Investors Await Clarity on
Tax and Spending Policies
January 17, 2017
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The post-election rally took a break last week as investors await corporate earnings news.
We believe global economic growth will accelerate, providing tailwinds for equities and other risk assets.
2017 is likely to be a stock-pickers market, as we expect further diversion between individual securities.
Equity markets were mixed last week, with the S&P 500 Index down fractionally.1 Investors grew more wary about President-elect Trump’s increasing scrutiny of specific corporate policies and a possible push for higher tariffs. The health care sector suffered due to drug pricing concerns, while retail sectors were hurt by generally disappointing earnings results.
Forward Guidance Is Key for Earnings and Equity Prices
As the fourth quarter earnings season begins, we think earnings are improving, but we expect mixed results. We believe interest rates, the U.S. dollar, oil prices and wage rates will drive results over the course of 2017. For the current reporting quarter, we expect higher oil prices will benefit energy and related sectors, and think the stronger dollar will present a headwind for larger multinationals.
Furthermore, we are closely watching forward guidance. Investors will scrutinize earnings statements for hints about what corporate management teams expect in terms of possible tax reform, regulatory changes and economic growth. These factors are likely to drive capital spending, hiring plans and a range of other corporate actions that could affect equity prices.
Overall, both consumer and business confidence appears high, and corporate earnings and economic growth should accelerate in 2017. This should produce tailwinds for stock prices, but gains are likely to be uneven and more company-specific compared to recent years.
Weekly Top Themes
- Rising wage inflation brings positives and negatives. Rising wages are good news for consumer spending, but they may drag down corporate profitability.
- We expect action on the “Trump Agenda,” but with little economic impact until 2018. We expect the new president and Congress to aggressively move on tax reform and fiscal stimulus. Such legislation is complex and it will take time to take effect, so any results won’t be felt until next year. Investors are hoping that fiscal stimulus will offset tighter monetary policy, allowing growth to accelerate. The risks are that the economy slows before fiscal stimulus can take effect or decreasing liquidity becomes a problem for financial markets.
- Correlation between individual stocks is falling, possibly presenting opportunities for active managers. According to Bernstein Research, the post-election environment produced the period of the lowest correlation between individual U.S. stocks since the height of the financial crisis (meaning the performance of any one stock was less affected by moves in the overall market). We expect this low-correlation environment to persist, which should make security selection and careful research critical to investment success.
Global Growth Should Improve, Helping Risk Assets
Investors remain highly attuned to potential changes in the political backdrop. Since the election, expectations for more pro-growth policies in 2017 have caused increases in equity prices, bond yields and the U.S. dollar. Sharply rising yields and a stronger dollar could present risks for stock prices, but bond yields and the dollar have retreated slightly in recent weeks. These moves probably reflect fading concerns over a faster-than-expected rate hike campaign by the Federal Reserve. The minutes from the Fed’s December meeting show that policymakers expect growth and inflation to rise, but not at a pace requiring significant or rapid monetary tightening.
Outside of the United States, we think growth will be uneven but improving. The political environment in Europe is not supportive of growth, but we think this region will see some economic acceleration. Our outlook for China is mixed. Growth is slowing in the world’s second-largest economy, as Chinese authorities enact reforms to make the economy less dependent on investment and more driven by domestic spending.
The U.S. and global economies were already improving before November’s elections, and appear set to continue accelerating. Corporate earnings are also experiencing some tailwinds. The global political backdrop could create risks given rising populism around the world, but for now we think it makes sense to stick with a pro-growth investment stance.
1 Source: Morningstar Direct, as of 1/13/17
Last Week's Commentary
Improved Global Growth
Favors a Risk-On Stance
January 9, 2017
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2017 begins as 2016 ended — with an equity rally driven by political optimism and improved economic growth.
Stronger growth should keep the Fed on track to raise rates two or three times this year.
Equities face several possible risks, but for now we see more positives than negatives for stock prices.
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.
Weekly Top Themes
- The labor market remains strong while wages are rising. December’s employment report was solid, showing 156,000 new jobs were created and upward revisions to prior months.2 Wage growth was quite strong, rising 0.4% for the month and 2.9% year over year, the highest in several years.2
- Broader economic trends point to likely increases in the fed funds rate. It’s tough to find much wrong with the U.S. economy. In addition to the labor market report, last week’s economic data showed new record 2016 vehicle sales of 17.55 million.3 The overall improvement in economic data suggests the Federal Reserve remains on track to raise interest rates two or three times in 2017.
- The benefits from fiscal stimulus may be balanced by economic headwinds later in 2017. We think some combination of tax cuts, tax reform, overseas repatriation, infrastructure spending, defense spending and regulatory revisions should help consumer and business confidence this year. Possible negatives include rising labor costs, the stronger dollar, higher interest rates and pockets of weak overseas growth.
- U.S. stocks will likely be plagued by an ongoing tug of war. We think corporate earnings improvements will primarily be the primary driver of prices this year. That trend will likely be counterbalanced by contracting price/earnings multiples.
- The state of the global economy should be a positive for equities in 2017. Deflation risks appear to be receding around the world while excess inflation has yet to surface. This could create a “Goldilocks” reflationary environment that would be good news for equities and other risk assets.
Positives for Equities Outweigh the Risks
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.
1 Source: Morningstar Direct, as of 1/6/17
2 Source: Bureau of Labor Statistics
3 Source: Autodata Corp.