Outlook: Summer 2017

Economy

Consistent with the trend of the last few years, the economy was soft in the first quarter with growth of just 1.4%. However, we expect the rate of growth to increase as we progress through the remainder of the year, just as it has in the recent past. Sustained gains in the labor market combined with low rates of inflation suggest that the expansion can continue with little risk of overheating. Given the sustained improvement in the labor market, our central bank raised interest rates twice in the first half of 2017 and has provided guidance that there will be another hike later this year.

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 stabilize close to current levels given strength in the labor market, rising capacity utilization 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 remain somewhat soft while the U.S. expansion is firmly entrenched.      

Asset Class

Cash/Money Market Instruments

With three Federal Reserve rate hikes in six months and U.S. money market reforms almost nine months behind us, the money markets are starting to approach normalcy. Yields on money market funds and short-term bonds have appreciated along with the Federal Reserve policy moves. This rise is likely to continue over the course of this year and next as policymakers are expected to continue with rate normalization.

Intermediate Government/Credit Bonds

Intermediate-term bond yields appear to have settled into a range with the five-year U.S. Treasury trading between 1.7% and 2.2% this year. Incremental moves within the range are likely to continue until there is a clear break in economic data, a shift in monetary policy or implementation of fiscal policies that would change the outlook for inflation and growth. The Federal Reserve is expected to continue reducing the level of stimulus as they have provided guidance that they expect to raise interest rates one more time this year. There are also indications that they will begin reducing the size of their $4.5 trillion balance sheet later this year. However, the course of their future policy remains fluid as it is data dependent.

Tax-Exempt Municipal Bonds

It has been an eventful first half of the year for municipal bonds. Despite challenges ranging from Puerto Rico’s troubles to tax reform and the perpetual concern of rising interest rates, the municipal bond market has been strong. The sector has been aided by a strong technical position. Supply from new issuance has been down about 50% compared to last year, while maturities and calls have risen to elevated levels. In the second half of 2017, the market remains vulnerable to the repercussions of tax reform, if and when the details of the legislation are announced and finalized. From a credit perspective, generally, we continue to favor AA and AAA rated bonds at tighter spreads rather than reaching for yield in the A and BBB categories.

U.S. Equity

The stock market has generated strong gains in the first half of the year fueled by rising corporate earnings, expectations for an eventual increase in economic growth and improving conditions in many foreign economies. As we progress through the year, 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 without the help of a tax cut. 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 performed well in the first half of the year and for the first time since 2012 are on track to outperform U.S. stocks. The gains are justified as economies in many foreign countries have improved and economic growth rates are accelerating. In addition, the improved outlook has resulted in a declining U.S. dollar which has provided a nice tailwind to foreign stock returns. Despite the recent improvement in the outlook, valuations remain attractive and aggressive monetary policies continue to be employed in Europe and Japan.  

Commodity

Commodity prices have been mixed this year. Within the commodity markets, each segment has provided modest gains or losses except for energy. Advances in technology are allowing for a sustained increase in U.S. production which has pushed the price of oil down approximately 14% this year. Looking forward, we expect commodity prices to stabilize and eventually to trend upward as the global economic expansion continues.

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 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 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. 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 expressed an interest in reducing the size of its balance sheet later this year. 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 given persistent attacks on the international money transfer system, SWIFT, and on systemically important financial institutions.