Thus far in 2017, stocks and other risk assets have been pushed higher by economic growth, low bond yields, and astonishingly muted levels of market volatility. By many measures, the global economy is in better shape today than at any point since the conclusion of the Great Recession. This bullish outlook is supported by expanding profit margins, broad upside participation globally, worldwide expanding economic growth, continued accommodative monetary policy from most central banks, a healthy “wall of worry,” and rising earnings momentum among a vast majority of markets. With corporate earnings positive and on the rise, our outlook for stocks remains optimistic. As we look ahead to the remainder of the year, we feel the market can maintain its highs.
Clients have expressed concerns that all-time highs cannot be sustained indefinitely and that a market crash is a real fear. Know that we fully understand those worries and aim to actively manage accounts in a manner that protects and preserves assets during times of market downturn. The good news is that there are no reasons why markets would drop simply to mark a 10-year anniversary or end a streak only because a gain would set a new record. The truth is that milestones are often meaningless. Plenty of milestone events have come and gone without a change in the market’s trend. By assessing the underlying fundamentals of the economy and markets, we are able to identify reasons why certain stocks have risen this year and why opportunities for gains remain.
In general, fast economic growth leads to shorter business cycles, while slow growth produces longer business cycles. This current eight-year cycle has been one of steady, but slow, growth in the US. Proof of continued domestic growth can be shown by several indicators. The latest metrics indicate that Q2 real GDP was revised up to a 3.1% annualized rate, the fastest pace of growth since Q1 2015, due to greater consumption expenditure and nonresidential fixed investment. Additionally, the ISM Manufacturing Index rose 2.0 points in September, up in four of the past five months, to 60.8, its highest reading since May 2004. Wage growth appears to be picking up at a pace of roughly 3% year-over-year and the unemployment rate is at 4.2%.
The market boom has also been aided by overseas economic growth. The Eurozone is not as far along as the US in the business cycle, and continues to benefit from rising global trade levels and improving sentiment and credit conditions. As such, the world’s strongest performing economies in Q3 were from developed Europe, led by Sweden, Switzerland, and Germany. This has led the US dollar index to its lowest level since January 2015, a major benefit for large US-based multinationals which derive substantial profits overseas. The key data to watch will be exports and inflation, to see how a weak dollar may boost both.
Political questions regularly arise in conversation with clients when discussing investments. The reality is that economic fundamentals influence market performance far more than politics. However, it can be said that politics can impact markets around the margins. For example, it is likely that governmental regulations being rolled back or delayed, a business-friendly Supreme Court, and political gridlock have all been beneficial to stock market performance in 2017. Furthermore, if the corporate tax rate is reduced, it is estimated that the S&P earnings per share could be boosted by an additional 5% in 2018. Of course, with the median corporate tax rate for US Small Caps at 33% in 2016, compared with 29% for Large Caps, a 20% corporate tax rate would skyrocket Small Cap earnings per share by 26.6%. We are certainly in favor of provisions that would eliminate the Alternative Minimum Tax (AMT) and offer corporations a one-time incentive to “repatriate” untaxed earnings from overseas. As a recent popular article reminds us all, “Six Republicans craft the tax blueprint behind closed doors. Now 535 lawmakers with opinions will have a say in the details. And thousands of lobbyists looking to protect their carve-outs will get in on the action.” We will be keeping a close eye on the events surrounding tax legislation and are cautiously optimistic that a modest tax reform package will pass in early 2018. Any hiccups in passing the tax plan could lead to sharp pullbacks.
Another developing story that we are watching concerns the appointment of the next chair of the Federal Reserve. This comes at a time where the Fed has announced its plan to slowly tighten monetary policy and begin shrinking its balance sheet. While current Fed Chair Janet Yellen, whose term expires in February, remains a candidate, a reappointment appears slim at this time. A front-runner for the position is current Fed board member Jeremy Powell, who would likely signal more policy consistency and stability. Another leading candidate is Kevin Warsh, a former Fed governor who cares less about inflation as a key metric and could set out to raise rates faster than the current chair. Two other candidates are John Taylor, a former Treasury official under George W. Bush, and Gary Cohn, head of the President’s National Economic Council.
A temporary market correction, while not explicitly imminent, is always a possibility in the short-term. Should one arise, we will utilize options to protect profits and set up attractive purchase points for stocks. Global political events to monitor include the upcoming election in Japan, tax debates in the US, the current government funding agreement deadline of December 8, and ongoing tensions with North Korea. Additionally, markets could react to ongoing Federal Reserve tightening and a possible uptick in inflation, although these do not presently appear adverse. Economic data is likely to be volatile due to hurricane damage, but natural disasters historically tend to have only transitory negative effects on growth, while rebuilding efforts act as a positive, especially when backed by federal spending. These events, while clearly tragic by definition, do not present tragedy on a macroeconomic level. The US is a diverse and resilient machine generally capable of absorbing shocks bigger than most would expect.
This year, however, has presented a strikingly low level of volatility in investment markets. Should we continue trend, this would be the first time in a dozen years in which there were no +/- 2% days in the S&P 500. Additionally, at this pace, 2017 will register to be the lowest daily price change on record since 1965 and the shallowest calendar-year peak-to-trough drawdown ever. History tells us that low volatility can persist for extended periods, as we went from 1990 to 1998 without a double-digit correction.
While this economic cycle is a long one, it does not appear to be ending in the near future. Before that happens, we would need to see a combination of average hourly earnings accelerating to 4%, falling corporate earnings, slowing global economic growth, or the Treasury yield curve to become inverted. We are not close to any of these points yet. The greater cyclical risk will be in the upcoming years, when economic and earnings cycles will be more mature, a growing contingent of central banks will be tightening, valuations could be more broadly stretched, and complacency could be excessive. For now, the US remains in a mix of mid and late-cycle dynamics and the slow pace of inflation and solid global backdrop imply a prolonged full transition to late cycle. Opportunities still exist in the markets and it is our mission to construct portfolios that continue to capitalize on them.