For the US, the second half of 2016 was a tale of two economies, with a strong domestic economy and weaker industrial sector. These trends are largely unchanged, but are now set against a very different political backdrop. While the impact of Donald Trump’s election as US president remains unclear, the improving economy should be supportive of US equities in 2017.
One economy, two inflation levels
Robust US consumer spending continues, with indicators showing encouraging data for areas such as retail, housing and auto sales. However, this sits alongside a relatively lacklustre industrial sector, driven by two factors:
- Weak export growth because of sluggish non-US economic activity and a strong US dollar.
- The collapse of the US energy sector, which followed the sharp decline in energy prices.
This split economy subsequently led to different levels of inflation in services and goods. As shown in the first chart below, service prices (which are largely determined by domestic economic conditions) have been rising around 3%, while goods prices (which are more a function of global economic conditions) have been flat or falling.
What this means for the Fed
The bifurcated nature of the US economy presented the US Federal Reserve (Fed) with a challenge: how to account for the fact that one half was growing at a rate better than expected while the other was showing the opposite trend. In response, the Fed chose to raise interest rates in December, while its rate-setters forecast further rises in 2017, contingent upon positive incoming economic data. We anticipate, however, that if additional rate rises do take place in 2017, these will be small and the ‘lower for longer’ scenario will remain intact.
Strengthening macroeconomic conditions
In a positive development, the two headwinds facing the industrial sector in 2016 have abated. Energy prices have rebounded, bolstered by the agreement between OPEC and other oil-producing nations to cut oil production. At the same time, the US dollar has weakened since the beginning of the year. This should lead to the industrial sector posting stronger growth rates in 2017, and in turn allow overall US economic growth to reaccelerate to a rate of 2%-2.5%, which we saw after the recession ended in mid-2009.
The Trump factor and policy uncertainty
The big change for the US has been in the political arena. President Trump’s bold proposed policies have already affected markets in anticipation of their implementation, but much remains uncertain.
If Trump’s fiscal policies were to be fully implemented, we could see stimulus reaching a level of around 3% of GDP, which may be problematic in the longer term. US unemployment is now below 5%, which is what most economists consider to be the economy’s natural rate. As the unemployment rate has moved further below 5%, wage growth has accelerated in a typical way. In past cycles, wage growth has accelerated every time the unemployment rate has fallen below 4%. If the economy does 3 indeed reach the 2%-2.5% growth rate, and there is a further 1%-1.5% of additional stimulus in 2017, the unemployment rate would likely continue to fall further, triggering a further acceleration in wage growth. This would result in a stronger economy in 2017 as consumers benefit from wage growth, but it may also cause the Fed to respond more aggressively than what the markets have currently priced in, by raising interest rates higher and faster.
Higher US interest rates would likely lead to higher bond yields, albeit within limits. Despite rising since the election, real yields have remained very low, at just above zero. This seems inconsistent with an expected economic growth rate of 2%-2.5% plus additional stimulus. These low yields are likely a by-product of policies implemented by other central banks around the world. Quantitative easing, by which central banks create money to purchase bonds, has directed vast volumes of money to the US Treasury market, driving bond prices higher and yields lower. While the US may have ceased its bond-buying programme, other markets, including the EU, have continued theirs. So while we can expect higher US Treasury yields, there will probably be a limit to how high they go, making them unlikely to pose a risk to the economic activity of 2017.
The costs of economic stimulus
Before the presidential election, the Congressional Budget Office had forecast that the federal debt-to-GDP ratio would increase over the next decade, reaching around 80% by 20251. However, if Trump’s proposals were fully implemented, that ratio would exceed 100% during that period2, reaching the same levels as in countries affected by the European debt crisis countries. If the growth in US debt continues along this trajectory, concerns about debt sustainability could increase over the next decade. This, coupled with a less favourable supply-and-demand balance within the Treasury market, could ultimately put upward pressure on yields. However, these are potential areas of concern that will have an impact beyond 2017.
The other key area of concern for the US economy is Trump’s policies on trade. There are currently trillions of dollars of goods that flow into and out of the US economy on an annual basis. Should significant tariffs on imports be levied, US consumers would lose purchasing power, while other countries could implement tariffs in retaliation. The result would be much higher prices for US consumers and so reduced consumer spending, as well as dampened export growth. Finally, there are well-entrenched global supply chains that rely on the relatively free movement of goods between countries. To disrupt those supply chains would no doubt have a negative impact on economic activity. Again, however, none of these outcomes are likely to play out in 2017, but rather in 2019 or 2020.
Realistic expectations
There are significant obstacles that President Trump would have to face should he push for his full proposed stimulus and policies. Firstly, many of the policies would require congressional approval, which is not guaranteed. Even if they were approved, it would then take time to implement them. For example, a large infrastructure spending package would take a significant amount of time to execute as projects have to be identified and resources mobilised. The same goes for trade policies.
A supportive backdrop for US equities remains despite uncertainties
The US equity market currently appears fully valued, with the price-to-earnings ratio at a level that has rarely been exceeded. As a result, we believe a reasonable expectation is for total return over the next 12 to 18 months to be driven by a combination of earnings growth and dividend yield.
Fortunately, with an economy that is improving, an industrial sector that is recovering and the possibility of corporate tax cuts, the outlook for US earnings is positive. In our view, it is also reasonable to expect solid earnings growth over the next 12 to 18 months and, if you factor in dividend yield on top of that, there is the potential for positive equity market returns as we go through 2017 and into 2018.
Ariel Spooner 