Outlook: Winter 2017

Economic trends

Economy

The U.S. economy continues to grow at a modest pace although, consistent with the trend of the last few years, growth accelerated in the latter half of 2016. Looking forward, we expect the expansion to continue, fueled by the combination of a pro-growth agenda of the new administration and accommodative monetary policy. In fact, the economy should expand at a faster pace than in prior years if the administration is able to implement their plans for tax cuts, stimulative government spending and deregulation. Accordingly, our central bank may be able to raise interest rates at a more rapid pace in the coming year. 

Inflation

Inflation remains low, but it has been trending upwards. In fact, it is too early to say definitively, but we may be shifting from an environment of deflation to one of reflation. In 2015, inflation hovered around zero and in 2016 it averaged approximately 1%. The increase was driven by the strength in prices for medical care, services and housing. Looking forward, we expect inflation to continue to rise given the increase in the price of oil, rising wage inflation, the agenda of the new administration in the U.S. and a gradual shift away from negative interest rate policies in Europe and Japan. 

U.S. Dollar

The U.S. dollar increased significantly after the presidential election given rising interest rates, the new administration’s economic platform and their plans to renegotiate trade agreements. In the coming months, we expect the dollar to remain elevated as President Trump attempts to implement his agenda and foreign economies remain somewhat soft.    

Asset Class

Cash and Money Market Instruments

The October implementation of new SEC rules governing money market mutual funds has resulted in higher interest rates for non-government securities that have short terms to maturity. The new rules were introduced to increase the systemic stability of money market funds given severe dislocations during the 2008 crisis and the European crisis in 2011. The introduction of floating net asset values (NAVs) and redemption restrictions based on liquidity has led to an exodus from prime money market funds to government funds. This transition has driven up interest rates for non-government securities and generated strong demand for short-term Treasuries. In addition to the money market mutual fund reform, the Federal Reserve raised short-term interest rates in December.  With the expectation for additional hikes in 2017, there is an upward bias to money market rates.   

Intermediate Government and Credit Bonds

While economic data displayed signs of improvement late in the third quarter, the selloff in Treasuries gained steam after investors began to digest the new administration’s pro-growth agenda. For several years, the central banks and monetary policy were the only game in town. The focus has now shifted to fiscal policy with hopes of higher real and nominal GDP growth driven by expectations for tax reform, infrastructure spending and reduced regulation. Stronger economic data drove the Federal Reserve to raise rates in December. They also increased their outlook for additional rate hikes this year from two to three. While investment grade corporate bonds remain our preference in the taxable bond universe due to the additional yield over Treasuries, we will closely monitor how the new administration’s ideas are transformed into policy and how these policies are implemented.

Tax-Exempt Municipal Bonds

The municipal sector must contend with rising interest rates as well as concerns related to potential policy initiatives under President Trump. In the coming year, lawmakers will be looking at potential tax reform and the continuing status of tax exemption. A reduction in tax rates as proposed by President Trump may impact demand for tax-free bonds on the margin, but tax exemption will remain valuable to investors subject to high tax rates.  Increased infrastructure spending has also been highlighted as a concern but the details have yet to be laid out. Financing for such stimulus may not even come in the form of traditional municipal bond issuance as many fear. We prefer utility enterprises, general airport revenue bonds and established surface transportation agencies. In contrast, we remain cautious on state and local governments that have significantly underfunded pensions.

U.S. Equity

The stock market finished 2016 with a strong rally led by gains in finance and small cap stocks. As we progress into 2017, we expect the market to trend higher driven by the pro-growth agenda of the new administration and a resumption of earnings growth. Earnings declined in 2015 and throughout much of 2016, but should return to growth given a continuation of the economic expansion and a recovery in the price of oil. Corporate tax cuts, if implemented, should also provide a significant boost to profits as the savings on the reduced tax will fall right to the bottom line. While stocks are expected to provide solid gains, returns may be tempered by valuations that are above average. We also expect volatility to increase as the new administration attempts to implement its agenda.     

International Equity

In response to difficulties in their attempts to generate an enduring economic expansion, foreign governments continue to utilize a myriad of strategies, including aggressive monetary policies. Given the strong actions by these governments and attractive valuations, international stocks are compelling from a long-term perspective. However, in the short-term we expect these markets to remain volatile given a strong U.S. dollar, upcoming elections in France and Germany, a lack of consistent economic growth, an undercapitalized banking system in Europe and excessive debt levels in some countries.

Commodity

After declining dramatically in recent years, commodity prices have rebounded from their lows. Oil and industrial metals increased significantly last year. A decline in U.S. oil production growth, along with OPEC’s agreement to cut supply, resulted in a reversal in oil prices after a steady drop that started in June of 2014. Metals prices increased given an expected increase in economic growth and rising demand from China. Looking forward, we expect prices to remain volatile, but to trend upward as the global economic expansion continues.

Potential Threats

Risks and Notable Items to Watch

Rising Protectionist Sentiment

Globally, there is a 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 with Russia’s involvement in Syria and a number of terror attacks in Europe. Just as important, heightened tensions in the South China Sea, including recent interactions between the U.S. and China, also present some risk.

U.S./China Relations

The new administration is taking a different approach in its relationship with China. Instead of focusing on threats emanating from China’s long-term goals, the new administration is placing a stronger emphasis on trade and the loss of U.S. jobs. This includes threats to label China a currency manipulator which may spark an increase in tariffs or significantly damage trade relations.

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 the economy. 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

There are persistent deflationary forces in the current environment, but the new administration plans to implement a significant change in policy. These policies of tax cuts, renegotiating trade agreements and increased government spending may result in more inflationary pressure than intended.   

Cyber Security

Cyber security is becoming a significant issue given persistent attacks on the international money transfer system, known as SWIFT, and on systemically important financial institutions.