The Dow Jones Index continued its upward climb in the second quarter reaching a high of 21,528 on June 19, 2017. Year-to-date, the Dow Jones Index has gained 9.3%, Europe is up 15.4%; Japan has increased by 9.9%; and emerging markets have surged 18.4%. Global diversification has paid off for the first time in several years, assisted by a weaker dollar. Fixed income securities have been generally stable on a price basis and captured their earned interest rate during the quarter. We believe that the stock market is on a path that will eventually lead to new highs by the end of the year (Figure 1).
The key to higher values for the stock market is corporate tax reform, dividend repatriation and regulatory relief. Health care reform is becoming an albatross for the Republicans and is unlikely to pass in present form. Up next on the political calendar are a five-week congressional vacation followed by an increase in the debt ceiling, which cannot be done without Democratic help. Trade reform appears to have been deferred on the agenda by special interests and corporate lobbyists. Tax reform will be delayed until the Fall Congressional session at the earliest. I would not be surprised if full tax reform was replaced by scaled down temporary corporate tax reductions as it is easier to give tax breaks rather than take them away. My guess is that tax reform will be a carrot that helps drive the stock market higher.
Figure 1 – The Dow Jones Should Rally to its 23,000 Target this Year
The U.S. Economic Story Remains the Same
The U.S. economy remains strong despite entering the eighth year of the recovery. The odds of a recession occurring in 2017 continue to be low. GDP growth in the first quarter of 2016 was 1.2%. After the election, consumer and investor confidence improved, followed by improvement in regional manufacturing indexes and housing sales. Leading economic indicators such as employment, business confidence, retail sales and new home sales all suggest the U.S. economy is on a sustainable growth track for 2017 (Figures 2-3). While late-cycle economic growth is hard to achieve, investors remain optimistic that fiscal stimulus and deregulation will improve the economy later in 2017.
Figure 2 – Real GDP Growth Remains in a 1% to 3% Band
Figure 3 - Leading Indicators Remain Positive
Figure 4 – The Labor Market is Booming
As described in the JOLTS labor report, a new record was set with over 6 million job openings reported in June (Figure 4). However, there are 6.8 million unemployed Americans looking for work. While some of the difference is due to job location, the majority is due to the mismatch of skills required for new jobs. For example, most job postings for secretaries now require a college degree yet only 19% of actual secretaries have them. The current labor shortage is for skilled labor. Educated and trained labor, particularly younger workers, are seeing significant wage increases to entice them to stay in their current position or to entice them to change jobs. However, these wage increases are being camouflaged by the lack of improvement in wages for unskilled and older workers. At some point, we expect to see wage-driven demand return to the inflation data.
European Growth Continues to Outperform in 2017
Global economic growth is improving, led by Europe, which appears to be back from the brink of disaster, and Asia. Economic growth in Europe has gone from mediocre to respectable as a weak Euro has stimulated employment and GDP growth this year. Political uncertainty has been reduced since pro-Euro political parties won convincingly in both the Dutch and French elections. The populist movement that led to BREXIT and the election of President Trump, appear to be on the wane in Europe. Eurozone growth is expected to stay in a 1.5% to 2.0% range. European government and central bank policy is starting to shift from fiscal austerity and low interest rates to higher rates and more economic stimulus. European stock markets have underperformed the U.S. by a cumulative 40% over the last 3 years; but have outperformed this year as confidence in the EU improves.
Emerging Markets are Improving
The Emerging market sector continues to improve economically and in the financial markets. China’s ongoing rebalancing from investment-led to consumption-led growth will likely result in a continued slowdown in its still-powerful economic engine over the near term as the country manages the transition. Meanwhile, the recession in Latin America might find fresh relief from a mild recovery in commodity prices and generally easier financial conditions. In South America, we think Mexico, Chile, Argentina and Peru offer a much different and more constructive outlook. The risk of a Trump-induced trade war has declined as the administration is distracted by other priorities.
What Happened to Inflation?
To the surprise of many, U.S. inflation peaked in March and has been declining. This coincides with a 6.0% fall in the energy price index caused by a continued glut of OPEC oil and ongoing expansion in the U.S. oil fracking industry. With unemployment below 4.5% and likely to trend lower, labor market conditions are poised for wage increases in 2017 especially for those with college degrees where the rate remains well under 2.2%. During the second half of the year, I expect that housing and wages should contribute to higher inflation. A 2% inflation target appears reasonable for the near future.
