Market Data for year end 2016:
• S&P 500 Stock Index: 2239, up 9.5%
• Ten-year Treasury Note Yield: 2.45%, up 0.18%
• Gold: $1,152 per ounce, up 8.7%
• Oil: $54 per barrel, up 45.9%
After global stock markets began 2016 with their worst January on record on fears of weakness in the Chinese economy and an aggressive US Federal Reserve, markets staged a recovery that accelerated into year end. The Chinese economy stabilized due to stimulus enacted by Chinese authorities, and the Federal Reserve pulled back from its earlier stated expectation of four interest rate increases in 2016, settling on only one. Along with the moderation in policy by the Federal Reserve, unprecedented action by global central banks drove long-term interest rates to record lows, with the ten-year US Treasury Note yielding just 1.37% in July (currently 2.45%). Following the election of Donald Trump, the rally in stocks accelerated on hopes of economic stimulus in the US. Bonds reacted negatively on a renewed fear of inflation and a once again more aggressive Federal Reserve.
Going forward, several risks present themselves. First and foremost are higher interest rates and a stronger US dollar and their likely economic and financial impact. On the back of hopes for economic stimulus and resultant higher interest rates, the US dollar appreciated significantly in 2016 against other global currencies. A stronger dollar suppresses economic growth in the US by making US exports less competitive on global markets, increasing the market share of imported goods, and reducing the value of corporate income earned overseas. Higher interest rates reduce the capacity of consumers and businesses to borrow, providing a break on economic activity. Additionally, higher interest rates make stocks less attractive relative to bonds, thus pressuring stock valuations.
A stronger dollar and higher US interest rates also place stress on emerging markets, as their relatively fragile financial systems are strained by the flight of capital from their markets to the US and its promise of higher returns. Historically, dollar strength has precipitated financial crises in emerging markets, and given their increased share of global economic activity, the threat of such a dollar induced crisis is a significant risk factor for the American economy and markets. The Chinese financial system is particularly vulnerable because the aforementioned stimulus orchestrated by Chinese authorities was largely built upon debt. As indebtedness in China had already grown significantly since the financial crisis, many fear that their financial position is highly unstable.
The political and financial situation in Europe is also an area of concern. The British vote to leave the European Union (Brexit) shows that anti-globalization forces are ascendant in Europe. France, Germany, and Holland have important elections in 2017, which could negatively impact the stability of the European economy. France is of particular worry given the strong popularity of Marine Le Pen of the right-wing National Front party and the upcoming presidential election. Le Pen is campaigning on leaving the European Union and possibly the Euro currency bloc. If France were to exit the Eurozone, it could unleash a financial crisis of global proportions. As it stands currently, Le Pen is not expected to win the presidential election, but as Brexit and the election of Donald Trump have demonstrated, there are no certainties in politics.
The potential for erratic and impetuous behavior by President-elect Trump is a further economic and market risk, although difficult to handicap. A major international and/or constitutional crisis is a very real possibility with serious financial and economic implications. If he were actually go through on his threats of high tariffs on foreign exports to the US, dollar strength as described above could be exacerbated, in addition to wreaking havoc on global supply chains. Thus far, markets seem not to be taking these threats seriously, but we believe there is a definite whistling past the graveyard aspect to it. Given the many contradictory and irrational statements emanating from Trump Tower, it is difficult to divine what President-elect Trump actually intends to do once in office.
Fortunately, on the threat of a stronger dollar and higher interest rates, we are skeptical that the policies, such as they are, that Mr. Trump and his Republican colleagues in Congress are proposing will generate substantially higher economic growth. Contrary to popular belief, the supply side tax cuts that are likely to be the focus of the Trump administration have historically failed to spur economic activity. Reductions in corporate taxes typically result in cash returned to shareholders, the paying down of corporate debt, and spending on acquisitions, not on increased hiring and investment. Cutting taxes on the wealthy has little impact on growth as they are unlikely to spend their windfall given their already substantial ability to purchase whatever they want. On Mr. Trump’s oft touted infrastructure investment program, based on what we have heard thus far, it is built on further corporate tax benefits and not on an actual direct injection of funds into the economy. As such, the economic impact will be muted.
The upshot is that we expect dollar strength to moderate and for interest rates to stabilize at historically low levels. The economy, which has grown slowly but steadily since the Great Recession, will remain relatively unperturbed. This should provide a steady backdrop for stocks and bonds, offering modest but positive returns. Market sectors that have rallied significantly since the election of Mr. Trump, such as financial firms and small company stocks, may be vulnerable, but our exposure to them is limited. Higher yielding stocks, shares in multinational firms, and international stocks should perform well in our forecasted financial environment.
For 2017, we expect the American stock market as represented by the S&P Five-hundred stock index to trade in a range of 2050 to 2400. It finished 2016 at 2239. We appreciate your business and the confidence you have placed in us. As always, please do not hesitate to contact us with questions or concerns. We hope you have a healthy and prosperous 2017.