by Gerald Laurain
What is the economic outlook for 2017? Countless man hours have been devoted to this topic already and no certain answer has emerged. A seemingly infinite number of variables will impact the outcome ranging from politics, psychology and demographics to the weather. It is a local question as well as a global question. Let’s start with the global backdrop and see what the setting looks like from a very macroeconomic perspective, then drill down to the domestic scene.
World Backdrop – Eurozone, Japan, BRICs
Two organizations, The World Bank and Then International Monetary Fund, attempt to forecast and make projections about future economic trends and prospects. Let’s look at what The World Bank has to say about the outlook for 2017.
The World Bank, also known as the International Bank for Reconstruction and Development (IBRD) was founded in 1945 by two highly regarded economists, John Maynard Keynes and Harry Dexter White. According to its web site, the Bank has a highly ambitious mission: “End extreme poverty within a generation and boost shared prosperity.”
The World Bank Group’s recent publication, “Global Economic Prospects, January 2017 Weak Investment in Uncertain Times”, gives away their outlook very clearly in the title. Slow growth is expected, as is a high degree of uncertainty about outcomes.
On page 4 of the report, The World Bank posts their Outlook Projections. We see Real GDP projections of 2.7% growth for the world overall, 1.8% in Advanced Economies and 4.2% growth in Emerging Markets and Developing Economies. The Euro Area Real GDP is projected to grow at just 1.5%.
At the country level, the Bank sees the United States Real GDP projected growth at 2.2%, Japan at 0.8% and China at 6.5%. Many of these projected growth rates have been reduced from their June 2016 projections
U.S. Domestic Situation
The World Bank report footnotes its 2.2% Real GDP growth projection with the following disclaimer:
“The U.S. forecasts do not incorporate the effect of policy proposals by the new U.S. administration, as their overall scope and ultimate form are still uncertain. However, simulations indicate that the large reductions in corporate and personal income taxes suggested by the new administration could – if fully implemented and without consideration of any other policy changes – increase both U.S. GDP growth and global growth above baseline projections in 2017 and 2018. See “Risks to the outlook” section of Chapter 1 for further details.
Fiscal Policy & Trade
Those “further details” are quite interesting. They note that some areas of uncertainty, tax cuts and infrastructure spending, for example, have the potential to boost GDP. Others, trade tariffs, for example, would have quite the opposite effect. Why is trade so important? According to their report, “trade accounted for 30 percent of U.S. GDP in 2015”. Reducing trade would clearly be a negative for the economy.
Monetary policy under the Trump administration also has the potential to impact the economic outlook for 2017. The Federal Reserve is charged with carrying out monetary policy with a dual mandate from Congress: maintain full employment and price stability. Given that low interest rates foster full employment but can potentially lead to rising prices due to inflation, this is a delicate balancing act.
During the great financial crisis that started in 2007, the Fed systematically lowered the target rate on Fed Funds (the rate banks charge each other on overnight loans) from 5 1/4% (in July 2007) to 0%-0.25% and held it there until December 2015. In December of 2016, the Fed boost the target rate another 25 basis points (1/4 of 1%).
Fed watchers expect to see two or possibly three additional increases during the remainder of 2017 if the economy continues on its current growth path. Fed Chair Janet Yellen expressed concern that if the Fed waits too long to continue the increases, it could be forced to increase rates rapidly in response to inflation; that “could risk disrupting financial markets and pushing the economy into recession.”
Market Outlook – Five Factor Framework
Given the foregoing economic outlook for 2017, what are the prospects for the stock market? The challenge investors have is to extract the emotional aspect from the political theater of monetary and fiscal policy and focus on the data that matters.
Here is a Five Factor Framework for evaluating the 12 – 18 month outlook for the stock market. It is not meant to be a market timing device and it is always important to remember that past performance is not indicative of future results. Rather, it is meant to be a psychological weather report of sorts to allow you to prepare a mental umbrella if need be, or alternatively, pack your investor flip flops.
These factors look at the growth of the economy, the market trend, the monetary environment, investor psychology and equity valuations to assess the equity market outlook. Their current readings are a snapshot in time and will change with the data.
- Growth of the economy
- Market trend
- Monetary conditions
- Investor psychology
- Market valuation
The Economic Cycle Research Institute publishes a Weekly Economic Index (WLI) and its associated growth rate. When the growth rate is positive, it indicates that the economy is growing. All else equal, a growing economy is generally good for the stock market. This is in keeping with the philosophy that a rising tide lifts all ships. As of February 3, 2017, this indicator was positive.
There is an old investment saw that says “the trend is your friend.” Think of this concept in terms of your old high school physics law: a body in motion tends to stay in motion until acted upon by an outside force. Markets tend to be like that, too. Higher prices bring higher prices and lower prices are frequently followed by lower prices.
The trick in identifying a meaningful trend is drilling through the day-to-day volatility of the markets. When markets can gyrate up or down 1%, 2% or even more, it is difficult to determine what the longer term trend really is.
In an effort to focus on the long term, it can be helpful to look at longer term moving averages. A 12 month moving average (12 MMA) might be helpful in this regard. The way to interpret this indicator is to check where the S&P 500 Index is relative to its 12 MMA. If it is above the 12 MMA, you would conclude that the market is in an uptrend; if it is below the 12 MMA, you would conclude it is in a downtrend. As of February 17, 2017, the S&P 500 Index was above its 12 MMA, indicating an uptrend.
Monetary conditions and the availability of credit are important indicators of potential market performance. Much of the economy runs on credit. People buy homes and cars on credit. Hedge fund managers buy stocks and bonds and commodities on credit. If you take the credit punch bowl away from the economic party, the party winds down quickly.
There are many measures of monetary conditions. It is possible to observe the monetary base at the Federal Reserve and the willingness of banks to lend money. You can also observe the difference between short term interest rates (the prime rate, for example) and longer term rates (home mortgages, for example). When credit conditions are tight, short rates sometimes go above long term rates.
Currently, the monetary base at the Fed is shrinking and they have publicly announced that they intend to move rates higher. This should give rise to some measure of caution in investors’ minds as it is a potential headwind to stock prices.
Investor psychology is also something to keep in mind when trying to gauge the market outlook. Warren Buffett is credited with the advice that “you should be greedy when others are fearful and fearful when others are greedy”. There are over 100 measures of investor sentiment including the surveys of bullish consensus and the CBOE put/call ratio. In the aggregate, these indicators suggest that investors are reacting positively to record highs and that caution might be warranted.
Lastly, market valuations are thought to have an impact on future returns. The so-called Price Earnings Multiple, or PE, illustrates what investors are willing to pay for a dollar’s worth of next year’s earnings. The long term PE is around 15 and is currently approximately 18. That 20% premium to the historical average is another cautionary flag for forward returns.
Summary & Conclusions
According to The World Bank, the global economic outlook is for relatively slow growth in 2017. In the U.S., uncertainties with respect to fiscal policy translate into uncertainty about the prospects for economic growth and the outlook for the stock and bond markets. The prospects for significant tax cuts and infrastructure spending have created a high degree of optimism and valuations that may be as much as 20% higher than their historical averages. Given the possibility of restrictive trade measures and tighter monetary policy, a certain degree of caution is undoubtedly warranted on the part of equity investors.