Figure 5 – A 2% Inflation Target appears Reasonable
Only a 50-50 Chance of Additional Rate Increases this Year
In June, The Federal Reserve increased the Federal Funds rate by 0.25% to 1.15%. Fed officials also indicated that, conditions permitting, they would raise rates an additional 1 to 2 times before the year is over. With inflation subsiding and the economy in a sideways pattern, many believe that it is unlikely that the Fed will raise rates again in 2017. More likely, the Fed will start to trim it’s $4.5 trillion balance sheet by letting bonds in inventory mature without replacement. This would be the beginning of a gradual wind-down of Quantitative Easing.
In the big picture, the Federal Reserve is leading global central banks to tighten monetary policy. Recent comments from European Union, Japan and Canada have indicated that the easy money policies of the past 8 years are on the way out and interest rates have moved higher in those countries. Coordinated central bank actions are dependent on economic growth and the rising inflation that results. I believe that rates should increase globally over the next year or two.
Bond Market Outlook
Fixed income investments have moved sideways so far in 2017 (Figure 6). My strategy is to decrease maturity risk and increase credit risk to find performance in the bond market. Both high–quality and long-term bonds are most affected by the increase in interest rates and I believe it is best to sell these on rallies. On the other hand, high-yield bonds, floating rate funds, foreign fixed income and short maturity bonds are not as sensitive to changes in the yield curve and should become the focus in the fixed income portion of a diversified portfolio.
Figure 6 – U.S. 10-Yr. Treasuries Remain in a 2.1% to 2.9% Trading Range
Measures of Market Valuation Suggest a Frothy Stock Market
The U.S. stock market is at levels of valuation not seen since the 1929 crash and the 2000 dot.com bust (Figure 7). Several highly regarded investment managers are preaching caution and even the Federal Reserve has commented on the price/earnings levels of the U.S. stock market. Investors and advisors are as complacent and fully invested as I have ever seen. To the market’s credit, a substantial portion of the high valuation is due to the exceptionally low level of interest rates. While I do not want to be a naysayer, there are things that could go wrong which could prevent the market from achieving the target of 23,000 I see ahead.
Figure 7 - Measures of Market Valuation Suggest a Frothy Stock Market
My concerns that could affect the market include:
- Unified tightening of credit by global central banks. The markets have been spoiled by 8 years of exceptional central bank liquidity and low interest rates. As this cycle appears to be turning, the bond market may get ahead of the central banks and increase rates more than warranted. Higher interest rates would lead to compression of multiples for high dividend stocks.
- A collapse in oil prices. While most think that a decline in oil prices is good for the consumer and the economy, many oil companies (and countries) are highly leveraged. The result could be an oil bond bust. The decline in oil prices appears driven by lower cost shale oil & gas extraction, a global trend towards more efficient electric cars and countries dependent on pumping more oil at whatever the cost.
- The underfunded pension bubble. These outstanding liabilities continue to plague many governments, states, municipalities and some companies. As the baby boomer generation retires, the underfunded pension plans will either have to pay up and raise taxes to fund the obligation or reduce the payments to their retirees. At some point this problem is going to reach a boiling point which could result in problems for the municipal bond market.
- In April, a group dumped a collection of NSA spy tools on the internet. These are now being converted to weapons to be used against global commerce. Many companies and governments are unprepared for a global cyber terrorist attack. Stock markets would not react well should one develop.
- North Korea. The question is whether the U.S. should attack or isolate North Korea. Be assured that the stock market and economy would not like a shooting war.
Many view the U.S. stock market as overextended but with strong fundamentals. With investors setting their sights on the improving Emerging Markets and European stock markets, capital is starting to flow out of the U.S. to be invested overseas. Whether this may be the beginning of a trend or just a temporary phenomenon is unclear. Based on valuation, I have moved some of our U.S. equity exposure to international and emerging market equities.
The U.S. remains the safe haven for all global investors. With interest rates rising, capital is forced back into all forms of equities—there is no other alternative. While valuations remain rich relative to earnings, the path of least resistance is to be invested. I am optimistic that investor psychology will lead to a test of Dow 23,000 by the end of the year. I have built diversified global portfolios for clients and intend to have patience through the surprises presented to the financial markets in 2017.
Bonds are in a “coupon clipping” market with limited prospects for principal price improvement. Unless we see a material rise in inflation, yields are range-bound for the near future. Based upon a resilient economy, we are taking measured amounts of credit risk and reducing maturity risk.
Overall stock market performance in the U.S. is likely to be dependent upon the success of Republican pro-growth tax policies, avoiding major trade wars, and approving constructive economic plans. Initial optimism about the Trump agenda has faded due to possible scandals and the slow legislative process. However, I am optimistic that corporate tax cuts will be delivered by early 2018 and should propel the stock market higher.