by
Badgley Phelps
| Oct 13, 2017
Outlook: Fall 2017
Economy
The U.S. economy continues to expand at a modest pace. Consistent with the trend of the last few years, the economy is expected to grow approximately two percent in 2017. However, growth in foreign countries is accelerating and the disinflationary pressures that dominated in prior years are showing signs of dissipating. This is a critically important development. Sustained improvement will allow the central banks to begin transitioning away from the crisis based policies of the last nine years and has the potential to facilitate a shift to a more traditional environment with interest rates and inflation at higher levels. It is far too early in the process to declare victory over disinflation, but the world’s economies are poised for solid growth as we progress into 2018.
Inflation
After peaking in February of this year, inflation rates have been slowly declining. This phenomenon has spread beyond volatile commodities, such as oil, with prices falling in recent months for automobiles, apparel and telephone calling plans. Looking forward, we expect inflation to increase modestly given strength in the labor market and a continuation of the economic expansion.
U.S. Dollar
The U.S. dollar has declined steadily this year, but remains at a historically high level. Improving fundamentals in foreign economies and slower than expected growth in the U.S. has increased demand for foreign currencies. In the coming months, we expect the dollar to stabilize as foreign economies are improving, but a continuation of the expansion in the U.S., along with hopes for meaningful tax reform, should provide support for our currency.
Asset Class
Cash/Money Market Instruments
At its September meeting, the Federal Reserve held current policy rates unchanged in a range of 1.00%-1.25%, but provided new insights into the expected trajectory of the benchmark interest rate in their updated “dot plot.” The Fed’s projections reaffirmed one additional expected tightening in 2017 and forecasted three more rate hikes in 2018. Finally, there is potential for volatility in interest rates as Janet Yellen’s term at the Federal Reserve will end in January and monetary policy may be altered if she is not re-appointed. For the time being, policy normalization by the U.S. will increase pressure on short-term interest rates.
Intermediate Government/Credit Bonds
As expected, the Federal Reserve has begun the gradual reduction in its $4.5 trillion balance sheet by limiting the reinvestment of maturing securities. The Fed’s intention to shrink its balance sheet and its method for doing so were clearly telegraphed in prior Federal Open Market Committee (FOMC) communications thus they have not prompted a sharp market reaction. While balance sheet normalization has had little impact so far, the speculation that tax relief could spur economic growth has propelled bond yields higher.
Tax-Exempt Municipal Bonds
The unveiling of President Trump’s tax plan has caused a flutter of speculation and analysis in the municipal bond market. Although the plan document does not mention municipal bonds, senior administration officials confirmed that the plan would not eliminate the municipal bond interest exemption. The framework calls for reductions in both personal and corporate marginal tax rates, as well as the consolidation of the seven current brackets into three. The impact on municipal bond valuations would be very limited under the proposed deductions. Finally, the overhaul also proposes the elimination of the deduction for state and local taxes. Here opinions are mixed, though the consensus seems to view this as more likely to boost demand for tax-exempt bonds, particularly in states with higher tax rates.
U.S. Equity
The stock market has generated strong gains through the first nine months of the year fueled by rising corporate earnings, a sustained economic expansion and improving conditions in many foreign economies. As we progress through the remainder of the year and into 2018, we expect the market to trend higher driven by a continuation of these trends. In fact, earnings are expected to grow by about 10% this year and the outlook for 2018 is favorable at this point. While stocks are expected to generate solid gains, returns may be tempered by valuations that are above average and a steady withdrawal of stimulus from the Federal Reserve.
International Equity
International equities have performed well this year. In fact, for the first time since 2012, international equities are on track to outperform U.S. stocks. The gains are justified as economies in many foreign countries have improved and earnings growth has accelerated. In addition, the improved outlook has resulted in a decline in the U.S. dollar which has provided a nice tailwind to foreign stock returns. Looking forward, we expect stock prices to move higher driven by a continuation of the economic expansion and solid earnings growth.
Commodity
Commodity prices have been mixed this year. Within the commodity markets, energy and agricultural commodities have declined, while industrial and precious metals have increased. Looking forward, we expect commodity returns to remain volatile driven by specific dynamics in each segment rather than a broadly based bull or bear market. For example, the outlook for oil is mixed as rising demand can be met by idle capacity. Environmental regulations in China should reduce the supply of some industrial metals and boost prices while gold is hampered by expectations for additional rate hikes by the Federal Reserve.
Potential Threats
Risks and Notable Items to Watch
Rising Protectionist Sentiment
Globally, there is rising protectionist sentiment that is fueling a backlash against free trade. While much of the rhetoric is likely a function of positioning for negotiating leverage, there is a risk that supply chains will be negatively impacted and costs for some goods will increase.
Geopolitical Risks
Conflicts in many parts of the world have escalated. Events in Syria are critically important to monitor given Russia’s support for the Syrian government. In North Korea, the government continues to develop and test ballistic missiles in defiance of trade sanctions and United Nations resolutions banning such tests. Just as important, the heightened tensions in the South China Sea also present some risk.
U.S./China Relations
The Trump administration is taking a different approach in its relationship with China. Instead of focusing on threats emanating from China’s long-term goals, the administration is placing a stronger emphasis on trade and the loss of U.S. jobs. After their meetings earlier this year, there has been a change in tone between the leaders which is encouraging, as there appears to be an increased willingness to work together. Looking forward, we will be watching for meaningful actions that demonstrate the leaders’ intentions to follow through on their discussions.
Debt Related Issues
Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.
Policy Risks
The Federal Reserve has announced their intention to continue to raise interest rates and has started to reduce the size of its balance sheet. At the same time, central banks in other major economies are considering when to alter their policies to a more restrictive stance. If the world’s central banks reduce stimulus too quickly, there is a heightened risk of slowing economic growth.
Cybersecurity
Cybersecurity is becoming a significant issue as evidenced by the Equifax breach as well as persistent attacks on the international money transfer system, SWIFT, and on systemically important financial institutions.
