Entering 2017, we are increasingly optimistic about the prospects for the U.S. and global economies. Fundamentals are improving, with higher GDP growth and increasing inflation expectations set against still-accommodative monetary policy and a move toward fiscal stimulus. That said, the economy and markets are not the same. Investors have already pinned high hopes on the Trump administration’s ability to ramp up U.S. growth and corporate profits (Figure 1), but the markets may well have gotten ahead of themselves over the short term. Also, transforming election promises into policies won’t happen overnight, and we expect volatility as policies are hammered out. Finally, many of the risks that dogged the markets in 2016 have not gone away, including global political uncertainties, coordination of central bank policies, the longer-term impact of Brexit and other populist movements, and turmoil in the Middle East.
U.S. economic fundamentals improved notably over the past year. Recessionary pressures abated and growth is likely to be stronger in 2017 than 2016. Trends in manufacturing data, consumer confidence, housing and auto sales are positive, and we expect deregulation to contribute to productivity gains. Inflation is likely to move moderately higher, but not to levels that are beyond control. The Federal Reserve doesn’t appear in a hurry to raise rates dramatically. Currently, our base case is two rate increases for 2017, noting that historically, the Fed has tended to foreshadow more activity than it has delivered.
FIGURE 1. GLOBAL ASSET CLASS PERFORMANCE, 4Q AND 2016
During the fourth quarter, investors flocked to cyclical and value oriented equities. Reflecting increased confidence in the U.S. economy’s prospects, small caps outpaced large caps. Outside the U.S., global equities—particularly emerging markets—gave back some of the ground gained during the third quarter. Within fixed income, high yield slowed its pace while the 10-year Treasury slid steeply.
Past performance is no guarantee of future results. Source: Bloomberg.
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Over recent years, fiscal policy has not provided a tailwind to GDP growth (Figure 2). With the U.S. presidential election behind us, we expect pro-business fiscal policy can provide a stronger catalyst for sustainable expansion over the next several years. We anticipate that reduced regulation and new tax policies, once implemented, can drive growth in the corporate sector and encourage responsible risk taking with capital.
Trump’s policies have not yet been set forth in detail, but the reflation trade looks set to continue. Over recent months, we have increased our positioning in cyclical growth names (such as industrials, materials and energy), while still maintaining secular growth exposure. We see growing opportunities in financials, where rising long-term interest rates and the potential for less regulation provide tailwinds. Within technology, we have increased our emphasis on cyclical growth areas, but still own traditional highgrowth names within the sector.
Although we believe that 2017 is setting up to be a better year for the U.S. economy, our outlook for the equity market is more cautious. Given the post-election strength in equities, we would not be surprised to see a pause or pullback as investors digest the first few months of the new administration. President-elect Trump’s comments have raised concerns of protectionist policies and trade wars, and these fears could stoke volatility in the market. Also, the strong dollar may also take some wind out of the sails of U.S. multinationals. Reflecting these concerns, we have remained attentive to quality and valuation as we have added names poised to deliver a better opportunity set in a higher-growth economy.
FIGURE 2. U.S. FISCAL POLICY HAS HINDERED GDP IN RECENT YEARS
Source: Hutchins Center calculations based on BEA data (https://www.brookings.edu/interactives/the-fiscal-barometer/). As defined by the Hutchins Center, the FIM “is a gauge of the contribution of federal, state, and local fiscal policy to near-term changes in the gross domestic product, the tally of all the goods and services produced in the economy. It includes both the direct effects of government purchases as well as the more indirect effects of government taxes and government transfers. When FIM is positive, the government is contributing to real GDP growth, and when it is negative, it is subtracting from it.” (Source: https://www.brookings.edu/research/the-hutchins-centers-fiscal-impact-measure )