“The markets are a classroom where lessons are taught every day. The keys to investment success lie in observing and learning.” – Howard Marks
Life and investing are long ballgames.” Julian Robertson
“Diversification is accepting good enough while missing out on extraordinary so you can avoid terrible.” – Larry Swedroe (etf.com)
Stock Market Outlook For 2017
Having to sit down and put pen to paper – or in a modern day sense tap on the keyboard – and write a stock market outlook for 2017 is a task that makes my head spin. Coming off 7+ years of good markets it is easy to be skeptical of what lies ahead for this year. The rally, after all, is long in the tooth. Markets don’t go up forever. Yet, answering the simple question – where do we go from here? – isn’t that easy. The easy answer is the one nobody really wants to hear.
The easy answer: it depends.
It depends on politics, both here in the United States and abroad. The worst phrase one can utter when talking about the markets is “it’s different this time.” Today, looking at a White House occupied by a man with a very different outlook on how the economy and world should be ordered, politics are different … at least for now.
It depends on the global economy. Can Europe and Japan break out of economic malaise that has engulfed them for years? Will commodity prices continue to move higher, allowing the emerging markets continue the move higher started in 2016? And then there’s China, where the transformation from an export dependent economy has been transforming into a more mixed model. Is this the year we start to see that transformation really start to develop in a material way?
It depends on inflation and commodity prices. For the past 8+ years the concern has been deflation. In other parts of the world deflation is still a concern. If the costs of goods and services start to go up there can be real benefits to a society. Too much of a good thing, however, can become problematic.
It depends on currencies. 2016 ended with U.S. Dollar strength vs. any of our trading partners. Does this trend continue? If not, does the dollar get substantially weaker or does it just continue on in the range it had been in for most of the past two years? This has an impact on both trade and corporate earnings.
It depends on the bond market and interest rates. Last year saw what may have been a break higher in interest rates. If the move higher in rates sticks and the Governors of the Federal Reserve continue to push up short-term interest rates, what effect will that have on the economy?
As we write these words early in 2017 it is very easy to build a case where the stock market continues to grind higher, ending the year at all-time high levels. It is also fairly easy to make a case where something goes wrong and we get the 20-30% correction that the perma-bears have been calling for since the beginning of 2010. Not only is it easy to make both cases, there are multiple ways to make both arguments!!!
If you are looking for a definitive answer to where markets will be heading in the coming year you should stop reading right now. We agree with Warren Buffett when he says stock forecasters only exist to make fortune tellers look good. Instead of a price prediction on where the Dow Industrials and S&P 500 will end the year we will instead focus on the issues we believe could matter over the next twelve months. By delving into the issues we believe you will have a better sense of what to think about and what to look for as the year evolves.
Now let’s dig in …
US Economy & Politics
Normally politics would be the last thing we discuss but today it’s where we start for one reason: Donald J. Trump. With a Trump victory in November, combined with a Republican House and Senate the path our country is headed is likely to be different then where it would have been with a Hillary Clinton win. Personal politics have nothing to do with understanding how politics can affect your retirement savings.
What we are looking for in the coming months is economic stimulus. During the campaign season we were told that stimulus in the form of tax reform, regulatory reform, and infrastructure spending would become reality. These three issues can have a huge effect on the equity markets. As Steve Mnuchin – Trump’s pick for Treasury Secretary – told CNBC in December:
“By cutting corporate taxes, we’re going to create huge economic growth and we’ll have huge personal income… Our number one priority is tax reform. This will be the largest tax change since Reagan.”
Being natural skeptics we wonder exactly what “huge economic growth” will look like. We are being told by Trump that 4% GDP growth and 25 million new jobs will be created due to the stimulus plan. This may or may not happen. If we do get to a 4% growth rate the question then becomes, is it sustainable? As investors, sustainable growth is what really matters as economic recessions are really bad for asset prices. For 2017 the IMF sees global growth coming in at 3.4% and US growth coming in at 2.3%.
With continued economic growth and a corporate tax cut, corporate earnings could be going much higher. According to Standard & Poor’s Investment Advisory Services (SPIAS):
“The prioritization of tax reform, inclusive of corporate tax cuts designed to improve the competitive position of U.S. corporations within the global economy, is potentially a huge plus for the equity markets since it can significantly boost earnings growth as early as 2017 and beyond.” source
From our perspective, even if economic growth doesn’t pick up as promised, corporate earnings could be going much higher simply because they will be paying less tax. US stocks, based on the assumption of lower corporate taxes, may be cheaper than current valuations suggest. And if economic growth begins to pick up as well, stocks could be headed even higher still.
