KEY TAKEAWAYS
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The global economy is turning a new page in 2017. For the first time in recent memory, it appears that the pendulum has swung from fears about deflation and a global recession toward hopes for higher growth and rising inflation.
An uptick in both stock prices and bond yields reflects the possibility that rates will not remain low forever, and that inflationary forces have been strengthening.While we do not expect the US economy to suddenly shift into overdrive, it is clear to us that we have reached an inflection point. Instead of flooding the market with cheap financing to resuscitate an ailing economy, the Fed may be focused on inflation in 2017. Still, the Fed is likely to move only gradually toward higher rates.
This shift marks a significant departure from the policies that have been in place since the global financial crisis in 2009.
Fixed income has been the biggest beneficiary of low rates and other accommodative monetary policies during the post-credit-crisis period. Yields fell to acutely low levels around the world, crushed by low nominal GDP growth, deflationary influences (such as global slack, especially in emerging markets, and a commodity market bust), a restrictive regulatory environment and a generally risk-averse investor base.
During the first half of 2016, we were skeptical of some of the reaction we saw in the market. For example, as bonds continued to rally there was a sharp movement into bonds and bond-like equity sectors such as utilities and telecom, which are generally considered higher-dividendpaying stock market sectors. This rotation was apparently based on the assumption that the Fed and other central banks would continue keeping rates lower and that deflationary forces would persist, making a high dividend more valuable.
We steadfastly believed the fall in yields was unwarranted based on economic fundamentals. At the time, we were convinced that deflationary fears were misplaced and that growth, though disappointing, was still positive. Indeed, the Fed and other central banks started to acknowledge the limitations of aggressive monetary policy as a tool to stimulate economic growth. Enthusiasm for lower and lower rates, including $14 trillion of negative-yielding sovereign bonds at one point, faded fast.
Inflationary forces also began to trend higher. Well before the election, near-full employment levels were putting upward pressure on wages.
The election also strengthened inflationary expectations, based on the possibility of President Trump’s pro-growth policies taking hold: repatriation of cash held by US corporations in offshore accounts, individual and corporate tax cuts and regulatory relief. The end result is an environment where the Federal Reserve, relieved of sole responsibility for supporting the economy, should feel more comfortable raising interest rates.
Rising Prices and Higher Wages Point to the Potential for Inflation in 2017
We see growth moving toward the upper end of “muddle-through” after 2016’s disappointing lower end of “muddle-through” growth. It appears that, as economic data improved, we have moved away from the deflationary fears prevalent in the first half of 2016, and toward a more positive outlook for 2017. As we move forward, the risk to the economy has likely now transitioned to inflation from deflation.
However, it is also important to remember that these policy proposals and shifts in monetary and fiscal policy also carry risks. On the margin, all of these dynamics could contribute to economic growth and rising inflation in 2017, but they also present a slight chance that inflation might overshoot the Fed’s 2% target. Additionally, history has shown that a united government, with one party controlling the presidency and both houses of Congress, has brought wider budget deficits than divided governments, regardless of the controlling party. If budget deficits fail to reignite stubbornly low growth, but inflation rises, we could see the possibility of stagflation.
Finally, these transitions will take the presidency and both houses of time. Any meaningful contributions of Trump’s pro-growth policies will probably percolate through the economy toward the end of 2017 or early 2018.
IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.
Ronald J. Sanchez, CFA
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