The Week Ahead by JPMorgan Funds

New Year, Old Expansion

I ran a 5K up in Lowell, Massachusetts on New Year’s Day.  Arriving at the starting line, I was brimming with optimism and resolution.  I was motivated and the competition, close to a 1,000 assorted New Englanders, looked distinctly hung over.  The start of the race was slow due to the size of the crowd but as soon as it thinned, I’d turn on the burners….and then….nothing.

Oh, I finished the race OK and not much slower than I had run last year.  But for all my optimism and resolution, the truth is the machinery was just one year older, with a more pronounced rattle to the bones and rigidity to the muscles.

Many investors will have entered 2017 full of renewed optimism and Republicans, now fully in control in Washington, have a long laundry list of priorities they would like to tackle.  Deregulation, repealing the Affordable Care Act, cutting corporate and personal taxes, increasing spending on defense, infrastructure and veterans’ affairs, cracking down on illegal immigration and playing tough on trade are all on the agenda.

However, this New Year’s agenda will have to contend with the realities of an old and slow expansion.

The current economic expansion has just entered its 91st month and by March it will become the third longest expansion since the year 1900.  It has become a sort of “expansion emeritus”, gaining some grudging respect just by virtue of its longevity.  However, as in the case of many professors emeritus, it cannot at this stage be expected to display much vigor.

There is little pent-up demand for vehicles left, although there is room for the housing industry to continue to grow.  Inventories remain high while a strong dollar is sapping export demand.  Meanwhile, both productivity and labor force growth remains weak.  Without radical structural change, it will be difficult for this economy to sustain real GDP growth above a 2.0%-2.5% range.

Data due out this week should confirm this overall picture.  Light-Vehicle Sales, at about 17.7 million units annualized for December, should look healthy but would still be slightly down from a year ago.  International Trade numbers for November should confirm a significant weakening in the fourth quarter.  On a brighter note, Purchasing Managers’ Indices for the manufacturing and services sectors should look strong, but still not strong enough to indicate an upshift in economic momentum.

Friday’s Employment Report should tell a similar story, with solid payroll job gains of between 150,000 to 200,000, and a rebound in wage growth from a weak October.   However, we expect the unemployment rate to remain at a low 4.6%, highlighting the continued lack of supply of easily-employable workers.

Overall, our models are tracking an annualized real GDP growth rate of only 1.0%-1.5% for the fourth quarter, which, in turn, suggests productivity growth of just 0.6% year-over-year.  In other words, an economy stuck firmly in second gear.

Of course it may well be that less regulation, lower corporate and personal taxes and significant fiscal stimulus will boost demand.  It could also be the case that a relaxation in immigration laws or rising wages boosts labor supply.

However, for now, we still don’t know which regulations are likely to be repealed and, more importantly, we don’t know the extent of any possible cut in corporate taxes or the exact nature of any change in the structure of corporate taxation.  Without this information, many firms may postpone decisions to expand capital spending.  It could be that deficit hawks in Congress block significant fiscal stimulus.  It is also possible, given campaign rhetoric, that the incoming Administration and Congress reduces rather than increases immigration or becomes embroiled in a trade war.

For the moment, then, while equity markets have rallied on the assumption of stronger economic growth and higher corporate earnings, the economy itself may not yet be ready to deliver.

If I put in the miles and follow all the other items on my training agenda, I may well be running races faster in July than in January.  However, that is a fairly big “if”.  Similarly, if the incoming Administration and Congress can focus on those issues that help business grow, the economy later this year and in 2018 may well justify further gains on top of the recent stock market rally.  But that is also a big “if” and, for now, investors may be wise to curb their enthusiasm until we have stronger evidence that Washington will actually implement a pro-growth agenda.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Schroders 2017 Investment Outlook Series: Emerging Market Equities

Schroders’ Tom Wilson, Head of Emerging Market Equities, comments: 1) Emerging markets (EM) are supported by a cyclical recovery in some important economies and expectations for earnings growth have improved. 2) Furthermore, EM are generally under-owned and valuations are reasonably attractive. 3) However, uncertain global politics will potentially increase market volatility. (read more)

 

 

The Week Ahead by JPMorgan Funds

The Kindness of Strangers

Like Blanche DuBois, successful long-term investors can always rely on the kindness of strangers – strangers who, in financial markets, bid prices too high or too low as they give in to unwarranted enthusiasm or despair.  Over time, logic tends to reassert itself, rewarding those who bet against the prejudices of others.

With just two weeks left in the year, it appears that U.S. stocks are going to outperform international stocks in both emerging markets and other developed countries for the fourth year in a row, at least when measured in U.S. dollars.  Investors are always warned that past performance is not indicative of future returns.  However, judging by the behavior of markets in the last few weeks, this warning is falling on deaf ears, as U.S. stocks and the U.S. dollar have surged ahead since the election.  In short, it seems that global equity markets are pricing in everything that could go right in the U.S. and everything that could go wrong overseas.

