The 2016 stock market year finished off with a rally based on anticipated higher valuations for stocks due to a new political environment. The new narrative implies that the administration of President Donald Trump will cut taxes, increase infrastructure spending, reduce regulation, and allow for the repatriation of foreign corporate profits, along with a host of other business friendly ideas. The expectation of these various tailwinds has re-ignited investor confidence and lifted economic growth assumptions. Of course, we undoubtedly anticipate volatility in the markets from legislation bottle necks, unprecedented use of social media as a political weapon, bouts of geopolitical uncertainty in the world community, a stronger dollar impacting multinational companies, and rising interest rate concerns. Nevertheless, we are cautiously optimistic about the prospects of 2017, for although the recovery in the US is already seven and a half years old, it is only now starting to take on typical characteristics of a normal recovery in which banks have been providing credit instead of the Fed, and businesses and households are in good financial shape and can resume normal spending momentum.
If you look at the incoming president, vice president, and the key cabinet positions, its collective 83 years’ worth of business experience is an all-time record in the modern era. This dramatic shift in the makeup of political leadership is certainly being noted by businesses. As a result, the NFIB Small Business Optimism Index surged in December to its highest level in 12 years and at its fastest pace since October 1983, signaling strengthening upward momentum in response to expectations for pro-growth and more business friendly policies.
The benefit for tax reform is clear, as the system is highly complicated and heavily manipulated. Last year, House Republicans issued a “blueprint” for reform that is similar to proposals Trump outlined during the campaign, including slashing both individual and corporate tax rates, eliminating the estate tax and repealing the Alternative Minimum Tax. A reduction in personal income tax rates could provide the underpinning for an increase in consumer spending which would further support economic growth. A lowering of corporate taxes will likely make the US more internationally competitive for major businesses to promote domestic job creation and bring back cash from overseas. As it stands now, the US marginal corporate tax rate is nearly 39% when including state/local taxes; ranking it highest among all global industrial countries. The median rate for the other 34 OECD countries is less than 25%. A move to the 15-20% range could bolster corporate earnings immensely. With concerns for keeping the federal debt in check, we expect the political wrangling for how to pay for these tax cuts to be contentious at times and for the actual laws to be full of compromise.
Need for sweeping improvements to national infrastructure is another area that is widely agreed upon. However, while an infrastructure spending proposal is likely to be discussed this year, the timing and scope of such a program remains unknown. Furthermore, given the fact that the total size of the U.S. GDP exceeds $18 trillion, it would take a massive infrastructure spending program to materially increase economic growth, particularly given the fact that any such program would likely be implemented over a period of several years, thereby reducing its impact in any given calendar year. A Caterpillar executive stated that “Even if you step back and thought about when we would start to see some impact from any sort of infrastructure program, I think the best case scenario you are talking about late 2017.” Such tax reform and fiscal stimulus legislation is complex and it will take time to take effect, so any results won’t be felt until next year.
In many ways, an increasingly harsh regulatory environment of the past few years has burdened small business owners from reaching their potential. While there are undeniable benefits from making sure that markets run fairly and have built-in protections for individual rights and environmental conservation, there will likely be benefits from rolling back several regulations. Fewer regulations will lower compliance costs for companies and permit spending on more productive investments.
The upcoming year is scattered with political risks that have the potential to shake up longstanding economic and security arrangements. While the US Presidential election is behind us, many major European nations will experience significant decisions at the ballot box that will influence their national direction moving forward. The rise of populism and protectionism is likely to continue and the world is curious to see the implications of the “Brexit” negotiations. Simply stated, uncertainly is abound and rising geopolitical tensions could undermine business confidence at times.
Following the December 2016 quarter point increase in the Federal Feds Rate, we expect further increases to be dependent on global economic stability, the strength of the dollar, and the pace of inflation. It appears that change from economic policies driven by the Fed have outlived their benefit and a slow but steady normalization of rates is welcomed. If bond yields are rising due to growth improving, but without inflation taking off, stocks tend to do well in this environment. Overvalued yield proxies may suffer but this process will benefit sectors heavy in cash and low on debt. Additionally, the absence of an inverted yield curve strongly suggests that recession risk is low and the economy will remain on an upward path.
We will be keeping an eye on investor sentiment for overt signs of excess optimism, as it can be guaranteed that some of the expectations of the Trump administration and the Republican Congress will not be met in a time frame being discounted by markets. However, while disappointments are likely on the US policy front, we would view those as buying opportunities for now. With correlations between individual stocks falling, opportunities for active management are growing. While it may be a more challenging and tactical environment, there is still upside potential and this regime shift is ideal for those that are attentive to the signs of momentum and the ability to adjust investment exposure accordingly. Analyst consensus expectation of about 13% earnings growth for 2017 does not include much benefit from tax reform, infrastructure spending, or regulatory reform, proving that positive catalysts remain in play. If the new administration executes on its key initiatives, business and investor confidence could significantly move cash off the sidelines and propel stocks higher. With knowledge and experience in security selection, we are excited to capture investment opportunities for our clients.
Happy New Year to all. Wishing you a prosperous, healthy, and profitable 2017!