With the New Year fast approaching, we are taking this opportunity to share with you, our valued clients and friends, Pennsylvania Trust’s 2017 investment outlook. As our outlook for stocks and bonds depends in large part on our economic outlook, we start there.
As we conclude 2016, the U.S. economy appears fairly strong, perhaps even gaining momentum. The unemployment rate is low. The housing market is improving—indeed, sales of existing homes are at their highest levels since 2007 and U.S. home prices recently topped their prior peak from 10 years ago. GDP in the third quarter rose by a 3.5% annual rate, the fastest growth in two years. Perhaps, not surprisingly, Americans have more confidence in the U.S. economy than at any time since January 2004, according to the most recent University of Michigan Index of Consumer Sentiment.
Against this backdrop, and factoring in a likely fiscal policy shift brought about by the November federal election results, we believe the U.S. economy will continue to grow during 2017—and probably at a faster overall rate than in 2016. Importantly, we do not see any material recession risk next year. The expected return of fiscal stimulus (reduced corporate and individual tax rates plus increased government spending on infrastructure and defense) supports this view, even though its impact may be greater in 2018 rather than 2017. Any easing of regulatory burdens in the energy, financial and/or healthcare areas likewise would be supportive of enhanced economic growth next year.
A stronger economy means that inflation likely will be headed modestly higher in the U.S. in 2017. We expect that inflation will be driven primarily by a pickup in wage growth, and perhaps by some year over year commodity price increases as well. With rising economic growth and inflation, the Federal Reserve likely will raise interest rates up to three times during 2017, continuing its move away from an extremely accommodative monetary policy.
On a relative basis, we believe U.S. economic growth in 2017 will be stronger than in Europe and Japan, where there is little prospect for fiscal stimulus, but weaker than in some developing economies such as India and China.
In our view, oil prices likely will only rise modestly from current levels in 2017, particularly given their major rebound this year…doubling from February’s lows. Our view toward other commodity prices is essentially the same. One of the headwinds for rising oil prices is a stronger U.S. dollar. The U.S. dollar recently has been trading at 14-year highs, and we see this dollar strength likely continuing in 2017, particularly against the Japanese Yen. Dollar strength derives from the relative strength of the U.S. economy and the relative (less accommodative) stance of monetary policy within the U.S. versus Europe and Japan.
Although vulnerable to a January or February pullback given the recent robust gains, we believe that stock prices in the U.S. will be higher in 12 months than at present. A relatively strong and improving U.S economy supports this outlook, as does an improving corporate earnings climate. In this regard, it is important to observe that the “earnings recession” in the U.S. came to an end in the third quarter, and earnings are expected to accelerate from current levels. On the negative side, valuations are no longer cheap; optimism is nearing elevated levels; and profit margins may be challenged by the wage growth we foresee. Of course, if the anticipated fiscal stimulus does not materialize, or if deregulation does not occur as expected, the stock market likely will give back its recent gains.
All in all, we continue to like U.S. equities. And while we have a long-term bias toward large-cap, high quality, blue chip companies, we do expect to maintain higher than normal weightings in U.S. small cap stocks in 2017 as we expect they will benefit disproportionately more from tax cuts and deregulation, and also will be less negatively impacted by a stronger U.S. dollar.
We also favor exposure to Japan on a currency-hedged basis, and to a lesser extent, to Europe as well, where overall valuations are somewhat cheaper and monetary policy remains very accommodative. For the long term, we also recommend some exposure to emerging markets, particularly in Asia.
The secular, 30-year bond bull market may well have come to an end post-Brexit in July. Certainly the outlook for 2017 is moderately bearish. The combination of a stronger economy, fiscal stimulus, monetary policy tightening, and rising inflation all are supportive of rising bond yields and falling bond prices. Bond yields, of course, already have risen dramatically from their July lows, but are still near historically low levels. While yields may have come too far too fast and may move lower in January or February, we see a path of gradually higher yields in 2017. Nonetheless, even assuming sub-par returns, we continue to believe that bonds are an important part of a diversified investment portfolio as they serve as a hedge against the downside risk inherent in the equity markets.
We wish everyone a healthy and prosperous New Year, and encourage clients to contact their portfolio manager with any investment questions as 2017 unfolds.
Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.
Disclosure: Data is for informational purposes only and should not be considered as marketing for any Pennsylvania Trust mandate or service and should not be considered a solicitation or an offer to provide any Pennsylvania Trust service in any jurisdiction where it would be unlawful to do so. The views expressed represent the opinions of Pennsylvania Trust and are not intended as a forecast or guarantee of future results. The sectors, industries, countries and regions discussed herein should not be perceived as investment recommendations and may no longer be held in an account’s portfolio. It should not be assumed that investments in any sector, industry, country or region discussed were or will prove profitable. Sector/industry weights and country and regional allocations of any particular client may vary based on investment restrictions applicable to the account. There may be additional risks associated with international investments. International securities may be subject to market/currency fluctuations, investment risks, and other risks involving foreign economic, political, monetary, taxation, auditing and other legal factors. These risks may be magnified in emerging markets. Pennsylvania Trust believes that transactions in any option, future, commodity, or other derivative product are not suitable for all persons, and that accordingly, clients should be aware of the risks involved in trading such instruments. There may be significant risks which should be considered prior to investing. All securities trading, whether in stocks, options or other investment vehicles, is speculative in nature and involves substantial risk of loss. Indices are unmanaged and not available for direct investment. Past performance is no guarantee of future results.