In the United States, the now common rationalization for the post-election surge is that one-party Republican government will deliver economic stimulus, less regulation and lower corporate taxes.  All of this should boost after-tax earnings, justifying higher P/E’s today.

However, there are some potential problems with this viewpoint:

–First, it is doubtful that a new “stimulus” plan will significantly boost economic growth. President-elect Trump’s fiscal agenda has the potential to push the debt-to-GDP ratio above 100% by the middle of the 2020s, something that Republican deficit hawks, (including his choice for Director of the Office of Management and Budget, Mick Mulvaney) may not be willing to accept.  In addition, Chair Yellen, in her press conference last week, noted that the economy was essentially at full employment.  If so, the major effect of fiscal stimulus would not be to raise output but to raise inflation and the Fed might well feel required to offset it through tighter monetary policy.

–Second, while Republicans are agreed on the need for a lower corporate tax rate, there is significant disagreement between the Trump plan, which calls for a cut in rates within the current system of corporate taxation and the House Republican plan, which would require companies to include imports and deduct exports from their tax base while also disallowing the deduction of corporate interest payments. The end result of negotiations is highly uncertain.  However, any compromise that didn’t significantly reduce effective corporate tax rates would probably be less beneficial for stocks than the market is pricing in today.

–Third, the President-elect campaigned on a platform to limit illegal immigration and apply tariffs on imports from countries perceived to be taking advantage of the United States. Higher tariffs would clearly increase inflation while a crackdown on immigration could worsen an already growth-stifling lack of labor-force growth.  It may be too optimistic to assume that the Trump administration will only implement those parts of his agenda that favor the market.

–Finally, the U.S. equity market is no longer cheap. As of the close of business on Friday, the S&P500 was selling at 17.1 times future earnings compared to a 25-year average of 15.9 times.  While this is justifiable assuming continued below-average inflation and interest rates, these assumptions are beginning to be erode. By contrast, investors may be unreasonably negative on international stocks:

–The global economy is heating up. The flash Manufacturing PMI numbers for December suggest that this may have been the best month for manufacturing around the world in over five years.  Moreover, both Europe and emerging markets have far more room to grow over the next few years than the U.S. due to still-high unemployment in the former and stronger natural productivity growth in the latter.

–International stocks are generally cheaper. The forward P/E ratio of the MSCI-EAFE index of developed country international stocks is 14.7 times compared to a 25-year average of 16.4 times.  The price-to-book ratio of the MSCI-EM index is 1.40 times compared to a 25-year average of 1.67.

–The dollar is too high. In the third quarter, the U.S. ran a current account deficit of 2.4% of GDP.  We estimate that this should rise to roughly 3.3% of GDP by the end of 2018 or over $670 billion.  This growing deficit, combined with prospects for slower U.S. growth, should push the dollar down in the long run, amplifying unhedged international equity returns.

This is a time of year when many of us make resolutions for the year ahead.  When it comes to financial planning resolutions, two seem particularly relevant for 2017.  First, avoid home country bias – that is the tendency of investors around the world to be over-invested in securities of their own country.  Second, and even more important, when choosing what to overweight in a portfolio, don’t focus on past performance.  Instead, look at current valuations and future prospects.  These valuations and prospects suggest more reasons for caution around U.S. stocks and optimism around international stocks than investors have demonstrated over the last few years and particularly over the last few weeks.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Handing over the Paddle

There were no canoes on the Assabet this weekend, as a glaze of ice coated the surface of the meandering river.  In warmer days, though, when our sons were growing up, I’d often rent a two-man canoe and paddle upriver with one of them to the old North Bridge in Concord, before drifting downriver with the current back to the start.

Of course, the trick for a Dad in a two-man canoe is to sit at the back.  There you can make huffing and puffing noises while your son does all the actual work up front.  Sometimes, I would help move the boat forward.  On other occasions, just for fun, I would quietly paddle in the other direction, leaving the lad in front baffled at our lack of progress.

In recent years, monetary policy has been the lead paddler in the canoe of economic progress with fiscal policy actually dragging on the boat, as the federal government reduced its budget deficit from a huge 9.8% of GDP in fiscal 2009 to just 2.5% of GDP by fiscal 2015.  However, now there is a shift change in the canoe, with fiscal stimulus rising again and potentially surging in 2017 and 2018, depending on how much of Mr. Trump’s agenda is implemented.

In this context, the Federal Reserve will move to the back of the boat.  However, a crucial question for both the economy and investing is whether it will help the economy grow faster by sustaining short-term rates at very low levels or try to normalize rates as the economy speeds up, essentially applying some braking power to the effects of fiscal stimulus.

This is something the Federal Reserve will likely discuss, although probably not decide about, when it meets on Tuesday and Wednesday of this week.  Chair Yellen talks about uncertainty a great deal and in her press conference she will very likely say that the Committee felt it should wait to see how much fiscal stimulus is actually signed into law before considering a monetary response.

