▪ Equities continued to rally based on anticipation of pro-growth economic policies from Washington.
▪ Economic and earnings growth also continue to solidify, supporting the case for a continued equity market rally.
▪ Nevertheless, potential risks to this outlook include rising bond yields, the advancing U.S. dollar and political uncertainty.
As has been the case for the past couple of months, investors continued to be highly attuned to the political backdrop last week. Early in the week, concerns over the president’s immigration and trade policies cased unease, but sentiment improved on Thursday after Donald Trump signaled a near-term announcement on tax reform. For the week, the S&P 500 Index rose 0.9%, with the industrials, technology and consumer sectors leading the way.1 Energy and income-oriented sectors lagged, with energy being the only sector to experience negative returns.1
Weekly Top Themes
1. Corporate earnings continue to rise and are on their best pace in over two years. As reporting season winds down, fourth quarter earnings are set to grow between 8% and 9%.2 This would mark the best performance since the third quarter of 2014.2
2. Despite a recent pullback, we expect the U.S. dollar to continue to strengthen. The dollar has rallied strongly since the election, but the rally has taken a breather in recent weeks. We could see some additional near-term consolidation, since the greenback may have been overbought. However, we expect a combination of accelerating growth and rising interest rates will likely put continued upward pressure on the currency.
3. The U.S. political backdrop remains a wildcard for investors. In general, investors remain optimistic about the prospects for a pro-growth Trump Agenda. Tax reform, fiscal stimulus, regulatory revisions and more infrastructure spending would promote economic growth. But investors are also wary about the president’s priorities and his propensity to lash out at individuals and specific companies with whom he disagrees.
4. The federal budget deficit is expanding, which could complicate the political background. On a rolling 12-month basis, the deficit rose to $587 billion for fiscal year 2016, up from $405 billion the prior year.3 Tax revenues have declined, while spending levels have advanced.3 These trends will make any tax cuts and spending plans problematic.
5. We expect to see tax reform legislation passed, but the details are still murky. At present, most are focusing on a possible border adjustment tax, which would tax goods imported into the United States. Such a tax would increase revenues and make broader tax reforms more possible, but some (including the president) appear skeptical about its merits. The border adjustment tax is an important issue, but even if it winds up not being a part of the final GOP plan, we still expect some sort of tax reform legislation to pass.
We Suggest a Pro-Growth Investment Stance
Equity markets have surged higher since the November elections. Some question whether markets have come too far, too fast and even if stocks are in a bubble. While some market areas may look expensive (e.g. bond market proxies such as utilities), we do not believe equities as a whole are close to bubble territory.
That said, we think the bull market skeptics are right to point out some risks. Late last year, investors were deeply concerned that the rapid rise in bond yields and the soaring value of the U.S. dollar could derail the ongoing economic expansion. These trends have moderated in recent weeks, easing this concern. If these rapid uptrends resume, it could be a source of renewed worry. Additionally, the political backdrop has the potential to trigger a setback in economic growth and the equity rally. If President Trump remains focused on immigration and trade restrictions, we think it would be a negative for growth. Even if he shifts his attention elsewhere, investors must face the possibility that expectations for tax reform and fiscal stimulus may be too high.
Despite these possible risks, we think the scales favor continued economic expansion, improving corporate earnings and rising equity prices. International markets will probably begin outperforming the U.S. at some point, as non-U.S. markets appear relatively inexpensive and may have more upside potential. For now, though, we continue to think that U.S. stocks look more attractive thanks to better relative economic and earnings growth.