U.S. stocks were marginally lower on the week as the beginning of the fourth quarter's earnings season and political headlines captured investors' attention. While aggregate index earnings are expected to rise, not all companies will meet analysts' projections. That's why we recommend investors monitor their portfolios' exposure to any single investment. By owning several stocks within each market sector, you may be able to reduce your portfolio's volatility – especially through the earnings season.
Looking Back: 4th Quarter and Year in Review
Stock prices rose and bond prices fell after November’s election due to expectations about President Trump’s pro-growth policies. Investors are increasingly optimistic that lower taxes, relaxed regulations and higher infrastructure spending would finally fuel faster economic growth and consequently higher inflation and rising interest rates. But the range of likely outcomes for economic growth, interest rates, inflation and the dollar is wider than in the past eight years – leading to higher uncertainty and probably more market volatility ahead. But in the first half of 2016, falling interest rates meant bonds generally outperformed stocks, an unusual result. Despite political surprises such as Brexit and the U.S. election, the global economic outlook improved and interest rates rebounded in the second half of the year. The result was higher returns for riskier (higher volatility) U.S. asset classes. In contrast, as the dollar rose, international investments fell in the fourth quarter, reducing their 2016 returns.
The combination of solid job growth and President Trump’s expected pro-growth policies should spur stronger economic growth later this year and into 2018. But the pace depends on the timing and specifics of policy changes, as well as the possible negative effects of trade or immigration restrictions. That’s why we expect modestly better growth as well as greater uncertainty ahead. Although lower taxes, regulatory relief and infrastructure spending can raise economic growth, changes take time, and the policy specifics matter. Trade conflicts or tighter immigration policies could cause disruptions and hurt growth. We think the pace increases modestly to 2%-2.5% in 2017 and faster in 2018. But still modest economic growth means inflation is likely to stay near 2%, putting less pressure on the Federal Reserve to raise interest rates. Smaller companies (small- and mid-cap stocks) are expected to benefit more from these pro-growth policies.
The shift toward pro-growth policies should result in better economic growth and a return to earnings growth in 2017. But the changes are likely to take longer and be partly offset by others that hinder growth. That means policy disappointments and delays could trigger market pullbacks. Historically, stocks drop an average of 14% during the year, but still have an average annual return of almost 10% by year end. Although past performance doesn’t guarantee future results, we think pullbacks are opportunities due to the improving outlook for earnings and economic growth.
Rising stock prices at the end of 2016 pushed the price-to-earnings ratio for the S&P 500 and other valuation measures above their long-term averages and led investors to wonder whether stocks rose too high too fast. While the gains reflected investor optimism about policy changes, the fundamentals were improving, too. As a result, U.S. stocks remain attractive, but due to above-average valuations, we think returns are likely to be near the low end of our range of 6%-8%.
Expectations of faster growth and rising inflation led to rising long-term interest rates and supported the Fed’s second quarter-percent increase in short-term interest rates in December 2016. But we think the Fed remains patient and plans to move slowly in 2017, especially if policy delays keep economic growth near 2.5% and inflation remains contained. Rising energy prices have started to push overall inflation measures back toward 2%. The tighter labor market has pushed wage growth up to 2.9% over the past year, and higher wage growth is likely to continue based on modest economic growth in 2017. But the stronger dollar means lower import prices, partly offsetting the impact of rising wages. We think the mix is likely to keep inflation subdued. Since long-term bond rates are more sensitive to inflation, we expect more volatility in long-term rates as inflation expectations fluctuate.
Global economic growth is expected to rise to 3.3% in 2017 from 2.9% in 2016, according to the Organisation for Economic Co-operation and Development (OECD). A strengthening U.S. economy can benefit from expected foreign developed country growth as well. And China’s growth is expected to slow to 6.4% from 6.7% in 2016. We think slowly improving economic and earnings growth should support rising stock prices in foreign developed markets. However, elections across Europe in 2017 have raised fears that populist and nationalist parties in Europe could win and implement policies to curtail immigration, reduce integration and possibly abandon the euro. We think stocks reflect those pessimistic expectations, as well as some concerns about U.S. trade restrictions. But the result could also be a shift toward pro-growth policies and more fiscal stimulus, helping European growth accelerate. And stock prices also could rise in response, as happened in the U.K., where stocks (represented by the FTSE 100 Index) returned 16% between June’s Brexit vote and the end of 2016. Low expectations can be positive for investors, representing opportunities if conditions improve.
Outlook for the Dollar: Rising and Falling Over Time
The value of the dollar tends to rise and fall with relative interest rates, inflation rates and growth rates. The dollar has generally risen since mid-2014 because all have favored the U.S. And U.S. interest rates are higher than most foreign rates, which is why the dollar is expected to keep rising. But U.S. inflation is also higher and expected to increase more quickly, partly offsetting the interest rate gap. If interest rates rise less than expected, the impact would tend to stabilize the value of the dollar. The value of the dollar has gone up and down over time, but rapid currency moves can be a source of volatility. A stronger dollar means imports tend to be cheaper, helping keep inflation low, and it can lead to lower commodity prices, which are mostly priced in dollars. But it also tends to reduce foreign earnings of U.S. companies and hurt U.S. exports, doing the opposite for their foreign competitors. And a strong dollar generally reduces returns on international investments and tends to hurt emerging market growth. Historically, a strong dollar aligned with China’s desire to keep its currency low, supporting its export growth. But recently the yuan has declined rapidly, and the stronger dollar could make stabilizing it more difficult. If the dollar doesn’t rise further, we expect international investments to benefit, and other recent trends could reverse.
|Dow Jones Industrial Average||19,886
|S&P 500 Index||2,275
|10-yr Treasury Yield||2.40%||-0.02%||-0.05%|
Next week, inflation data will be reported on Wednesday, and housing data, including starts and permits, will be reported on Thursday.
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