Q2 2017 – “Outlook for the Remainder of 2017″ (Part 1)

July 7, 2017

With the momentum in the market carrying over from the first quarter, the first half of 2017 has been the best start for global equities since 1998. Although equity markets outside of the United States were up more, the Standard and Poor’s 500 (S&P 500) had its best first half of the year since 2013. International markets performed well as confidence in economic recoveries around the world have been gaining or surpassing growth in the US. While there were pullbacks in the marketplace during the quarter, the market continued to bounce back with the S&P 500 setting 24 new closing records.

The world economy continues to strengthen. In early July, the first quarter Gross Domestic Product was revised upward to 1.4%, better than initial expectations. The US job market continues to be strong, adding 222,000 new positions in June, and the unemployment rate at 4.4%. The recent Labor Department report also showed that there were 6 million unfilled job openings as of the end of April, the most since it started keeping track in 2000. While the employment picture looks bright, wage growth has only been modest, possibly held down by the weak pace of productivity growth in recent years.

Throughout the world, economies have been recovering and central banks have been contemplating normalizing their balance sheets. This has had a negative impact on the dollar, as it suffered its worst stretch in six years during the first half of 2017, beginning down 5.6% year-to-date against a basket of major currencies, distinguishing the greenback as the worst performing among the major currencies. However, a weaker dollar will actually help US multi-international companies with international sales, as prices on US products become more competitive in the foreign market, further helping the US economy.

Nonetheless, putting the recent decline of the dollar into proper context, this past November the dollar was at a 14-year high right after the US presidential election as the pro-growth platform that President Trump outlined in his presidency bid excited investors on the prospects of strong economic growth and higher interest rates.

However, pro-growth initiatives such as an infrastructure spending bill and comprehensive tax reform have taken a backseat to the push for the passage of healthcare reform.

Even though predicting legislation progress can be a futile endeavor, Republicans have signaled that something could be done before year-end on the tax reform effort. Materially lowering the corporate tax rate to 15% (as suggested previously by the Trump Administration) would be viewed positively by the equity market.

A territorial tax system (border tax) would place the US tax system on equal footing with that of other tax systems around the world since the US is the only developed economy that does not impose a “border tax.” While Congress continues to struggle with legislation, House Speaker Paul Ryan has communicated a goal of introducing a tax legislation in the House in the early fall with the objective of passing final legislation before year-end.

With the economy continuing to hum along, and the hope that Congress can pass legislation that will help the economy continue to work, investors have drawn their attention to monetary policy throughout the world, with the key question: when do interest rates “normalize”?

Given what has transpired throughout the world with the extraordinary accommodating monetary policies through quantitative easing (QE), asset purchases by central banks and near zero to negative interest rates throughout the world, the definition of a “normalized” environment can be hard to define. The next two graphs illustrate what has transpired over the past 17 years: Central Bank’s asset portfolios and the US Federal Funds Rate.

In June, Federal Reserve policy makers raised the Federal Funds Rate by 25 basis points to a range of 1% to 1.25%. This is their fourth, quarter-point raise since December 2015. In addition to raising short-term rates, the policymakers laid the framework for the normalization (shrinking) of the Central Bank’s large portfolio of bonds and assets that has accumulated over the past several years due to QE policies. As illustrated in Graph 1, central banks throughout the world have increased their balance sheet significantly with the QE programs implemented since the financial crisis of 2008 to help spur economic growth.

Central banks would prefer to gravitate towards the process of “normalizing” in order to provide optionality to address future economic stimulus in recession periods. Historically, central banks have addressed recessions with typical monetary policies such as setting short-term interest rates.

A lowering interest rate environment encourages investment, while a tighter monetary policy (higher interest rates) helps to cool an overheating economy. Graph 2 illustrates the lack of flexibility the Federal Reserve currently has to affect the economy with monetary policy with its fed funds rate significantly lower than historical levels. The shaded area on the graph represents recessionary time periods.

While the Federal Reserve officials have laid the framework to slowly shrink the Central Bank’s large portfolio of bonds and other assets ($4.5 trillion), it is widely anticipated that they will start the plan in September; the Fed has also indicated that it will unlikely decrease to a level seen before the financial crisis of 2008 (under $1 trillion).

Click here for Part 2.