US economy steams into 2017

U.S. Economy Gaining Steam into 2017

Since the election of Donald Trump on November 8, financial markets have shifted significantly as they adjust to account for strengthening U.S. economic data as well as for the changes to come under the Trump administration. In recent years, stocks and bonds have both managed to move higher together.  However, since the election there has been a sharp divergence in the direction of these two primary asset classes: stocks pulled out of their pre-election tailspin to vault higher while bonds have suffered through one of their worst periods in years as interest rates spiked higher.  In fact, the 0.84% increase in the yield of the ten-year U.S. Treasury note from October to December was the largest quarterly increase since 1994 and caused many billions of dollars of losses in the bond market.  (When yields move up, bond prices fall.) Other income-oriented investments that are perceived to be relatively safe, such as real estate investment trusts and utility stocks, have also declined since the election. Investors are, in general, expecting faster economic growth, increased government spending and higher inflation under the new administration.  

While it is of course impossible to pin down with certainty the reasons behind any particular movement in the stock market, part of the post-election rally is more than likely due to the turnaround in corporate earnings that began in the third quarter of 2016.  Growth (or contraction) of corporate earnings is, historically, the single most important factor behind the performance of equities. Recall that prior to the third quarter, corporate earnings had been contracting for five straight quarters, largely due to evaporating earnings from the energy sector but also from poor earnings trends in the financial sector.  After posting a gain of 3.1% in the third quarter, earnings are poised to continue their positive momentum into the new year.  Analysts are expecting earnings growth of 3.2% for the fourth quarter and high single-digit gains in 2017.

In addition to the favorable earnings trend, there are three changes likely under the new administration that could prove supportive for stocks: 1) corporate tax reform, 2) increased fiscal spending and 3) looser regulations for businesses.  Given that precise policies are not yet in place, it is not possible to calculate how much each of these factors might add to corporate earnings.  It is likely, however, that corporate tax reform holds the biggest potential for fueling gains in corporate earnings (and therefore stocks).  The current U.S. corporate tax rate of 35% is likely to be reduced, and will thus enable companies to immediately bring significantly more earnings to the bottom line.  A lower tax rate and/or corporate tax holiday to persuade U.S. companies to repatriate some of their massive cash hoards stashed overseas could also be a boon to domestic growth.

Potential Risks Ahead

Investors have largely given Mr. Trump the benefit of the doubt when it comes to his yet-to-be-clarified but business-friendly policies regarding tax and regulatory reform.  As a result, stocks have accordingly moved higher without a commensurate improvement in fundamentals.  Or, said another way, stocks have gone up mostly because their valuations have increased, and less so due to earnings gains.  For stocks to hold at current levels or move higher, the fair winds that investors are anticipating for the economy and business climate in 2017 will likely have to come to fruition.  It is easier to disappoint investors when valuations are high.

While there are of course innumerable geopolitical risks to be faced in 2017, three of the main financial and economic risks that concern investors today are: 1) changes in trade policy, 2) rising interest rates and 3) the strong dollar.

As the new administration takes office, perhaps the biggest worry for investors is what the Trump administration will do about foreign trade.  In our increasingly interconnected and interdependent world, will the U.S. lurch toward protectionism?  The U.S. economy is heavily dependent on foreign trade, with nearly half of all revenues from companies in the S&P 500 Index coming from overseas.  The pre-inauguration tone of the Trump team makes it seem probable that eventual actions taken on trade policy will be somewhat softer than those articulated on the campaign trail, however.

Second, interest rates look poised to continue to rise in 2017.  The U.S. economy has exited 2016 with a good head of steam and there appears to be little reason for the Federal Reserve not to continue to push rates higher in the coming year.  The Fed only controls short-term interest rates; long-term rates are decided in the markets by the collective actions of investors.  Rising interest rates help banks earn more on their loans, but they act as a brake on the rest of the economy.  If rates should rise more quickly than investors expect, they will weigh on bond prices and perhaps also on real estate and stock valuations. 

Third, the strong dollar may become a headwind in 2017 for the earnings of U.S. multinationals.  In 2016, the WSJ Dollar Index, which measures the dollar’s performance against a group of sixteen other currencies, gained 3%.  The greenback now sits at a 14-year high, primarily due to the solid economic situation in the U.S. and the fact that our interest rates are higher than those in other developed markets such as Europe and Japan.  (Demand for dollars increases as U.S. interest rates widen the gap with rates in Europe and Japan.  All else equal, global investors like to park their cash in a higher-yielding currency.  The U.S. dollar is a particularly appetizing choice at the moment.)  A strong dollar, however, makes it tougher for U.S. exporters to sell their products and it reduces the dollar value of earnings that U.S. corporations generate in foreign currencies.

All in all, 2017 holds much uncertainty for investors.  Please do not hesitate to contact me if there is anything about the election, the markets or your portfolio that you would like to discuss.

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Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

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