Having said this, economic numbers themselves will likely push the Fed into a first rate hike of 2016 this week.  Economic growth has strengthened after a slow start to the year with real GDP rising at a 3.2% annualized rate in the third quarter.  The labor market continues to tighten, as witnessed by the descent of both the U-3 and U-6 unemployment rates to expansion lows in November.  The OPEC agreement of late November combined with more recent sympathetic output cuts from non-OPEC members are boosting oil prices, which could be up at a double-digit year over year pace by January.  This, in turn, should cause the headline consumption deflator to hit 2% year-over-year by early next year for the first time since 2012, meeting a key Fed objective.

Economic numbers due out this week should not change this narrative. Inflation measures, including Import Prices on Tuesday, Producer Prices on Wednesday and Consumer Prices on Thursday should all look relatively mild for November but seem likely to accelerate in December.  Similarly, Industrial Production could be weak for November.  However, the Markit PMI index along with reports on manufacturing from the Philadelphia and New York Federal Reserve banks for December should look strong.  Retail Sales should also have built on recent gains in November while a fallback in Housing Starts should reflect an unsustainable surge in October rather than any genuine weakness.

Given all of this, a Fed rate hike does seem likely.  In addition, new forecasts could slightly upgrade estimates of economic growth for 2017 and 2018 while cutting forecasts for the level of the unemployment rate.  Still, unlike financial markets which seem willing to assume major policy change, the Federal Reserve is likely to sound dovish.

It may be that a relatively dovish tone in the FOMC statement and Chair Yellen’s comments help stem the recent losses in the bond market and recent surge in the dollar.  The Fed probably doesn’t appreciate either and won’t want to exacerbate the situation by letting its rhetoric get ahead of its actions.

Having said this, the pieces of major stimulus are falling into place.  Proposals to cut corporate taxes and the elimination of the estate tax and the tax on net investment income used to fund the Affordable Care Act are very popular among Republicans and they will likely want to seize the opportunity to enact them while the political and economic winds are still favorable.  There is equal enthusiasm among Republicans to fund greater defense spending.

However, these proposals are unlikely to be enacted without broader cuts in income taxes and the greater spending on veterans, child care and border security promised by Mr. Trump on the campaign trail.  All of this cannot possibly be done in the context of a deficit neutral approach and once the principal of deficit neutrality is breached – well, there is an old Irish saying – “you might as well get hung for a sheep as a lamb”.

If this plays out, then, while deregulation and lower corporate taxes could boost productivity somewhat, the net effect of fiscal policy changes will be to increase demand in the economy more than supply.  This being the case, it may well be that the Fed feels the need to apply some braking power to the economy to both reduce the risk of overheating and rearm itself for the next time it feels the need to deliver monetary stimulus.

In other words, if the federal government is paddling too hard in the direction of stimulus, the Federal Reserve is likely to begin to paddle more aggressively in the other direction suggesting more rate hikes in 2017 than it currently projects or even may be willing to forecast this week.  For investors, regardless of a dovish tone from the Fed and uncertainty about fiscal policy, the ultimate direction of policy is still likely to mean stronger growth, higher inflation, higher interest rates, and higher stock prices in 2017, justifying a continued overweight to stocks over bonds.

David Kelly
Chief Global Strategist
JPMorgan Funds

Schroders QuickView: Renzi’s Resignation

By Azad Zangana, Senior European Economist & Strategist at Schroders:

Italian Prime Minister Matteo Renzi is set to resign after losing his referendum on constitutional and voting reforms. Having staked his political career on the vote, the larger-than-expected defeat (59% vs. 41%) left him no choice but to announce his intended resignation.

Electoral reform is still needed
Renzi was Italy’s best hope of enacting badly-needed economic and structural reforms, and so his departure is a major blow for Italy’s medium to long-term outlook. The question posed in the referendum was related to voting reforms, which would have given the ruling party more power to enact legislative change. Italy’s equal system of power between the Chamber of Deputies (lower chamber) and the Senate (upper chamber) has created gridlock, and is a key obstacle to greater economic reforms.

Renzi’s government has already changed the voting system for the Chamber of Deputies to give additional bonus seats to the party that wins the largest number of seats; this is  designed to reduce the need for coalition governments. A “yes” vote in the referendum would have completed the reform process in harmonising the system in the Senate, and would have changed the Senate’s role to an advisory role of checks and balances – similar to the UK’s or Germany’s upper houses.

Instead, with the result of the referendum, Italy now has an incomplete and incompatible electoral system. This will need to be resolved before the next election in 2018, meaning that Italy’s next leader will be lumbered with this task instead of working on boosting growth.

Early elections unlikely
Italy’s president, Sergio Mattarella, will proceed to find a caretaker leader as soon as possible, in order to minimise political uncertainty. The favourites include finance minister Pier Carlo Padoan, senate speaker Pietro Grasso and economic development minister Carlo Calenda. All three would provide a safe pair of hands, although there is a chance that the president is forced to bring in a non-political technocrat (like Mario Monti in 2011-2013) if the two houses are divided on the candidate.

