Key Points
• Equities and bond yields moved higher as the Fed raised rates without indicating it would quicken the pace of increases.
• Investors remain optimistic about the political backdrop, but we think a lack of policy clarity presents risks.
• A number of risks could spark a near-term equity correction, but we retain a constructive longer-term outlook.
The Federal Reserve’s decision to raise interest rates by 25 basis points, while keeping its dovish tone, was the big story last week. U.S. equities finished slightly higher, with the S&P 500 Index rising 0.3%.1 Treasury prices also advanced after falling the week before.1 Among stock sectors, income-oriented bond proxies outperformed, while health care and financials sagged.1
Investors Need Clarity on the Trump Economic Agenda
Political observers have been focusing on the GOP’s health care plan and President Trump’s proposed budget. Both face an uncertain political future, but the president and Congress are clearly looking to significantly reorient the federal government.
Both initiatives could shape economic growth and financial markets. But tax reform will likely have the greatest impact. Any tax reform plan is certain to address corporate tax repatriation. At present, U.S. companies are estimated to hold over $2 trillion in foreign income overseas.2 Enacting a plan that returns this money to the U.S would allow the government to tax these profits and produce revenue that could help pay for other tax cuts or infrastructure spending.
In our view, the chances of passing such tax reform are high and the markets have already priced in this change. This is one reason stock prices and bond yields have both risen since the election. Investors are anticipating an increase in tax revenues from repatriation that could fuel economic growth. If any such plan is smaller in scope than investors anticipate, it could present downside market risks.
Weekly Top Themes
1. The Fed signaled that it will continue to raise interest rates slowly. The central bank’s relatively dovish statements seemed to signal that it intends to continue a slow and moderate pace of rate hikes.
2. U.S. economic growth appears to be accelerating modestly. In our view, manufacturing is improving, home demand is on the upswing and consumer spending is stable. At the same time, inflation appears to be creeping higher.
3. We expect Chinese growth to slow. We do not anticipate a hard economic landing, but slowing Chinese growth represents a risk to the global economy.
Equities may be growing more expensive in absolute terms, but still look relatively attractive. Given the strong run-up in prices over the last year, equity 4. valuations may be less attractive. But we still think they appear better valued than Treasuries or other government bonds.
Several Risks Could Cause a Setback or Correction
Equities and other risk assets have continued to be resilient over the last several weeks, but higher-risk areas of the market (small cap stocks, cyclical sectors and some fixed income credit sectors) have been flagging to various degrees.1 We have been suggesting for some time that the broader equity market may be slightly overextended and could be due for a setback or correction.