several risks. Chief among these is that improving growth and rising wage inflation will likely translate into less accommodative Fed monetary policy. We don’t expect rapid or dramatic rate increases, but policy appears on track to slowly normalize after years of the fed funds rate remaining at the emergency zero level. As such, we think the risks are to the upside for both the fed funds rate and U.S. bond yields. As yields rise, they will likely pressure equity multiples and could create spillover volatility in equity markets and other asset classes.
Some are also growing concerned about equity valuations. We do not believe that valuations are currently stretched, but stocks are certainly more expensive than they once were. We are not worried about valuation pressures at this point, but this will bear watching later in the year if interest rates and inflation increase.
The political backdrop could also create some risks. The likely pro-growth policies from the Trump Administration are boosting investor optimism, but we remain wary of possible protectionist moves from the next President. Additionally, rising geopolitical tensions could undermine business confidence.
On balance, however, we think the improving economic outlook warrants a moderately pro-growth investment stance. The strong post-election equity rally could mean stocks may face a near-term consolidation or correction. However, the fundamentals of improving corporate profits and better nominal growth suggest that stocks look more attractive than bonds or cash. If the global economy shifts into a higher gear, select pockets of non-U.S. equities could have the potential for significant gains. For now, however, we expect U.S. stocks to continue their 2016 outperformance.
Last Week's Commentary
Ten Predictions for 2017: A Year of Transition
as Markets Return to Fundamentals
January 1, 2017
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Key Themes for 2017:
Secular stagnation and deflation fears should give way to somewhat better growth, higher inflation and rising interest rates.
2017 will bring high degrees of uncertainty about the economy, markets and politics.
Investors should expect a difficult ride and mediocre returns in most asset classes over the next 5 to 10 years.
In such an environment, markets are likely to be driven less by broad macro trends and more by securityspecific fundamentals.
2016 Recap: A Tale of Two Markets
In many ways, the beginning and ending of 2016 were mirror
images. As the year began, financial markets were dominated
by fears of recession and deflation, and investors were uneasy
over the Federal Reserve’s December 2015 rate hike. This
environment produced a sense of malaise that resulted in a
10% drop in equity markets by early February.1 From that point,
dovish global central bank policies, improving liquidity and a
stronger labor market boosted economic growth modestly.
As corporate earnings began to recover, stock market indices
rose through most of the rest of the year, and rallied strongly
following the presidential election.
In addition to changes in equity market performance, we saw
several other key inflection points. Amid economic growth concerns, the yield on the 10-year U.S. Treasury bottomed at
1.37% on July 8 and has climbed more than 100 basis points
since then.1 We believe the July low marked the end of what
had been a 35-year bull market for bonds. Fed policy also
shifted as the central bank again hiked rates in December
and indicated additional increases would follow in 2017.
And, of course, the global political environment changed
markedly. The Brexit vote, Donald Trump’s election and the
Italian constitutional referendum all point to a world that
is increasingly rejecting globalization and growing more
nationalistic and protectionist.
Amid this complex backdrop, we venture forth with our Ten
Predictions for 2017:
2017 Ten Predictions
U.S. and global economic growth improves modestly as the dollar strengthens and reaches parity with the euro.
Unemployment drops to its lowest level in 17 years as wages increase at the fastest pace since the Great Recession.
Treasury yields move higher for a third consecutive year for the first time in 36 years as the Fed raises rates at least twice.
Stocks hit their 2017 highs in the first half of the year as earnings rise but price/earnings multiples fall.
Stocks outperform bonds for the sixth year in a row for the first time in 20 years while volatility rises.
Small caps, cyclical sectors and value styles beat large caps, defensive and growth areas.
The financials, health care and information technology sectors outperform energy, utilities and materials.
Active managers’ performance improves as flows into equities rise.
Nationalist and protectionist trends rise as pro-domestic policies are pursued globally.
Initial optimism about the Trump agenda fades in light of slow legislative progress.
We dub 2017 as “A Year of Transition,” as many of the trends that emerged
in 2016 should continue and perhaps accelerate.We expect a shift from an
environment of secular stagnation and deflation fears to one marked by somewhat
better growth, higher inflation and rising interest rates. This environment will likely
trigger several key changes in the economic, investing and political landscape:
2017: A YEAR OF TRANSITION
|Economic stimulus driven by monetary policy||Stimulus driven by fiscal policy|
|A world progressing toward globalization||Rising nationalism, protectionism and isolationism|
|Fears of stagnant growth and deflation||Improving growth and rising inflation|
|Investors focusing on safety||Higher appetites for risk amid rising volatility|
|A “rising tide lifting all boats” market||An environment where selectivity is critical|
2017 will also likely produce a high degree of uncertainty. The election of Donald
Trump may usher in significant changes to tax, trade, immigration and regulatory
policies. At the same time, fiscal stimulus should lead to higher wage inflation.
As interest rates rise, a critical question is whether an equity bull market that has
been driven by liquidity can continue as one driven by revenue and profit growth.
In this environment, investors may be in for a difficult ride. The 35-year
disinflationary, falling interest rate world is coming to an end, and that brings with it
some challenges. We think investors should expect mediocre returns over the next
5 to 10 years from nearly all asset classes as a result of relatively slow long-term
global economic and earnings growth and generally full valuations.
We expect the investing environment will be driven less by broad macro issues
and more by security-specific fundamentals. Given the changes we expect,
we forecast the following investment themes: stocks over bonds, small caps
over large caps, value over growth, cyclical sectors over defensive ones and credit
sectors over government bonds. More critically, we think that making the right
portfolio decisions will require a focus on individual security selection to generate
outperformance in all asset classes.
1 Morningstar Direct and Bloomberg