In any case, the risk of a snap election remains low. An early election could allow anti-establishment parties like the Five Star Movement or the Northern League to increase the share of seats they have. Both have gained popularity in recent years while advocating anti-austerity policy as well as leaving the EU and euro.

Worsening outlook as economic reforms are delayed
The change in leadership in Italy will mean a delay in the introduction of economic and structural reforms. Without such reforms, Italy is likely to remain stuck in a low growth deflationary dynamic. Its ageing population is a major headwind, while its cumbersome business rules and complex labour laws make it an unattractive place for multinationals to invest. Worse still is that a lack of growth puts the sustainability of Italy’s public finances at risk. Gross debt is the highest in Europe at 133% of GDP, and the debt servicing stands at 4% of GDP per annum. Should interest rates rise in the future, the government will have little choice but to implement more austerity, hurting growth further.

Market reaction subdued
So far, markets have been relatively calm since the result. This is because opinion polls had been flagging a defeat for Renzi for some time, and so investors have been reducing their holdings accordingly. The Italian FTSE MIB equities index is currently trading a little lower today, but year-to-date, the index has fallen just over 9%. This represents a substantial underperformance compared to the German DAX 30 (up 13.6%) or the French CAC 40 (up 13%) over the same period.

Meanwhile, the yield on a 10-year Italian government bond has risen by 0.139 percentage points to 2.035%. As with the equity market, Italian bonds have seen yields rise over recent months in anticipation of the result. While higher interest rates will increase the cost of borrowing for the government at the margin, the average interest rate paid by the government is still over 3% (due to debt issued when yields were even higher). Therefore, the rise in yield so far will not have much of an impact on public finances.

Italian banks in focus
Concerns over several Italian banks will persist. A high ratio of non-performing loans to equity is a concern, and one bank’s private sector bail-out could now be in jeopardy. This could result in a “bail-in” of investors before the government can step in to recapitalise the banks. The trouble is that many of these investors are actually ordinary retail customers, with little capacity to absorb losses. None of this will be easy to manage, especially if a lack of leadership persists for too long.

Pressure rises on ECB
One of the key reasons for the muted reaction in markets is the dampening effect of the European Central Bank’s (ECB) quantitative easing (QE) programme. The ECB’s ongoing buying of bonds (including Italian bonds) means that investors are less concerned about a sudden stop in demand. However, the ECB’s governing council will meet later this week where it is expected to provide an update on its outlook, and whether or not it will allow its QE programme to end in March 2017 as planned.

Given the events in Italy, the ECB’s QE programme has become more important than ever. Although not designed to bail out governments, if the ECB were to announce tapering of purchases, or an end to the programme, then investors could panic and sell their holdings of Italian government bonds. This could trigger a wider crisis in financial markets, calling into question the solvency of the Italian government and the fragile banking system. Fellow countryman and ECB president Mario Draghi will be under pressure to maintain QE for the time being.

Conclusions
Events in Italy mark a missed opportunity for the nation to follow the likes of Spain in successfully implementing growth-supporting reforms. The political uncertainty that will follow will be short-lived, but the new leadership will suffer from political paralysis until the voting system is fixed, and a new election takes place.

Even if the anti-establishment parties are fended off in the expected 2018 election, true economic reforms are unlikely to have an impact until 2020 or beyond. In the meantime, Italy will remain highly vulnerable to global shocks, and could easily fall out of favour with investors, especially once the ECB’s support is withdrawn as it inevitably will be at some point. More widely, this is the third major political upset in six months. Following Brexit, Trump and Renzi, attention will turn to the Dutch, French and German elections next year, where all three present more risks for investors.

The Week Ahead by JPMorgan Funds

Room to Run

The four weeks since the U.S. election have seen strong rises in both stock prices and long-term interest rates.  However, given the size of these moves, many investors are asking if markets have now moved too much or if both interest rates and stock prices have room to run further.

From an economic perspective, it is a close call.  There is a significant risk that single-party government will adopt too much fiscal stimulus at a time when the federal finances can’t afford it and the economy doesn’t need it.  Such a policy could overheat the economy, raising the risk of an eventual recession that would push both stock prices and interest rates lower.  Or it could be that, in the end, the American economy responds to more demand with more supply, allowing for stronger economic growth with continued low inflation.

The reality is that there is a great deal of uncertainty about the economic implications of this regime change.  However, regardless of economic implications, 2017 should see tax cuts, spending increases and Federal Reserve rate hikes as we transition to a world of easier fiscal policy and tighter monetary policy.  For investors it is important to appreciate that, even without studying their economic effects, the change in policies themselves favor stocks over bonds and more than justify the moves seen since election day.

