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2017 Outlook: Transitioning from Monetary to Fiscal Policy Support

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KEY POINTS:

  • Expected reflationary policies have changed the investing landscape and resulted in upward pressure on growth, inflation and interest rates.
  • If fiscal policies translate into an acceleration of economic growth and better earnings, then the eight year bull market run in stocks could continue.
  • Interest rates are expected to rise, but slack in the global economy, dollar strength and monetary policy normalization could keep a lid on inflation and rates.
  • Actual policy implications can create a wide variety of outcomes highlighting the need for diversification.
  • While a cyclical (near term) bounce is possible, increasing debt and unfavorable demographics are headwinds for long term growth.
  • Current economic and financial market conditions support modest returns for both stocks and bonds.

 

WHAT’S GOING ON:

The U.S. election results put upward pressure on global growth, inflation and interest rates. This marks a shift from the “lower for longer” regime of muted growth, low interest rates and deflationary scares. A cyclical (near term) bounce is possible, but growing debt and unfavorable demographics remain headwinds for long term growth.

Global monetary policy makers have been providing unprecedented support since the financial crisis. In 2017, monetary policy is expected to give way to fiscal policy in the form of tax cuts, infrastructure spending and deregulation to ignite economic growth.

Global growth is accelerating led by the U.S. and emerging markets while international developed economies such as Europe and Japan are still dealing with weak expansions and excess capacity.

Inflation expectations have picked up, but risk of an inflation surge is relatively low as there are still limited signs of overheating in the broader global economy and normalization of monetary policy will partly offset the upside in fiscal easing. Real rate differentials between the U.S. and its major trading partners can strengthen the dollar and adversely impact growth and inflation outcomes.

Chart: J.P. Morgan Asset Management

Modest interest rate increases in the U.S. are expected and should be viewed as a positive sign indicating that central bankers believe the economy is strong enough to withstand higher rates. Outside the U.S. central banks are expected to remain low for some time.

CURRENT STOCK OUTLOOK:

The term “animal spirits” was coined by economist John Maynard Keynes to describe human emotions that influence behavior and in turn lead to action, in particular investment and economic activity. Should fiscal stimulus successfully awaken these “animal spirits” and ignite real economic growth than earnings should also improve and stocks could move higher in the near term.

Forecasts from Yardeni Research show that if the corporate tax rate is reduced into the 15-20% range (from the current level of 35%) than a boost to earnings of 20% in 2017 is possible. Without tax cuts, earnings are expected to grow 10% this year.

However, risks do remain as expectations take shape politically and this highlights the need for diversification. Higher interest rates could derail stocks and bonds if inflation expectations get out of hand. But, modest rate increases derived from real economic growth and stable inflation should not upset the stock market.

Overseas the meaningful populist gains in core European countries and pending elections present potential risks for developed international stocks. The ongoing BREXIT negotiations will also be important to watch in 2017 and beyond. While Japan could benefit from a weakening Yen through increased exports, returns could be constrained due to needed structural reforms that have yet to materialize.

Emerging markets look more attractive relative to U.S. stocks on a valuation basis, but near term returns face headwinds from U.S. interest rates and a higher U.S. dollar. The U.S dollar has rallied strongly over the past couple years and it is likely that this trend will eventually reverse. Over a longer time horizon, domestic investors in international stocks (both developed and emerging) will ultimately benefit from this reversal.

Global equity returns could be positive in 2017, but current prices relative to future earnings tell us we have already borrowed some returns from the future. Overtime, equity returns should be lower than the long term historical average.

CURRENT BOND OUTLOOK:

APCM’s fixed income team expects two rate hikes from the Federal Reserve in 2017. Upward pressure on rates creates a more challenging environment for fixed income. Near term risks associated with rising debt levels, European elections, and the tightening of monetary policy in the U.S. could create some volatility.

When rates gradually rise, modest returns should be expected as investors offset some capital losses with higher income going forward. However, this interest rate cycle will be difficult given the current extraordinarily low starting levels. Fixed income investors only have modest income to protect against falling bond prices as rates rise.

Despite these historically low rates, bonds are still a viable component of a balanced portfolio given we are in the later stages of a U.S. expansion and policy risks remain.

PORTFOLIO POSITIONING:

At APCM, we expect the long post-crisis economic recovery to continue in 2017 making us cautiously optimistic on the earnings outlook. We are positioning portfolios for reflation which translates into owning a bit more U.S. stocks while also holding some extra cash to cushion against potential interest rate volatility.

U.S. mid and small cap stocks will benefit from anticipated tax cuts and a focus on U.S. production while large cap stocks face headwinds from a strong dollar. A modest overweight to U.S. equities is warranted.

Interest rate normalization and the wide range of outcomes that can transpire as a result of policy decisions provides support for our overweight in cash. Within fixed income, we are cautious on corporate bonds, especially long dated BBB’s. With upward pressure on interest rates bond portfolios are slightly short duration and underweight mortgage back securities as they historically underperform in a rising rate environment.

As always, we caution against making drastic portfolio decisions based upon macro projections and during times of heightened volatility. It’s important to digest the flow of information to determine the resulting impacts to economic growth and most importantly future earnings.

We hope our outlook has been helpful and we look forward to working with you in 2017.

Brandy Niclai, CFA®
Chief Investment Officer
Multi-Asset Strategies

 

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