Not a Bad Place to Be: Market and Economic Forecast for the 2H 2017

Not a Bad Place to Be: Market and Economic Forecast for the 2H 2017

by Brad McMillan, CFA®, CAIA, MAI, senior vice president, chief investment officer, Commonwealth Financial Network®

Despite a weak first quarter, the second quarter has looked good, and signs are pointing to a solid remainder of the year. Recent data has shown an expanding economy, while companies have grown both their top and bottom lines. Markets around the world have reacted to this by rising substantially, and we’ve continued to hit new highs here in the U.S.

Although there are risks to this continued improvement, they are largely political. And, thus far, they have been far less dangerous than feared. Brexit, the French election, and even the political turmoil here in the U.S. haven’t been able to derail the economy or the markets. While there are more risks to come—the pending debt ceiling debate and the Italian election are two examples—it seems unlikely they will derail the recovery.

The big picture, then, is one of continued improvement through the remainder of 2017. The economy should continue to grow, perhaps a bit faster than it did in 2016. Corporate revenue and earnings have increased by more than most analysts expected, and that trend is likely to continue as well. Add in high levels of consumer and business confidence, and financial markets are also likely to continue their rise.

What kind of growth can we expect? I believe economic growth for 2017 will end up between 2.25 percent and 2.50 percent, somewhat below estimates at the start of the year, but still respectable. Constrained by this growth, inflation should stay around 2 percent. The Federal Reserve, encouraged by growth but limited by low inflation, will raise rates to 1.50–1.75 percent by year-end, which will drive the 10-year Treasury yield to around 3 percent. Finally, the S&P 500 will appreciate further, to 2,500.

Let’s take a closer look at the factors that will contribute to these numbers.

The U.S. Economy

The best way to analyze the U.S. economy is to go back to basics. GDP comprises consumer spending, business investment, government spending, and the net result of trade. We need to consider each separately.

Consumer spending requires both the ability to spend, in the form of income, and the willingness to spend, in the form of confidence. Labor income growth has remained above 4 percent on a nominal basis, indicating that the ability to spend is there. Similarly, confidence has remained high, suggesting that the willingness is there as well. Despite a pullback in the first quarter, the most recent data suggests that spending is back to the levels of previous years, which should continue to support growth.

Business investment has been a weak spot, but that started to change in early 2017. After languishing in negative territory in 2016, private investment growth has bounced back, in some cases, to levels not seen since before the financial crisis. Buoyed by consumer and business confidence, business investment should continue through 2017 and may well accelerate.

What business gives, however, government is likely to take away. After supporting the economy in 2016, all levels of government have actually decreased spending in 2017. Although the decreases are small, the transformation of government from an economic tailwind to a headwind will hurt growth in 2017 as a whole. In fact, this was a major reason for the first-quarter slowdown. The decline is particularly damaging given expectations at the beginning of the year for fiscal stimulus, which has not happened.

Finally, both exports and imports continue to expand. Exports are rising faster, however, which takes this sector back to net from a negative in 2016.

For the economy as a whole, things look a bit slower than they did at the start of the year. While consumers are still spending, and businesses investing, the decline in government spending looks likely to overwhelm any improvements, leaving growth slightly slower, at around 2.25–2.50 percent on a real basis. This is consistent with past years and is, all things considered, a reasonably healthy rate.

Interest Rates and Monetary Policy

Given the improvements mentioned above, we could reasonably expect inflation to rise—and it has, but not by much. More, the most recent data suggests that it has started to pull back again to levels the Fed considers too low. The Fed’s actions are defined by a dual mandate of employment and inflation, which means it now finds itself in a difficult position. The low unemployment rate says start raising rates, but the low inflation rate says not yet. Which side will win?

Right now, the Fed has said—more clearly than in years past—that the risks of not raising rates are greater than those of raising them. So, expect continued slow increases, to 1.50–1.75 percent by the end of the year. Also, expect the Fed to start rolling off its asset base, not by selling but by lowering the reinvestment rate. Markets now largely expect continued policy tightening, so absent any surprises, the impact should be minimal, as it has been so far.

Longer-term rates should rise somewhat. Given stable growth, and ongoing low inflation, the rate on the 10-year Treasury can be expected to drift up slowly, to a probable level of around 3 percent at year-end. The risk here is most likely to the downside, but this seems a reasonable target.

Overall, the real monetary policy story of 2017 is likely to be that there is no story. Economic growth is steady, inflation is running within a reasonable range, and the Fed’s plans are consistent with that, so interest rate policy becomes driven by stability rather than change.

Financial Markets

A growing economy and a normalization of monetary policy mean global stock markets are likely to continue to trade on fundamentals. Here in the U.S., both revenue and earnings growth were greater than expected at the start of the year, a trend that should continue through 2017. Similarly, valuations have risen, though they could well pull back a bit from their high levels with a moderation in consumer and business confidence.

Given projected earnings growth and a pullback in valuations to levels prevailing through the past couple of years—to between 16 and 17 times forward earnings—the S&P 500 is likely to end 2017 between 2,400 and 2,500. Strong performance so far this year makes the upper end of that range reasonably achievable. This is about 4 percent above what I estimated at the start of the year, but it is consistent with both revenue and earnings growth projections and with economic growth as a whole.

More of the Same?

2017 has been eventful so far. Despite the turmoil—in particular, the political risks—the economy and financial markets have continued to grow. And sound fundamentals should continue to support markets, perhaps driving them even higher.

Things to watch at this point include the U.S. debt ceiling debate, the pending Italian election, and the situation with North Korea, among others. Any one of these events could certainly be disruptive, but we’ve seen situations in the past that were equally as scary—and they didn’t knock the economy or markets off their path.

Overall, the remainder of 2017 looks likely to bring more of the same. More growth, more market appreciation, and more normalization across the board. After the turmoil in recent months and years, this is not a bad place to be.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. Emerging market investments involve higher risks than investments from developed countries and also involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation.

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Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation's largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth's investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.

Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.

Commonwealth Financial Network is the nation's largest privately held independent broker/dealer-RIA. This post originally appeared on Commonwealth Independent Advisor, the firm's corporate blog.

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