he first half of 2017 was an unexpected boon for equity markets. The election of Donald Trump and Republican control of Congress, continued favorable economic conditions, and the acceleration in the growth of corporate profits were the main contributing factors. The total return of the S&P 500 Index was 9.3% for the first six months of 2017.
The total return of the Bloomberg Barclays U.S. Aggregate Bond Index in the first half was 2.3%, which was better than we anticipated. In the second quarter, interest rates fell, causing bond prices to appreciate. We believe, however, that this adjustment in long term rates is only temporary and that over the next 12 months interest rates will move higher, which will challenge fixed-income returns.
The long-term performance of equity markets depends on economic fundamentals, assuming that the political backdrop is reasonably stable. Substantially all of the return of the S&P 500 Index in the last 12 months was realized in the period following the election of Donald Trump, driven by investor expectations that the new administration, supported by a Republican Congress, would implement an economic program to stimulate the economy. It is ironic that while the Trump administration has been sidetracked by other issues jeopardizing the implementation of the bulk of its economic agenda, equity markets have continued to advance. This is because positive expectations for the U.S. economy and strong corporate profits recorded in the first quarter have provided important support for equity valuations. Although there is still some possibility the new administration can implement fiscal stimulus, which would potentially generate upside to our economic and profit forecasts, visibility and predictability are limited, particularly given the contentious issues and investigations embroiling the president and key administration officials.
The U.S. Economy and Corporate Profits
The economy got off to a rough start as first-quarter real growth dropped to 1.4% from 2.1% in Q4 2016. The below-trend performance was attributable to soft consumption, but there were a host of transitory factors involved, suggesting that consumption will likely improve over the course of the year. Gross private domestic investment and net imports looked strong. Our confidence in the economy is boosted by the very low unemployment rate, most recently reported at 4.3%, the strong jobs market (the JOLTS index of unfilled advertised positions1 is at peak levels), the recovery in the energy sector, low interest rates, and low inflation. However, there are some disturbing indicators such as the stagnation in real wages, demographics, and below-trend productivity. The 77 economists surveyed by Bloomberg hold that second-quarter growth will rebound to 3.0% and that for the full year, GDP will advance at 2.2%.
There seems to be broad consensus that the United States will continue to experience moderate but consistent growth over the next two years, which provides a positive backdrop for capital markets. The Federal Reserve forecasts growth through 2019 at close to 2% per annum and the long-term “central tendency” of the U.S. economy at between 1.6% and 2.2% per annum.2
Using data from the Congressional Budget Office, economist Jason Furman prepared the table below, which forecasts U.S. growth in the 2016-2026 period at 1.8% per annum. This rate of growth is down sharply from 1953-2007 owing to lower productivity and diminished population growth. Furman ran a Monte Carlo analysis, which after 10 million trials generated future long-term median real growth of around 1.8% per annum.3 Especially important in his analysis is that a 3% growth rate or better was achieved only 5% of the time, which places in perspective the challenge to lift economic growth to the 3%-4% range predicted by the Trump administration. While the 2% rate of growth for the United States is disappointing, we should bear in mind that no recession is expected in the foreseeable future, which is the most important factor causing bear markets in stocks.
|BASE CASE FOR POTENTIAL GROWTH|
Components of Potential Real GDP Growth, 1953–2026
|Growth Rate, Percent|
|Change in Potential Labor Force Participation Rate||0.2%||-0.4%|
|Potential Real Output per Hour Productivity||2.1%||1.7%|
The favorable view of U.S. economic prospects was reaffirmed by the Federal Reserve in its most recent statement issued on June 14, 2017. The Federal Open Market Committee raised its target rate for short-term Federal Funds 0.25% to the 1.0% to 1.25% range. The impact was more symbolic than real as there was no measurable impact on the yields of the 10-Year or the 30-Year Treasuries. Most economists expect at least one — possibly two — more Federal Funds rate hikes in 2017. In addition, the Fed will begin gradually reducing its massive holdings of U.S. Treasuries, which should exert moderate upward pressure on interest rates. As long as the rate of inflation remains at current levels of around 2%4, interest rates will probably rise in line with median consensus expectations — by Q3 2018, Fed Funds Rate at 1.75% to 2.00% and the 10-Year Treasury at around 3.1%.
