Key Points

• The post-election euphoria continued last week as investors bid equity prices to new highs.
• Investors face a number of risks, including rising bond yields and a potential December rate hike, but we think equities should continue outperforming in 2017.

Equities continued to rally last week as all major U.S. indices hit new highs.1 Investor optimism rose as expectations for deregulation, corporate tax reform and fiscal stimulus under President-elect Trump accelerated. These same factors put upward pressure on bond yields and the U.S. dollar. For the week, the S&P 500 Index gained 1.5%, as the consumer discretionary, energy and financials sectors pushed higher, while heath care, consumer staples and utilities lagged.1


Weekly Top Themes

1. Consumer confidence is growing. The University of Michigan Consumer Sentiment Index jumped from 87 in October to nearly 94 this month.2 The post-election bounce shows consumers expect improvement in their financial situations in a Donald Trump administration.

2. Improving economic data should lead the Federal Reserve to raise interest rates next month. U.S. durable goods orders surged 2.8% in October,3 putting further upward pressure on yields and the dollar. At this point, we would be surprised if the Fed did not raise rates in December and we expect central bankers to hint at a few more increases in 2017.

3. Inflation expectations are increasing. We think commodity prices have likely bottomed. and we expect higher levels of federal spending next year. We don’t think inflation will rise sharply, but it appears to be accelerating, another reason to expect an upward move in bond yields.

4. Increased fiscal stimulus could accelerate in-progress market leadership trends. In particular, we expect economically-sensitive cyclicals to outperform, while income-generating sectors, defensive areas and low volatility segments could struggle.

5. The Italian referendum vote scheduled for December 4 could cause headline risks and spark financial market volatility. The prospects for constitutional reforms could reshape the Italian political landscape and have unexpected financial results.

Markets Face Risks, but Equities Appear Well Positioned

In retrospect, it appears the economic and equity market backdrop was already improving before the election. Trump’s victory and the Republican sweep provided a catalyst for investors to ratchet up their optimism. Since the election, investors have rushed out of government bonds toward risk assets. While we think the economic and earnings environment remains favorable for stocks, investors should be aware of several risks.

The first, and most evident, is that the bond yield surge and U.S. dollar rally cannot be sustained without causing economic damage. We think upward pressure on bond yields and the dollar may continue long-term, but post-elections euphoria may be overdone and a near-term consolidation could occur. In any case, the pace of yield increases from the past few weeks will probably not continue.

On a related front, the likelihood of an imminent rate hike could cause market volatility. Today’s environment is somewhat similar to a year ago when the Fed last increased rates. The dollar is rising and some areas of the global equity market (Europe and some emerging markets) are underperforming. Last year, the Fed rate hike contributed to a souring of economic sentiment and a risk-off phase in markets. However, today we see some key differences: Equity markets are stronger, oil prices are more stable, inflationary expectations are rising and the global economy is healthier. As such, we do not expect one or even a few rate increases over the coming year to severely damage investor sentiment.

In addition to these risks, commodity prices could weaken and geopolitical turmoil may increase both home and abroad. Nevertheless, we think the recent equity rally has been driven by solid fundamental underpinnings of improving economic growth and better corporate earnings. Over the next year, we expect investors to become increasingly confident about the durability of the economic expansion. There will no doubt be periods of greater volatility, contractions and sell-offs, but we continue to maintain a pro-growth investment stance.

Bob Doll is chief equity strategist at Nuveen Asset Management.