8 Arms and 3 Educated Guesses

It is that time of the year again when we make some educated guesses as to where financial markets are heading.  While we never miss an opportunity to express our opinion, we are feeling a little like the proverbial eight-armed economist this year.  You know who we’re talking about—“on the one hand…, on the other hand…, but on the other, other hand…”.  You probably spent some time with him or her over the Christmas holidays.  We bring up the eight-armed economist only to say that there seem to be as many possible threats as there are opportunities.  But we’ll jump into that later.

Before we sort through this year’s tea leaves, let’s look back on our 2016 predictions and see how we did.  Prediction #1: “Although Federal Reserve Vice Chair Stanley Fischer has indicated that the Fed will look to raise rates four times in 2016, we, along with many investment professionals, believe that the number of rate increases should be half that.”  We almost had this one. The Fed raised interest rates only once in 2016, and that move came on the heels of the US Presidential election and the promise of increased infrastructure spending.  The Fed cited global economic concerns as the primary reason for not having made four rate increases.  Prediction #2:  High yield bonds will be one of the top performing asset classes in 2016.  We got this one.   Coming off a dreadful 2015, high yield bonds returned more than 17% for 2016 vs. almost 12% for the S&P.  Prediction #3:  The US consumer will continue to shine in 2016.  We were on track with this as well.  Another year of continued growth, low interest rates and benign inflation provided the backdrop for increased consumer confidence.  This was reflected in a recent excerpt from the Conference Board’s most recent Consumer Confidence Survey®: “the post-election surge in optimism for the economy, jobs and income prospects, as well as for stock prices which reached a 13-year high, was most pronounced among older consumers.” 

Okay so that makes us 2 out of 3 for 2016.  What about 2017?  Here is what we are thinking:

1)    US equity markets break the trend of negative returns during the first year of a new US Presidential term and finish positive.

We think the expectation and ultimately implementation of financial and regulatory reform will continue to drive stocks in a positive direction.  Corporate tax reform and the repatriation of overseas dollars held by US companies would boost stock returns: not necessarily from companies reinvesting in capital expenditures, but through enabling these companies to continue buying back their own stocks.  This will buck the trend that has seen markets fall by nearly 3% on average in the first year of a new Republican President’s first term.

2)    Emerging Market (EM) stocks have a solid performance during the 3rd and 4th quarters.

Our expectation that Emerging Markets perform well in the second half of the year is as much about US infrastructure spending as it is anything else.  Many EM countries are exporters of commodities, which are needed for building.  You need building materials to build all the roads, bridges, hospitals and municipal projects that find their way into infrastructure spending bills.  In our improving EM scenario, the US dollar would need to stabilize, as a continually strengthening dollar would have a harmful effect on EM and global growth.

3)    The Fed raises rates twice for 2017, versus their announced intentions to raise rates 3 times. 

We think again that the Fed will only raise rates twice in 2017.  Rising US rates could push the US dollar higher as foreign investors would continue to prefer higher yielding US government bonds over the lower yields offered in Europe and Japan. An overly strong dollar could hurt global growth, ultimately hurting the US economy.  And the Fed proved last year—when they cited economic concern in China as a reason to keep rates unchanged for most of the year—that they absolutely do consider the global impact of their interest rate decisions. 

We make these predictions with the caution of an eight-armed economist, with arms filled with potential positives balanced by arms full of possible negatives.  Year one of the Trump Presidency, the initiation of Brexit, and key European elections could all make for a very eventful investment environment…on the other hand….