MARKET COMMENTARY

Economic Outlook

CIO Ronald Sanchez shares his views on the markets and economy for the year ahead.

12.23.2016 - Ronald J. Sanchez, CFA


KEY TAKEAWAYS
  1. Continued Economic Growth 
    Economic growth remains “muddle-through” but more likely at the upper end of the range.
  2. The End of Austerity 
    Washington appears ready to complement the Fed’s monetary policy by boosting government spending on infrastructure and cutting taxes.
  3. Inflation ahead? 
    On the margin, pro-growth presidential policies and higher rates could contribute to economic growth in 2017, but they also present a slight chance that inflation might overshoot the Fed’s 2% target. 

View Our Full 2017 OUTLOOK


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.

This trend certainly gathered momentum after November’s presidential election. After years of government budget cuts and other austerity measures, Washington appears ready to complement the Fed’s monetary policy with support for a looser fiscal policy, assuming some responsibility for promoting economic growth. The end result could be lower taxes and more generous government spending on large capital improvement projects such as rebuilding America’s aging roads and bridges.

This combination of rising rates, more government spending and tax cuts presents the risk of higher-than-expected inflation for the first time in many years.

A New Direction for Monetary Policy

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


 

Great Expectations for Government Spending
At the same time central bankers were recognizing the futility of below-zero interest rates, politicians and lawmakers around the world began to rethink the austerity measures they put in place to avoid another Greece-like debt crisis.

In the US, the 2010 Budget Control Act put the brakes on government expenditures, cutting discretionary spending by 13.5% from its peak and pushing government spending as a percentage of GDP to its lowest levels since the 1950s.

Despite these constraints, employment levels improved and wages grew modestly in the first half of 2016. But the US economy never shifted into second gear. A combination of modest consumption growth and higher inventories weighed on GDP, while lower oil prices brought previously robust energy investments to a screeching halt.

This bout of slow growth in the US and international markets reignited support for more generous government spending on large capital improvement projects around the world. For the first time in years, infrastructure spending is back on the table in Washington as policymakers and lawmakers discuss the best way to support growth through fiscal policy, alleviating the pressure on monetary policy as the sole driver of growth.

Considering the Potential Benefits and Risks ahead

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.


This communication is intended solely to provide general information. The information and opinions stated are as of December 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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