For stocks, a lower corporate tax rate could significantly raise earnings per share.  In the absence of a corporate tax cut, we estimate that S&P500 operating EPS would have risen from $105 in 2016 to $117 in 2017, an 11% jump mainly reflecting a bounce-back in energy company earnings.  However, there is a significant chance that the federal corporate tax rate could be cut from its current 35% to either 20% or 15% as proposed by House Republicans and the President Elect respectively.

Assuming that it is cut to 20%, operating EPS, which is an after-tax measure, would receive a major boost.  The effective total corporate tax rate for the S&P500 (including state and local income taxes) is roughly 29% according to Standard and Poor’s.  This is significantly lower than the federal official rate due to various deductions taken by corporations.  Assuming a lower rate leads to fewer deductions, it may well be that a cut in the official rate from 35% to 20% would only reduce the effective rate from 29% to 19%.  However, even this would be enough to boost 2017 operating EPS to $134, assuming the tax cut was applied retroactively to the start of the year.

The S&P500 closed at 2,192 on Friday.  This represents a P/E of 18.7 times if 2017 earnings are $117 but only 16.4 times if 2017 earnings are $134.  Thus a corporate tax cut would imply that U.S. stocks are at roughly average valuations instead of being on the expensive side.  Moreover, given a lack of attractive alternative investments in fixed income or cash, this does suggest that the stock market rally has room to run.

For bonds, changes in fiscal and monetary policies should push long-term interest rates further.  For one thing major fiscal expansion would significantly increase the supply of Treasuries.  Moreover, it is unlikely that even this very dovish Federal Reserve will hold rates flat to accommodate fiscal stimulus.  More likely, the Fed will take the opportunity to gradually normalize monetary policy with a rate hike in December and potentially more than the two rate hikes the Fed currently projects for 2017.  Historically, higher short rates have triggered higher long-term rates, as investors continue to demand compensation for the extra risk of being in long-term bonds as opposed to holding cash.

In addition, it should be noted that Treasuries remain very expensive.  On Friday, the 10-year Treasury yield closed at 2.4%, up half a percent since the election.  However, since core CPI inflation is running at 2.2% year-over-year, this represents just a 0.2% real yield compared to an average real yield of 2.4% since 1958.  Given all of this, it is very hard to argue that the move in the Treasury market in recent weeks is overdone.

As we have argued many times in the past, the first few rate hikes by the Federal Reserve are unlikely to slow the economy in any meaningful way.  Consequently, the net impact of a policy shift to easier fiscal policy and tighter monetary policy should be expansionary.  Spending increases and tax cuts will likely boost growth and inflation far more than a few hikes in the federal funds rate could slow it.  If this is the case, the economic impacts of this policy shift should amplify the more direct implications of these policies for asset prices.

Numbers due out this week should demonstrate continued health in the U.S. economy and are unlikely to impact markets much.  Globally, markets will focus on the implications of a No vote in the Italian referendum, further evidence of a populist trend among voters in the United States and Europe.  However, a No vote was widely expected and shouldn’t, on its own, elicit a dramatic reaction.

More important in the short run will be next week’s Federal Reserve meeting and any hints from Congressional Republicans on their priorities for a fiscal package.  For now, however, investors should recognize that while uncertainty persists about the ultimate macro-economic implications of fiscal expansion and monetary tightening, the asset class implications of the policy shift are clear and both U.S. stocks and U.S. interest rates should have room to run higher.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Putting a Well-Done Steak on Broil

So how do you like your steak?  My wife prefers it on the “medium-rare” side while I’m a boring, straight-down-the-middle, “medium” guy.  Janet Yellen, judging by her recent comments lauding the virtues of running an economy hot[1], may like her steak “well done”.  However, a combination of very low interest rates and major fiscal stimulus in the eighth year of an economic expansion is the equivalent of putting a well-done steak on broil.

As for the current condition of the U.S. economy, data due out this week should confirm that it is already “well done”.  GDP, due out on Tuesday, should show an upward revision to third-quarter numbers, while Personal Income and Spending for October should show a healthy start to consumer activity for the fourth quarter.  Markets may pay some attention to retail reports over the Thanksgiving weekend, although changing holiday spending patterns may make Black Friday numbers hard to interpret.  November Light-Vehicle Sales, however, will be a little more tangible and look to be strong based on industry reports.  Finally, on the consumer side, the Conference Board’s Index of Consumer Confidence probably followed other confidence indices higher in November, as Americans finally put a miserable and very negative election campaign behind them.

Friday’s Jobs data will also be important.  Very low unemployment claims suggest the unemployment rate may have fallen back to 4.8% in November with healthy gains in both payrolls and wages.  In addition, Manufacturing PMI data should confirm nice momentum in industry in both the U.S. and around the world.

All of this should copper-fasten a rate increase when the Fed meets on December 13th and 14th.  However, it is very important to recognize that this rate hike and indeed the next few rate hikes in 2017 and 2018 are more likely to speed the economy up than slow it down.  A careful look at the transmission mechanisms between interest rates and aggregate demand suggests that the first few rate hikes from zero actually stimulate demand while further rate hikes from a higher level begin to undermine it. In other words, monetary policy will likely be stimulative for some time.