The other major issue investors will face from politics in 2017 is what happens with healthcare. While we have no idea what direction legislators will ultimately take, we do know that “Trumpcare” will not be the same as “Obamacare.” Even after reading all the plans we could find from the politicians, there is nothing we see that is 100% guaranteed to be in the new plan. There are two critical components to reform that have to be watched as the debate takes shape.
First is what form will health insurance take for all Americans? Will we really have lower premiums, lower deductibles and all the healthcare we require? If so, how is it paid for and by whom is it paid for? And from the provider’s side, will there be true cost savings? Cost savings, of course, is a nice way of saying less profit in the system for providers – doctors, drug manufactures, hospitals, insurance companies. This is a very complex issue with no easy solutions. How the new system is ultimately designed will have real world consequences for the entire healthcare complex.
Moving from the US to the global stage, things could get very interesting around the world this year. As we mentioned earlier, global growth is expected to come in around 3.4% with emerging economies like China and India leading the way. This is significant, in our opinion, as these two economies are the current growth engines of the world. With commodity and oil prices back up from trough levels in 2016 many other developing economies should be ok this year as well. From an investor’s perspective, emerging market equities turned around in 2016 after five hard years. We expect a continuation of the 2016 uptrend to continue, assuming commodity prices do not collapse and there is no major global crisis.
Just as interesting is what is going on in the developed world. Europe, mired in economic stagnation since the global recession of 2008, looks to be moving from bad to less bad. There are problems for sure. The banking system in Italy is teetering, Brexit in Great Britain is a big economic unknown, and elections in Germany and France later this year could change the political and economic landscape. Yet we agree with Credit Suisse’s Anais Boussie when she says the euro area is “set to deliver an upside growth surprise this year.” Japan may finally be coming out of the longest period economic malaise any of us has witnessed.
From an investor’s perspective going from bad to less bad is a good thing. What we will be looking for this year is small progress in all of these areas. Importantly we will focus on what is actually happening while filtering out opinions.
Inflation, or should we say the lack of inflation, has been a concern of the market and policymakers since the end of the Great Recession in 2009. Low interest rates have been a byproduct of these concerns. Another byproduct has been much lower commodity prices. Early in 2016 the CRB Commodity Index looks to have put in a bottom which lines up with what appears to be the bottom in inflation. Of special note, crude oil prices bottomed out at the exact same time. Today crude oil prices are back above $50 per barrel.
Market has been highly correlated with energy as crude prices have increased. This makes sense as the energy sector profits are tied to the commodity, and many of the industrial companies are tied to the energy sector. Going forward we expect this relationship to continue.
We will be watching what happens with inflation and commodity prices. Some inflation is good for the markets. Higher prices allow companies to be profitable and then reinvest in their businesses. But if commodity prices get too high it starts to hit the consumer, stifling growth and sales. While there is no exact point where we can say there is too much inflation or too high commodity prices, we know it does exist.
Oil, arguably the commodity that most effects consumers, can move quickly in price based on supply and demand. We know that demand continues to steadily grow globally along with global GDP. Supply is trickier. OPEC has agreed to production cuts to boost oil prices. US shale production, however, is not subject to the guidelines set up by OPEC, making it hard to predict where supply levels will be. In the past production has been shut down as prices fell, but as we saw the last time oil got to $60pb, production ramped up quickly. Due to the nature of fracking, once a drill begins production it continues to produce until the drill runs dry. In the end oil dropped as low as $26 per barrel.
When it comes to thinking about currencies it is important to look at what is actually happening, not what politicians are saying. Currencies move for two reasons. When one country is growing faster than the rest of the world and exporting greatly increases currencies will change to “rebalance” the world. The other is manipulation.
Every central bank across the globe has as some point talked about how their currency should be stronger or weaker in regards to those of said country’s trading partners. That talk can move markets, at least in the very short-term. What is important, however, is not the public jawboning, but the activities taken by these same central bankers and how it influences the value of global currencies.
