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Expert Insight & Commentary

Key Points

  • U.S. equities have held gains seen following the election, while there has been a definitive sector rotation indicating more confidence among investors. We believe the bull market will continue, although the sharp gains seen recently may give way to more sideways movement and/or potential pullbacks.
  • Economic data has improved alongside a more business-friendly incoming Trump administration, helping bolster both stock and Treasury yields. The Fed is likely to raise rates at its December meeting, and may also raise its forecasts for economic growth and the trajectory of interest rates for the first time in this cycle.
  • Populism has been a theme in 2016, but that doesn’t necessarily mean it carries into 2017, while for investors, it may not matter so much.

Animal Spirits?

November turned out to be an excellent month for the major U.S. stock indexes, with all three, plus the Russell 2000 index of small caps, hitting record highs. Although seasonal tailwinds should persist throughout the remainder of this year, we do expect to see some sideways trading and consolidating of gains at some point. That said we do believe the secular bull market is intact and, in fact, recently upgraded our view of U.S. stocks to outperform from neutral—offsetting a move to underperform for developed international stocks and the maintenance of a neutral rating on emerging market stocks.

We appear to be witnessing the revival of “animal spirits” among businesses and investors. After consistent outflows from U.S.-based mutual funds throughout this bull market, inflows have been strong over the past few weeks. This is a trend which could have significant legs into next year. In addition, the outperformance of more cyclical areas of the economy—financials, industrials, and energy—all indicate greater investor confidence in economic growth (for more on sectors go to Schwab Sector Views).

Economic momentum building into 2017

That improvement in investor confidence is matched by a boost in consumer confidence, which reached the highest level since July 2007 at 107.1 according to The Conference Board. The economy has shown steady improvement throughout the year, with quarterly annualized real gross domestic product (GDP) growth moving from 0.8% in the first quarter, to 1.4% in the second, and 3.2% in the third according to the Commerce Department. And the most valuable asset for most Americans continues to increase in value.

Home prices continue to rise

Home prices continue to rise

Source: FactSet, Standard & Poor’s. As of Dec. 5, 2016.

Also bolstering consumer confidence has been strong labor market data. Jobless claims remain near historic low levels, 178,000 non-farm payroll jobs were added in November, and the unemployment rate declined to a nine-year low of 4.6%. We saw a surprising pause in the rise in average hourly earnings (AHE), but we believe that to be an anomaly as the Atlanta Fed Wage Growth Tracker—arguably a better measure than AHE as it eliminates “mix shift” problems—shows much stronger wage growth.

Consumers appear to be making more money

Consumers appear to be making more money

Source: FactSet, Federal Reserve Bank of Atlanta. As of Dec. 5, 2016.

We are also seeing improvement in business confidence. CEO confidence according to ChiefExecutive.net rose 10.8% in the weeks following the election; while the Institute for Supply Management (ISM) reported their Manufacturing Index rose to 53.2 from 51.9, and their Non-Manufacturing Index rose to an impressive 57.2 from 54.8.

Of course there are always concerns about what could derail the momentum in the New Year and one of main issues has been the strengthening in the dollar, which could impact profits for those companies that do business overseas, while also tightening financial conditions more broadly.

Will a stronger dollar derail the rally?

Will a stronger dollar derail the rally?

Source: FactSet, Intercontinental Exchange. As of Dec. 5, 2016.

One important factor to consider is why is the dollar strengthening? Is it because of a flight-to-quality in a fear-based environment, or because the U.S. economic prospects are better than those elsewhere around the world? We believe this time around is due to the latter, and that tends to bode relatively well for stocks historically. According to data compiled by Strategas Research Partners there have been eight sustained periods of dollar strength over the past 25 years. Of those eight, U.S. stocks (S&P 500) posted gains on an annualized basis in seven of them, while they outperformed international developed stocks (based on the MSCI EAFE Index) in six of the eight periods. History doesn’t predict the future but it can lend some perspective and leads us to believe that a stronger dollar won’t necessarily derail the bull market.