Other policy actions will also be important.  One decision out of U.S. control, which should come mid-week, will be whether OPEC has managed to cobble together an agreement to cut output and what cooperation they have managed to get from non-OPEC producers and particularly Russia.  While the potential for a surge in prices is limited by high inventories and the ability of U.S. shale producers to boost supply in response to better prices, some OPEC agreement would presumably prevent a repeat of the collapse in oil prices that has followed some previous OPEC get-togethers.

More important, however, for the economic outlook will be the smoke signals coming out of Washington (or rather Fifth Avenue) on President-Elect Trump’s fiscal policy.  Presumably, he will make further announcements on his economic team in the days ahead.  His appointments and particularly any statements from either the incoming administration or congressional leadership on a fiscal package will be very important to asset allocation in 2017.  Some reduction in capital gains tax is likely, even if limited to the repeal of the 3.8% investment tax used to fund part of the Affordable Care Act.  However, the extent of other tax cuts on corporations and individuals could have a major impact both on after-tax earnings and overall economic momentum over the next few years.

With the economy essentially at full employment, any fiscal stimulus could boost inflation as much as growth.  This would particularly be the case if aggressive action on trade and immigration were to result in higher tariffs and fewer workers.  Implementing the full Trump agenda, in an environment of low interest rates and full employment, would be the equivalent of putting a well-done steak on broil and could easily lead to too much inflation in 2018, followed by recession.

So far, since the election, markets have taken an optimistic view of Mr. Trump’s agenda and some parts of it, including lower corporate tax rates and less regulation, would clearly be investor friendly.  If the new administration and Congress agree to less stimulus and if higher tariffs are not imposed and if net immigration doesn’t fall and if the economy responds to more demand at least in part with more productivity and labor supply, and if the economy is not hit by any major unexpected shocks, then the outlook for U.S. stocks and risk assets in general over the next few years should be quite positive.  However, there are a lot of “ifs” in that statement, implying that investors’ apparent current optimism on all of this should be hedged by broad diversification across long-term assets.

 [1] Macroeconomic Research After the Crisis, Janet Yellen, 60th Annual Economic Conference, Federal Reserve Bank of Boston, October 14th, 2016.

David Kelly
Chief Global Strategist
JPMorgan Funds

 

The Week Ahead By JPMorgan Funds

The Wrong Time for Fiscal Stimulus

Two dice, rolled once, gives you a seven or greater 58% of the time.  But no one should be shocked to roll a six or less.

Going into last week’s election, the polls showed Hillary Clinton with a small lead.  However, given a lack of enthusiasm for her campaign, her difficulty in turning out the African-American vote in the same numbers as Barack Obama, and more general problems in modern polling, I thought it was about a 60/40 shot that she would win.  I wasn’t shocked when Donald Trump won – no one should have been, although many claim they were.

Many commentators, perhaps through a continual repetition of what is most likely, underestimate the uncertainty of any forecast. This also appears to have been happening in financial markets since last Tuesday.  The truth is, Donald Trump’s victory added a great deal of uncertainty to the market outlook.

Following Mr. Trump’s generally conciliatory victory speech in the early hours of Wednesday morning, U.S. equity markets rebounded along with the dollar while U.S. Treasury yields rose more rapidly.  Emerging market equities pulled back.  On net, the bottom line is that, for most investors, election week 2016 saw some nice stock market gains.

However, it is worth asking whether investors are, yet again, underestimating uncertainty.  There are at least three issues worth considering:

First, while Mr. Trump’s tone has been conciliatory since the election, his many changes of position during the election campaign beg the question of how aggressively he is going to pursue his stated agenda.

In a speech, delivered at Gettysburg in late October, he promised on his first day in office to direct his Treasury Secretary to label China a currency manipulator and announce his intention to renegotiate or withdraw from NAFTA.  He also planned to begin to build a wall on the Mexican border and start rounding up more than 2 million illegal immigrants with criminal records.  Needless to say, the Chinese, Mexicans and Canadians would not take kindly to any of this and an early, all-out trade war could have significantly negative implications for both the U.S. and global economies.

It may be that on these issues and others such as the Affordable Care Act or the Iranian Nuclear deal, the new President takes a much more pragmatic approach than he espoused on the campaign trail.  However, with such a wide range of issues, it is not certain that he will do so in all cases.  And, as with all new Presidents, it is also not clear how he might react to the various crises that will inevitably emerge on his watch.

A second uncertainty concerns the degree of cooperation he will get from Congress.  On the one hand, the Republican Party has never been more dominant in American politics.  They control the White House, the Senate, the House of Representatives, 33 of the 50 state governorships and 68 of 99 state legislatures.  Moreover, by avoiding confirmation hearings on President Obama’s nominee to the Supreme Court, they have ensured that at least five of the nine Supreme Court justices in 2017 will be Republican appointees.

