Economic trends

Economy

The U.S. economy continues to grow at a modest pace. Consistent with the trend of the last few years, the economy appears to have been relatively soft in the first quarter, but we expect the expansion to continue and the pace of growth to increase as we progress through the year. In fact, the pace of the expansion may accelerate if the administration can execute their plan to reduce government regulations and cut taxes. Given their expectations for an acceleration in the rate of growth and rising inflation, our central bank has provided guidance that there will be two more rate hikes this year.

Inflation

Inflation remains low, but it has been climbing steadily over the last couple of years. In fact, it is too early to say definitively, but we may be shifting from an environment of deflation to one of reflation. The Consumer Price Index, a widely-followed inflation gauge, hovered around zero in 2015, averaged about 1% last year and climbed to 2.7% in the early stages of 2017. Looking forward, we expect inflation to continue to rise, but at a much slower pace, given the increase in the price of energy, rising wages, 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 declined in the first quarter, but remains close to its recent high given expectations for additional rate hikes by the Federal Reserve and the new administration’s economic platform. 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/money market instruments

Yields on money market instruments have increased given two rate hikes since the middle of December, expectations for two additional hikes later this year and the potential for a reduction in the Federal Reserve’s balance sheet before the end of 2017. In addition, economic data has generally been positive, yet continues to remain measured, and inflation, which has also been increasing, has not displayed an upward jolt. Given this backdrop, there is an upward bias for yields on money market instruments, but with the constraints on the economy tied to aging demographics and low productivity, we believe the path will remain gradual and relatively shallow. 

Intermediate government/credit bonds

The excitement tied to positive global economic data and optimism related to the new administration’s pro-growth agenda has moderated in the early stages of 2017. Most of the economic data has remained positive, yet the high expectations related to inflation and fiscal policy have become more measured and, as a result, the credit market has been range bound. Spreads and yields for taxable bonds remain largely unchanged as record corporate bond issuance was met by strong inflows and is bolstered by expectations for solid earnings growth. In addition to rate hikes, the Federal Reserve has begun discussions on reduction of its agency mortgage backed securities (MBS) and U.S. Treasury holdings as soon as the latter part of this year. For the balance of 2017 there is an expectation of two, or possibly three, more interest rate hikes as well as measures to reduce the Federal Reserve’s $4.5 trillion balance sheet. Investment grade corporate bonds remain our preference in the taxable bond universe due to the additional yield over Treasuries.

Tax-exempt municipal bonds

Municipal bonds are off to a good start in 2017 but continue to face ongoing challenges from the Federal Reserve, Washington, D.C. and the oft mentioned underfunded pensions. While we will likely witness moderately higher rates from the Federal Reserve, the outlook from Washington, D.C. remains less clear owing to the shadow of tax reform. The tax reform discussions to date have centered on reducing tax rates, but many municipal investors are concerned over possible changes to the tax-exempt status of municipal bonds. We will be closely monitoring the tax-reform discussions but do not expect them to negatively impact the market in the second quarter. From a risk management perspective, our primary focus will remain on credits with significant unfunded pension obligations. Finally, tax-exempt bonds remain fairly valued versus other fixed income sectors, and our preference remains with revenue bonds over general obligation bonds though we have pared back our overweight.

U.S. equity

The stock market rallied in the first quarter fueled by rising corporate earnings, expectations for an eventual increase in economic growth and improving conditions in a number of foreign economies. As we progress through the year, we expect the market to trend higher driven by a continuation of these trends. Earnings declined in 2015 and throughout much of 2016, but should continue to rebound as the economy expands and the price of oil stabilizes. Corporate tax cuts, if implemented, should also provide a 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

The economies in many foreign countries have improved and economic growth rates are accelerating. Despite the recent improvement in the outlook, aggressive monetary policies continue to be employed in Europe and Japan. Regarding the equity markets, valuations remain attractive as the fundamentals are improving and performance has been modest in recent years. Given the strong actions by these governments and attractive valuations, international stocks are compelling. However, we expect these markets to be volatile due to the strength of the U.S. dollar, elections in France and Germany, 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 acceleration 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 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 recent meeting, 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 recent 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

Asset prices in the U.S. are currently reflecting expectations of at least a modest amount of corporate tax reform and regulatory relief. A disappointing outcome in the Trump administration’s efforts could lead to downward revisions in future earnings growth. In addition, 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. If the central bank acts on either of these fronts too rapidly, 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.