Of particular importance to investors has been the sharp improvement in corporate profits in the first quarter. According to Bloomberg data, S&P 500 Index earnings rose 13.4% year-over-year, boosted by the sharp recovery in energy company earnings. Outsized gains were also recorded in the technology and financial sectors. We expect corporate profits for the full year to increase by 8% to 10%. Consensus forecasts for corporate profits in 2018 and 2019 are also around 10%. Since these projections are constructed on the estimates of analysts who tend to be too optimistic, we believe that corporate profits will more likely grow at mid-to-upper single digit rates. However, if corporate tax rates are reduced and a repatriation tax holiday is legislated, corporate earnings would receive an important boost.5
The Trump Administration
In January, we noted that there were four parts to the new administration’s economic program that could have an important positive impact on corporate profits, although probably not so much on the economy as a whole: (a) the reduction in the corporate tax rate from 35% to between 15% and 20%; (b) measures to induce corporations to repatriate their foreign profits; (c) an infrastructure program; and (d) the reduction in regulation of certain industries. We thought the first three items could actually garner some bipartisan support while the fourth would largely be implemented through executive orders.6
It seems to us that the administration’s initial priority in rescinding the Affordable Care Act (Obama Care) and replacing it with its own health insurance plan was a mistake, because the proposed legislation is highly contentious, will not improve our health care system, will have little impact on the economy, and is crowding out the Trump economic program as well as other important legislation like raising the debt ceiling and enacting the fiscal year 2018 federal budget.7
In view of the expanding investigation of Russian intervention in the presidential election, one wonders how our government can focus on its legislative agenda. There is a good chance that Congress will not address corporate tax issues and infrastructure until next year, which would be disappointing.
Some Final Thoughts
Equity valuations are stretched in relation to historical averages. However, viewed within a framework of subdued inflation, low interest rates, unemployment of less than 5%, and steady real economic growth, common stocks are not unreasonably valued. There could be further gains in 2017 if the administration can begin to stabilize the political situation and focus on its economic program. However, if the current investigations permanently derail or significantly postpone implementation of the economic agenda, look for capital markets to adjust accordingly. There are international economic risks: the most important is the deceleration in China’s growth, and there are always unexpected outside risks, the most unsettling being North Korea. A hard landing in China, which does not seem imminent, would especially wreak havoc with emerging market economies. No one is hedged for a “black swan” event by North Korea.
While we expect returns to be positive over the next year, the risks are to the downside. Equity returns in the second half will likely be limited to a few percentage points at best and potentially could be negative. Our bond returns, which were generally in the low single digits in the first half, are not expected to show any improvement over the balance of the year.
Stratigraphic Asset Management, Inc.
- JOLTS stands for Job Openings and Labor Turnover Survey. https://www.bls.gov/jlt/
- Economic projections of Federal Reserve members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy,” March 2017.
- Jason Furman, “The Outlook for the U.S. Economy and the Policies of the New President,” Peterson Institute for International Economics, June 12, 2017. For a discussion of Monte Carlo analysis, refer to: http://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp
- One of the more astonishing aspects of the U.S. economy in this period is how low inflation has remained. Over the last year ended in May, the Consumer Price Index rose by 1.9% and even less if the more volatile energy and food components are removed. About two-thirds of domestic inflation is driven by the increase in wages. However, real wages are not rising and unit labor costs over the last 12 months increased by only 1.1%. All this makes little sense with the unemployment rate at historic lows. Some of the factors restraining wages are the shift abroad of higher-paying manufacturing and other jobs where labor is cheaper, and changes in the labor mix in the United States away from manufacturing to lower-paying service jobs. The unemployment rate may be understated as many people have left the labor force because of low pay. In part, such people are able to leave the labor force because of more generous transfer payments. It seems logical to expect wages to rise at some point, which in turn will lead to higher inflation and higher interest rates.
- One nagging question on the mind of analysts: When will corporate operating margins, which are at peak levels, begin to contract and regress to the mean? This will probably not happen until unit labor costs and real wages begin to rise meaningfully, which is a risk factor over the next 12 months.
- On June 13, 2017, the Treasury issued its first of six reports, “A Financial System That Creates Economic Opportunities, Banks and Credit Unions.” The report identified a wide range of changes that would simplify and reduce regulatory costs and burdens on the banking system. Future Treasury reports will address capital markets, asset management and the insurance industries, and non-bank financial institutions.
- The general plan of the administration is to reduce the federal government’s healthcare costs, mainly by curtailing federal financial support for Medicaid. Legislation that reduces the deficit through a procedure known as “reconciliation” is not subject to filibuster and only requires a simple majority in the Senate to pass. Moreover, the budget savings to be realized in healthcare can be applied to legislate a reduction in corporate and individual income taxes that also would not be subject to filibuster. The strategy is complicated; the Republican majority in the Senate is problematic; the legislation has to be passed by October 1; but the goal is achievable.