However, many in the Republican establishment fought hard to try to ensure that Donald Trump was not their nominee.  Apart from personal differences with Mr. Trump as a candidate, they tend to be far more in favor of free trade and against big deficits than the President-elect.  Will they acquiesce to his agenda or try to water it down or block parts of it entirely?

A third uncertainty surrounds the impact of Mr. Trump’s fiscal policy proposals on the economy and financial markets.  These proposals are predicated on the idea that the U.S. economy is seriously underperforming its potential and is in need of a big fiscal stimulus.

However, there are two problems with this viewpoint.  First, the federal budget is already dangerously out of balance.  Second, the economy is already at full employment so that stimulus applied now is more likely to stoke higher inflation and interest rates than greater real GDP growth.

The federal deficit is already rising, growing from 2.5% of GDP in fiscal 2015 to 3.2% of GDP in fiscal 2016.  The Congressional Budget Office estimates that, under current law, the national debt will grow from 77% of GDP in fiscal 2016 to 86% in fiscal 2026.

However, in a September analysis of President-elect Trump’s fiscal plans, the Committee for a Responsible Federal Budget estimated that they would push the debt to 105% of GDP by 2026 if fully implemented.  Most of the cost of these plans comes from large proposed tax cuts for both corporations and individuals, although increased defense spending also has a sizable impact.

In recent years, low interest rates have reduced the interest cost the Federal Government has to pay on the national debt and have somewhat numbed investors to the serious long-term threat it poses.  However, it does not take a brilliant mathematician to see that if long-term Treasury rates return to more normal levels, financing this debt will absorb a much greater share of federal revenues over time.  In the 50 years before the financial crisis, the average interest rate paid on federal debt was 5.6% but the average debt-to-GDP ratio was just 37%.  A 5.6% average interest rate on a debt equal to 105% of GDP would be ruinous.

The truth is boosting the federal debt to these levels is fiscally reckless. Equally worrying is that this is a completely inappropriate time to engage in further fiscal stimulus.  The U.S. economy is, for all intents and purposes, at full employment.  The overall unemployment rate is 4.9% – lower than it has been 77% of the time over the past 50 years while the short-term unemployment rate is lower than it has been 98% of the time over the past 50 years.

Numbers due out this week should show continued momentum in both growth and inflation.    On the growth side, Housing Starts, Retail Sales and Industrial Production all likely produced solid gains in October.  With regard to inflation, Import Prices, Producer Prices and Consumer Prices will all likely see strong increases.

In this economy, a shock boost to aggregate demand through tax cuts would likely boost inflation and imports more than domestic production, since the U.S. economy is supply-side constrained.  Higher inflation and bigger deficits should lead to higher interest rates – particularly if the Federal Reserve perceives inflation risks as having risen and so raises short-term interest rates.

The American economy is more like a healthy tortoise than a sickly hare.  Immigration reform designed to increase skilled immigrants or policies that boosted productivity growth might give the economy the ability to run faster.  However, in the absence of this kind of supply-side effort, boosting aggregate demand to make the tortoise run faster would mainly result in over-heating.

In the short run, a pickup in inflation and growth could be positive for U.S. stocks.  However, in the long-run, resorting to extra fiscal stimulus from a heavily-indebted government in a full employment economy would be very dangerous.   While the theme of Mr. Trump’s campaign was “Put America first”, the clear investment implication of inappropriately stimulative U.S. fiscal policy is for investors to make sure they have enough invested overseas.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Investing Through the Noise

For U.S. investors, the sheer noise of our wretched election campaign is making it hard to focus.  Consumer confidence, as measured by both the University of Michigan and the Conference Board, fell in October despite generally positive numbers on the economy.  Moreover, investors are clearly behaving in a very cautious manner.  While cash holdings continued to swell across the economy, net flows into domestic equity mutual funds and ETFs in the first three weeks of October were -$28 billion, worse than in any full month in a year and a half.

No doubt the week ahead will be dominated again by election coverage.  However, for long-term investors it makes sense to focus on investment fundamentals which should take center stage once the election is behind us.  This is particularly the case since, while the election tone has been getting frostier, the economic numbers have been warming up.  There are five themes that are particularly important to consider:

–U.S. Growth has Accelerated:Friday’s GDP report showed a significant bounce back to 2.9% annualized growth in Q3 as the inventory headwind which has dragged on growth for over a year, finally turned into a tailwind.  Data due out this week, including Consumer Spending for September, Auto Sales numbers for October and PMI data for October, should all point to a solid start to Q4.

–Global Growth has Accelerated:Flash manufacturing data for the U.S., the Euro Zone and Japan suggest that October was the strongest month for global manufacturing growth in two years.  This should be confirmed by this week’s final PMI reports.  In addition, solid GDP reports from Taiwan and Korea last week support the idea of more East Asian growth following a strong Chinese GDP report two weeks ago.  Meanwhile, UK GDP numbers continue to show remarkable resilience in the wake of Brexit.

