Following a year in which the price of oil increased more than 100%, we enter 2017 with the expectation that wild swings in asset prices are less likely. Fundamental conditions in the US economy continue to demonstrate steady improvement, with recent indications of acceleration. The US economy remains the best in the world, and it was gaining momentum prior to the election. Additionally, data suggest the recovery is beginning to broaden, and some strategists have described an extension of the current cycle – i.e., an economic expansion that many believed was in the late innings is about to head into several extra innings.
Much of the stock market’s double digit return occurred post-election, with the Dow Jones Industrial Average approaching an historic milestone by year end. The market’s positive follow through reflects expectations for de-regulation, tax cuts, and some measure of tax reform. Therefore, the largest risk for the stock market in 2017 will likely be the new Administration’s failure to deliver on aggressive campaign promises. Further, the Federal Reserve indicated a more hawkish posture toward monetary policy. While the market absorbed the rate increase in December without volatility, additional rate increases that are not offset by fiscal expansion represent another market risk for 2017 and could engineer a slowdown in the economy.
The possibility of increased infrastructure spending has improved, but tax cuts are likely to be the primary form of fiscal stimulus. For corporations, a reduction in the statutory rate is probable in 2017. Goldman Sachs estimates that, all else equal, each 1% decrease in the corporate rate could contribute more than 1% in incremental earnings per share growth for the S&P 500. Any tax cuts will be included among other adjustments as part of a comprehensive tax reform package. Other features could include reductions in the rate applied to the repatriation of offshore earnings. In addition, Congress is likely to pass measures such as a one-time “holiday” on the tax for the repatriation of accumulated offshore earnings and the immediate depreciation of capital expenditures. The most controversial measure relates to a shift toward a “destination-based” tax system and its “border adjustment feature”. Such a system would generate significant volatility as certain sectors face the prospect of smaller margins while others will benefit. It is clear from the proposals currently seeking support from members of Congress that the designs are focused on encouraging domestic production and investment. It is not yet clear, however, how much certain sectors will benefit and how much other sectors could be hurt. Therefore, while we believe that tax cuts and tax reform will serve as powerful tailwinds to corporate earnings, the negotiations necessary to pass the required legislation could contribute to market volatility.
The new Administration has indicated a shift toward protectionism that is likely to provide continued support for the US Dollar. A strong Dollar will render imports less expensive, but our exports will also prove less competitive. On balance, however, the global trend toward protectionism should prove inflationary, particularly if trade barriers are erected. Globalization, which began in the 1970s but accelerated following the collapse of the Berlin Wall, helped lift emerging markets out of poverty, helped open up new markets for US companies, and helped lower prices for all consumers. It could be in the process of reversal, and such developments have significant implications for the performance of asset classes going forward. Most notably, a trend away from globalization could suggest the era of “lower for longer” interest rates concluded in 2016. We believe, however, that deflationary pressures remain omnipresent, and the inexorable climb to higher interest rates will remain moderately paced.
We look back on the volatility in the First Quarter of 2016, and we must pat ourselves on the back for urging our clients to stay the course. In fact, we argued that the selloff which greeted investors early in 2016 was an opportunity. Our evaluation of underlying fundamentals proved accurate. As we enter 2017, we likewise maintain a sanguine outlook. The stock market’s valuation has climbed, but we do not consider valuation benchmarks stretched on a historical basis. Further, we expect earnings growth to recover for several sectors, and with the tailwinds associated with de-regulation and tax reform, earnings growth could surprise on the upside.
We acknowledge that the markets will require time to adjust to the new Administration’s unconventional communication style and aggressive policy agenda. We also acknowledge concern with regard to potential disruptions in geo-political matters. Both will be sources of market volatility. In terms of monetary policy, the Fed’s consistent approach provides stability, but the prospect for change in that regard will also become relevant as Chairwoman Yellen’s term ends in January 2018. We further note that the recent, sharp devaluation of China’s currency, a source of major concern just twelve months ago, represents uncertainty that is currently underappreciated by the markets. Notwithstanding the aforementioned concerns, we remain constructive, and we wish everybody the best for the New Year.