Fed set to raise rates, while expectations are high for Washington

Part of the reason for the rise in the dollar is the near 100% chance, according to the futures market that the Fed will raise rates at its meeting ending on December 14th. Perhaps more interesting than the decision on rates will be the accompanying statement and subsequent press conference, at which the pace and magnitude of future hikes will be discussed. We still believe the Fed plans to move gingerly, but there is the potential that rising inflation pressures could accelerate the pace of rate hikes.

The incoming Trump administration is moving full steam ahead, with a focus on tax reform, regulatory rollbacks, and health care changes. Part of the recent equity rally and spike in bond yields is likely due to high expectations for this fiscal stimulus. Of course the devil will be in the details and it’s important to remember that campaign promises often change when exposed to the realities of Washington. Not only could the scope and pace of change be less than expected, some of the more economically-damaging campaign promises—like protectionism and tariffs—could rise up the priority spectrum in 2017.

Will global political momentum carry over—and how much could it matter?

One of the most memorable aspects of 2016 was the global wave of populist political outcomes, including Brexit, the U.S. election and the Italian referendum. It would be easy to extrapolate this trend to 2017. After all, the 2017 elections in France (May) and Germany (August-October) are likely to feature anti-establishment candidates that, if elected, could usher in a movement to leave the European Union (EU). An exit by a core country could spark a financial crisis in Europe and beyond given the debt imbalances in some of the peripheral countries.

Fortunately for investors, the elections in 2017 don’t appear to be all that close. While we have all learned not to trust the polls, in Germany the difference is not a matter of a few points. German Chancellor Angela Merkel’s party has a wide 10 point lead over the establishment opposition, and a huge 20 point lead over anti-establishment parties. So while polls didn’t tell us much about the outcomes of 2016’s close votes, 2017’s votes don’t appear likely to be close. And polls also show a sizable majority of people in France and Germany are not in favor of leaving the EU, regardless of the election outcome.

The most relevant takeaway from 2016’s votes may be the market reaction, not the political outcome. The votes in Europe in 2017 may actually favor traditional parties and establishment candidates, which may mean the risk of another global financial crisis is relatively low. However, that doesn’t mean European stocks will be immune to investors’ fears. Stock markets generally “sold the rumor and bought the news” in 2016, meaning they weakened before the vote only to rally after the outcome was known, as you can see in the chart below. That means stock valuations could come under pressure in Europe leading up to the elections—even if stocks rally afterwards.

Stock markets slumped leading up to key votes then rallied

Stock markets slumped leading up to key votes then rallied

Source: Charles Schwab, Bloomberg data as of 12/7/2016.

Another important feature of 2016 was the turnaround for the global economy. After a weak start to the year, the global leading economic indicators tracked by the Organization for Economic Cooperation and Development (OECD) have picked up in the second half of the year, and the global manufacturing purchasing managers index continued a rise to a 27 month high in November, as you can see in the chart below. In fact, the OECD—the first international economic organization to update economic forecasts since the U.S. election—upgraded its 2017 forecast for global economic growth, including upgrades for the United States, Europe, Japan, and many other countries. Unlike a year ago, the global economy is accelerating as we head into 2017.

Global manufacturing sentiment has rebounded

Global manufacturing sentiment has rebounded

Source: Charles Schwab, Blooomberg data as of 12/7/2016.

So what?

U.S. stocks have surged since the election gave control of Washington to the Republicans, which are perceived to be more business friendly. Some of that enthusiasm may have pulled some gains from 2017 into 2016, but we believe the economic momentum seen in the latter half of 2016 will continue into 2017. A compelling support for 2017 is investor flows into U.S.-based funds, helping to keep the bull market alive. The populist trend seen globally last year may not continue and investors should focus on market reactions in the face of political “shocks” and on the improving global manufacturing picture.

Lastly, please note that due to the Christmas holiday, the next Market Perspective will be published on January 13, 2017.

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