–The U.S. Labor Market continues to Tighten:Continuing Unemployment Claims last week fell to their lowest level in 16 years.  This Friday’s Jobs report should show continued strength, with roughly 200,000 payroll jobs added, the unemployment rate likely falling to 4.9% or lower and wages rising at an accelerating clip.

–The Earnings Season Remains very Positive:Through last Thursday, with 65% of S&P500 market cap reporting for the third quarter, a higher-than-normal 74% of companies had beaten earnings expectations compared to just 20% that had fallen short.  While the year-over-year earnings per share growth rate is likely to fall from the 14.5% pace it is currently tracking, we do expect overall operating EPS (as defined by Standard and Poor’s) to be up sharply from a year ago.

–The Fed Remains too Accommodative:
The Federal Reserve meets on Tuesday and Wednesday and is expected to leave the federal funds rate unchanged for the seventh time this year.  The economy has ticked all the boxes necessary for further Fed tightening – stronger economic growth, further labor market tightening, signs that inflation as measured by the Personal Consumption Deflator (due out on Monday) is heading towards 2% year-over-year, and generally stable-to-improving global conditions.  However, Fed officials will not want to inject themselves into the election campaign by making a surprise move, suggesting that “monetary normalization” in 2016 will mean the same as in 2015 – a single rate hike in December.  For investors, the net effect of this snail’s pace tightening is to limit the potential returns from cash and fixed income, thus increasing the attractiveness of global stocks.

Two weeks from today, election uncertainty will be behind us and market prices will likely be adjusting to a world of less uncertainty with better equity market fundamentals.  For long-term investors, however, logic suggests having the discipline to invest through the political noise before others position assets in the wake of our long and tortuous election.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Confirmation

Throughout this year, the case for U.S. equities has rested on some key assumptions:

–Economic growth would pick-up
–Corporate earnings would rebound
–Inflation would only rise slowly,
–Global economic growth would improve, and,
–The Fed would be cautious in tightening.

The week ahead should provide some confirmation of each of these assumptions.

On economic growth, Friday’s 3rd Quarter GDP report should show a significant acceleration to close to 3.0% growth compared to 1.4% in the second quarter.  If this transpires, it will mainly reflect the end of the inventory drag that has dogged GDP growth for more than a year.  However, it should also reflect solid gains in private demand and, most notably, a 2.5% gain in real consumer spending.  The GDP numbers should confirm that, in its 8th year, the U.S. economic expansion is still ambling forward.

The week ahead also represents the peak of the earnings season with 178 S&P500 companies reporting.  With just over a quarter of market cap reporting by last Thursday,  77% of companies had beaten expectations with only 5% falling short – a better-than-average result.  However, more importantly, these analyst expectations were not particularly conservative and it now appears we will see a solid year-over-year gain in operating earnings per share for the first time in two years.  As year-over-year comparisons on oil prices (and consequently energy-company profits) continue to improve, earnings per share should see further gains.  However, this week’s numbers should confirm that we are at a turning point.

Data out this week should be relatively comforting with regard to inflation and interest rates.  The GDP Deflator, due out on Friday, should show only a modest 1.6% annualized gain in the third quarter.  Meanwhile, the Employment Cost Index should be relatively benign, potentially posting lower year-over-year compensation growth in the third quarter than in the second.  Inflation pressures are rising, but this week’s data should confirm that they are only rising slowly.

Global economic growth, while by no means explosive, continues to edge up. Chinese GDP data last week were in line with expectations while flash PMI data for Europe and Japan this week should show solid expansion in global manufacturing at the start of the fourth quarter.  As the drag from weak commodity prices and a manufacturing inventory cycle fade, this week’s international economic data should confirm global improvement.

Finally, despite a relatively healthy prognosis for both the U.S. and global economies, the Federal Reserve will likely to leave rates unchanged at their meeting next week.  While the Fed may avoid mentioning the election at all, the reality is that to raise rates one week before a U.S. presidential election would add uncertainty to an already difficult political situation.  However, their statement next week should confirm both their intention to raise rates and their determination to do so slowly.

Despite all of this, the stock market has meandered in recent weeks, partly reflecting political uncertainty.  To put it simply, America is almost equally divided between those who support a candidate who asserts that the economy is far worse than implied by official statistics and those who are deeply worried about the consequences if he wins.  Neither side could be described as being confident and this will likely be reflected by a decline in the Conference Board’s Consumer Confidence Index, due out on Tuesday.

In our age of skepticism, confirmation is valued more highly than assumption.  This being the case, confirmation of positive fundamentals combined with a decline in uncertainty after the election should be positive for equity prices.  However, for investors, it is important to invest based on a reasoned assessment in the face of uncertainty.  Waiting for confirmation of a viewpoint usually means waiting beyond the point when you can profit from it.

David Kelly
Chief Global Strategist
JPMorgan Funds