Key Points
• 2017 begins as 2016 ended — with an equity rally driven by political optimism and improved economic growth.
• Stronger growth should keep the Fed on track to raise rates two or three times this year.
• Equities face several possible risks, but for now we see more positives than negatives for stock prices.
The post-election rally in U.S. equities took a breather at the end of December, but stock prices bounced back strongly in the first trading week of 2017. The same factors that have driven prices higher since November — enthusiasm over President elect Donald Trump’s legislative agenda and stronger economic data — boosted equity prices last week, with the S&P 500 Index rising 1.7%.1 Looking ahead, we expect the tailwind from improved economic growth should continue through this year, while the positives from the political backdrop may be tested.
Weekly Top Themes
1. The labor market remains strong while wages are rising. December’s employment report was solid, showing 156,000 new jobs were created and upward revisions to prior months.2 Wage growth was quite strong, rising 0.4% for the month and 2.9% year over year, the highest in several years.2
2. Broader economic trends point to likely increases in the fed funds rate. It’s tough to find much wrong with the U.S. economy. In addition to the labor market report, last week’s economic data showed new record 2016 vehicle sales of 17.55 million.3 The overall improvement in economic data suggests the Federal Reserve remains on track to raise interest rates two or three times in 2017.
3. The benefits from fiscal stimulus may be balanced by economic headwinds later in 2017. We think some combination of tax cuts, tax reform, overseas repatriation, infrastructure spending, defense spending and regulatory revisions should help consumer and business confidence this year. Possible negatives include rising labor costs, the stronger dollar, higher interest rates and pockets of weak overseas growth.
4. U.S. stocks will likely be plagued by an ongoing tug of war. We think corporate earnings improvements will primarily be the primary driver of prices this year. That trend will likely be counterbalanced by contracting price/earnings multiples.
5. The state of the global economy should be a positive for equities in 2017. Deflation risks appear to be receding around the world while excess inflation has yet to surface. This could create a “Goldilocks” reflationary environment that would be good news for equities and other risk assets.
Positives for Equities Outweigh the Risks
Improving economic growth in both the United States and around the world should help equities in 2017, but we also acknowledge that markets face several risks. Chief among these is that improving growth and rising wage inflation will likely translate into less accommodative Fed monetary policy. We don’t expect rapid or dramatic rate increases, but policy appears on track to slowly normalize after years of the fed funds rate remaining at the emergency zero level. As such, we think the risks are to the upside for both the fed funds rate and U.S. bond yields. As yields rise, they will likely pressure equity multiples and could create spillover volatility in equity markets and other asset classes.
Some are also growing concerned about equity valuations. We do not believe that valuations are currently stretched, but stocks are certainly more expensive than they once were. We are not worried about valuation pressures at this point, but this will bear watching later in the year if interest rates and inflation increase.
The political backdrop could also create some risks. The likely pro-growth policies from the Trump Administration are boosting investor optimism, but we remain wary of possible protectionist moves from the next President. Additionally, rising geopolitical tensions could undermine business confidence.
On balance, however, we think the improving economic outlook warrants a moderately pro-growth investment stance. The strong post-election equity rally could mean stocks may face a near-term consolidation or correction. However, the fundamentals of improving corporate profits and better nominal growth suggest that stocks look more attractive than bonds or cash. If the global economy shifts into a higher gear, select pockets of non-U.S. equities could have the potential for significant gains. For now, however, we expect U.S. stocks to continue their 2016 outperformance.
Bob Doll is chief equity strategist at Nuveen Asset Management.