2017 Outlook

2017 Outlook

What a change a year makes! A year ago, the stock market was in decline while oil prices were plummeting and economic growth was declining. As we turn the calendar page to 2017, election uncertainty is over, the economy is expanding and investors are putting funds into the stock market with an optimistic view of an improving economy.

The new Trump Administration has communicated clearly its primary agenda items including tax reduction, infrastructure spending, regulatory reform and new trade negotiations. These policies are pro-economic growth initiatives exciting the “animal spirits” of companies and investors. The stock market is ‘pricing in” higher economic growth and corporate earnings. It is now policy implementation time.

Corporate tax reduction and regulatory reform should be accomplished easily with the Republican Party controlling both the White House and Congress. However, trade policy, The Affordable Care Act (ObamaCare) reform and infrastructure spending will be more difficult to implement. Senate Majority Leader Mitch McConnell stated that any tax reduction will have to be “Revenue Neutral” implying federal spending will have to be restrained. Corporate tax reduction and a one-time tax reduction for the repatriation of foreign cash (from foreign earnings) should attract capital to the U.S. and be deployed toward capital investment, dividends and share repurchases. The result should be higher earnings; a portion of which the market is already expecting.

The stock market’s (S&P 500 index) 17.1x P/E (price divided by earnings) multiple (15.5x average) is not a concern to us AS LONG AS CORPORATE TAX REDUCTION HAPPENS. President-elect Trump has been trumpeting (sorry for the pun) a 15% corporate tax rate, well below the 35% statutory current rate. Standard and Poor’s Investment Advisory Services estimates that for every 1 percentage point reduction of corporate taxes, S&P 500 earnings would rise by 1%. If the corporate statutory rate is reduced to 25% earnings should rise by 10%, implying a 15.1x P/E multiple for the S&P 500 Index. We believe the stock market may take a pause at the current level, awaiting affirmation that the above noted policies commence to be implemented.

Our expectations for 2017

Elevated market volatility: Public policy changes never occur smoothly and in-line with expectations. When surprises surface, markets usually sell-off until uncertainty abates. 5-10% market corrections are typical during most years even during an expanding economy.

Bond prices to decline as interest rates rise. The bond market has been in a 35 year bull market driven by a global secular decline of interest rates since the early 1980s. We expect the ten-year U.S. Treasury yield to rise above 3% to potentially 4%, driven by rising inflationary pressures. The current yield of the 10-year Treasury bond is 2.45%.

Stock Market (S&P 500) returns to approximate 8-10%, including dividends. By the end of 2017 the market should be discounting 2018 10-12% earnings growth.

Geopolitical risk, especially with China.

Are we in the early stage of a cyclical recovery?

We ask this question for a very specific reason. The stock market in 2016 was up 10% as measured by the S&P 500 Index, led by materials, industrials, financial and telecommunications stocks; and with healthcare and consumer staple stocks being the two worst performing sectors. In addition, gold and bond prices are on the decline. Please note: when bond prices decline interest rates are rising. This market behavior is classically associated with the early stage of an economic recovery and certainly not indicative of the latter stage of an economic cycle.

This market behavior may cause confusion to many, especially after nine years of economic expansion. Although the U.S. economy has been expanding, it has done so anemically with 1-2% real GDP growth. This compares to 6-8% annual GDP growth immediately after the deep recession of 1981 when the unemployment rate hit almost 10%. Then, in the 1980s and 1990s GDP growth was 2-5% annually.

After eight years of so-so economic growth, corporate and consumer balance sheets are in good shape and not overextended as is usually the case when the economic cycle is nearing a peak. The U.S. government however continues to run deficits, and its expenditures share of GDP has expanded from 19 to 21%. Obviously our government has not had the will to curtail expenses, and its balance sheet poses risk to our economy and taxpayers.

I envision two primary risks to the market as 2017 unfolds: saber rattling with China and to a lesser extent a strengthening dollar.

Trade stress between China and the U.S.: A Wealth Transfer to China

We have a $400 billion trade deficit annually with China. Why does this matter? Let’s “follow the money”. We sell China plenty of products, especially high technology and complex industrial products. China sells us a wide variety of products from low to high tech, most of which have a high labor content. There is a well known economic theory called “comparative advantage” that supports free trade. Essentially, comparative advantage stipulates that trading partners all win when each country produces that which they can produce most efficiently. And if trade balances are equal both trading partners win through sharing higher productivity.

Our trading situation with China is far different. The regulatory environment of the U.S. and China could not be more different in term of labor laws, environment and market access. Our trade deficit with China has been running between $300 and $400 billion annually for the past few years, and is literally a wealth transfer to China. These deficits provide China with $300 to $400 billion of U.S. dollar currency which can be used to buy U.S. Treasury bonds, businesses or real estate around the globe including back here in the U.S. If this trade imbalance goes unchecked, we will slowly be transferring our wealth to China.

President-Elect Trump brought this issue to the fore and it is at the cornerstone of his economic policy. I expect both countries will be pushing back against each other providing uncertainty and potentially stock market corrections. The good news is that both countries are economically dependent upon one another, so both economies will benefit greatly if trading activity remains brisk but moving back toward balance.

A Strong U.S. Dollar

A strong dollar has been discussed greatly as being a risk to corporate earnings and the stock market. However, the recent strength of the U.S. Dollar is based, in my opinion, on better economic growth prospects in the U.S than elsewhere, providing an excellent backdrop for earnings and stock market growth. “According to data provided by Strategas Partners, there have been eight sustained periods of dollar strength over the past 25 years. Of these eight, U.S. stocks (S&P 500) posted gains on an annualized basis in seven of them, while they outperformed international developed stocks (based on the MSCI EAFE Index) in six of the eight periods.” 1 While history does not predict the future, these data provide a perspective of what has happened when the dollar exhibited strength.

Other Risks: IMPORTANT

Surprise events: The market is always vulnerable to surprise events which at times cannot be predicted.

Recession Risk? At the current time our economy is gaining strength which should be supported by public policies noted in this report. Markets respond quickly to changes in the economy and when recessions unfold, most investors are unable to predict and time investment decisions around these events.

We continue to recommend having an appropriate exposure to the stock market over the long term and a strategy to ride through stock market declines, while participating in the stock market’s long term prospects. Cash and bonds for safety are always an important cornerstone of any long term investment strategy

Footnote:

1 Charles Schwab Research Report Dated December 9, 2016 page 4.

Important disclosure:

Investors can and do lose principal when investing in capital Markets (Stocks and Bonds). These investments are not guaranteed and may lose value at any time. Investment strategies should be based on short term and long term goals with ample protection for times of crisis and growth for the long term. This market update includes data we believe to be accurate. However Lawrence Wealth Management (LWM) does not warrant or guarantee its accuracy. Opinions about the future are not predictions, guarantees or forecasts.

6 thoughts on “2017 Outlook

  1. board of education says:

    Hi there! I just wish to give you a huge thumbs up for your great info you have got right here on this post. I will be coming back to your site for more soon.

  2. Having read this I believed it was extremely enlightening. I appreciate you finding the time and effort to put this informative article together. I once again find myself personally spending a lot of time both reading and leaving comments. But so what, it was still worthwhile!

  3. health coverage says:

    Why people still make use of to read news papers when in this technological world the whole thing is presented on net?

  4. thanks for visiting my website/blog in the past. You may want to read my note on Annuities. The article reviews clearly the differences among various annuities…some good…and some outright bad
    Thanks Rich Lawrence

Leave a Reply

Your email address will not be published. Required fields are marked *