China, for example, is popularly thought in the United States to be a currency manipulator. Our new President has been making this case for a long time now. See here, here, and here. And it seems very plausible. So plausible that there was a time that this was true. In fact, it still is true, just not in the way you may think – China has been manipulating its currency to prop it up in order to stem capital outflows from the country.
We will be focused on how the political currency war plays out in the coming months. Immediately we don’t expect growth in the United States to increase enough to significantly move the US Dollar. We will be on the lookout for an anticipatory move. In conjunction with that we will be monitoring the political happenings that surround currencies. Naming China a currency manipulator could have significant repercussions.
Bond Market/Interest Rates
The year 2017 may be looked back on as a crossroads for bond yields and interest rates. For the past 35 years we have been in a bond bull market with interest rates on the benchmark 10-year Treasury bond falling from the high teens down to a recent low of 1.36%. For at least the past 6 years pundits have been arguing for the end of the bull market and the beginning of a rising rate cycle. Prior to 2016 these pundits were wrong. In 2016 the benchmark 10-year Treasury began and ended the year yielding around 2.50% – not up but not down.
The Federal Reserve Board, headed by Chairperson Janet Yellen, is mandated by Congress establish monetary policy with the objective of maximizing employment, stabilize prices, and moderate long-term interest rates. For almost a decade these stated objectives led to historically low interest rates as the country fought through a deep recession and slow recovery. Finally we are at a point where the economy is stable enough to handle higher interest rates (both nominal and real). At its December meeting The Fed raised interest rates 25bps and noted that they expect to raise rates three more times in 2017.
Knowing this, we will be looking at is how the bond market reacts as rates either increase or the committee becomes more cautious. The Fed, it should be remembered, only controls rates at the short end of the yield curve. The expected economic stimulus and inflation, both of which could spark higher rates for longer-dated securities. Time will tell us is 2017 is the year of higher rates, a continuation of sideways yields, or the less likely (in our opinion) return to a lower interest rate environment.
There is no playbook for how to deal with the amount of change that is likely to occur in the next twelve months. We expect to see lower taxes, a change in how we pay for healthcare, a new dynamic in international relations, and at some point an unknown factor that nobody was thinking or talking about. This could be seen as good news by some, bad news by others. As a firm Magellan Financial is agnostic, only concerned with what the effect on investments will be.
We have laid out a number of variables that can have a major effect on the pricing of both equities and bonds – both positive and negative. What ultimately becomes important over the course of the year is a guessing game. The best one can do is identify what issues could be important while keeping an open mind to what is happening.
We believe asset prices are moving based on the assumption that we will have economic stimulus in the form of a corporate tax cut, tax reform for individuals, and an infrastructure spending plan. As a result, our base case scenario is the US stock market will continue to move higher. Until something happens to change this path we will remain in the bullish camp for US equities.
We are also constructive on international equities – both developed markets and emerging markets. After years of borderline recessionary economics the Eurozone growth appears to be turning positive. Japan, in an economic malaise for 2+ decades, just may be ready to turn the corner as well. Emerging markets started to turn up in 2016 and we see 2017 as an extension of that move higher.
While we do not expect returns to be as robust as we have seen in the recent past, we still believe a proper allocation will continue to hold bonds. We believe interest rates are likely to move up slowly. In such an environment there are gains to be made. And if our bullishness is wrong and there is a stock market correction, bonds will dampen the downside, likely making positive returns in such a scenario.
On behalf of Magellan Financial we thank you for taking the time out of your day to read our thought on the markets. If you know someone who may be interested in these materials we encourage you to pass it along. If you have any thoughts or questions, please do not hesitate to contact us either by email or at 610-437-5650 during regular business hours.
Past performance does not guarantee future results.
Indices are unmanaged and you cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Dow Jones Industrial Average is an un-weighted index of 30 “blue-chip” industrial U.S. stocks. The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. The Barclays Capital U.S. Aggregate Bond Index is composed of the Barclays Capital U.S. Government/Credit Index and the Barclays Capital U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.
High-yield bonds, also known as junk bonds, are subject to greater risk of loss of principal and interest, including default risk, than higher rated bonds. Investors should not place undue reliance on yield as a factor to be considered in selecting a high yield investment.
Asset Allocation and diversification do not ensure a profit or protect against a loss in a down market.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner Jeff.Bogert@wfafinet.com
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com