Midyear Forecast: The Economy and Markets in 2017

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1 Midyear Forecast: The Economy and Markets in 2017 As we move into the second half of 2017, we find ourselves in a familiar place. Once again, as in 2016, we saw a weak first quarter and rising concerns that the economy was rolling over. And once again, we have seen stronger data in the second quarter, which should lead to another solid year for the economy and markets. Employment continues to grow, both consumers and businesses remain confident, and markets have responded by moving up around the world, even hitting new highs here in the U.S. The fundamentals remain sound from both an economic and a market standpoint, and at this point, it seems likely the rest of the year will show continued growth and market appreciation. There are risks, of course, but they are more political than economic. Even the real political risks, however, have not been as damaging as feared. Both the French and British elections, for example, failed to derail markets, and the political turbulence here in the U.S. has not prevented markets from reaching new highs. Strong economic fundamentals have allowed us to sail through the political storms, and this should continue to be the case. The big picture, then, is one of continued improvement through the rest of The economy should continue to grow, perhaps a bit faster than it did in 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 to rise. So, 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 remain near 2 percent. The Federal Reserve (Fed), encouraged by growth but limited by low inflation, will raise rates to 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 still growing, but more slowly The best way to analyze the U.S. economy is to go back to basics. Gross domestic product comprises consumer spending, business investment, government spending, and the net result of trade. We need to consider each separately. Consumer spending. Consumer spending growth requires two things: the ability to spend, which comes from jobs and wages, and the willingness to do so, which depends on confidence Marsh Road Securities and advisory services offered through Commonwealth Pittsford, NY Network member FINRA/SIPC, a Registered Investment Adviser. P: (585) Fixed insurance products and services offered through CES Insurance F: (585) Agency.

2 The number of jobs has continued to grow, albeit at a slowing rate. Although the decay in the job growth rate raises concerns about the future, based on historical trends, growth should continue through A growing number of employed people will enable spending to grow faster. Beyond the number of people employed, wage growth also contributes to the ability to spend more. As the labor market tightens, wage growth should remain at current levels of between 2.5 percent and 3 percent, per the chart below, or it could increase. Even the lower end of the range would support additional spending growth.

3 Overall, labor income growth, which includes both job growth and wage growth, has remained around 4 percent on a nominal basis, as seen in the following chart, indicating that the ability to grow spending is there.

4 The second part of the equation the willingness to spend depends on consumer confidence, which is doing even better than income growth. Confidence has risen to levels last seen in 2001, and although it has pulled back a bit from the peak, it remains at levels that historically have led to faster spending growth. Business investment. Business investment had been a weak spot, but that started to change in early 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.

5 Looking forward, business confidence, as measured by the Institute of Supply Management (ISM) surveys, has historically been a good indicator of investment trends over the next several quarters. Per the following chart, the recent gains in the combined survey of business confidence suggest growth could accelerate from current levels through the rest of the year.

6 Government spending. 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 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. Exports and imports. Finally, both exports and imports continue to expand. Over the past several years, imports have grown faster than exports, subtracting from economic growth. The most recent data, however, shows changes in trade in rough balance, taking this sector back to net zero from a negative in the second half of This should also help maintain economic growth.

7 For the economy as a whole, things look a bit slower than they did at the start of the year. Consumers are still spending, and businesses are investing again, but the decline in government spending looks likely to overwhelm any improvements. This should leave growth slightly slower for 2017 as a whole, at around percent on a real basis. This is consistent with past years and is, all things considered, a reasonably healthy rate. Slower growth has allowed a longer expansion, and at this stage of the cycle, faster growth would risk overheating the economy. Interest rate policy driven by stability 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.

8 The risk of low inflation and the dropping unemployment rate put the Fed in a difficult position. The Fed s actions are defined by a dual mandate of keeping employment high (but not too high) and inflation low (but not too low). Now, the low unemployment rate says start raising rates, but the low inflation rate says not yet. Which side will win? The Fed is now saying 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 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 level of around 3 percent at yearend. The risk here is most likely to the downside, but this seems a reasonable target.

9 Overall, the real monetary policy story of 2017 is likely to be that there is no story. Economic growth is steady, inflation is within a reasonable range, and the Fed s plans are consistent with that, so interest rate policy becomes driven by stability rather than change. We are not quite at normal yet, but we will continue to approach it through the end of Financial markets supported by revenue and earnings growth A growing economy and a normalization of monetary policy mean global stock markets are likely to continue to trade on fundamentals, such as revenue and earnings growth. 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 Revenue growth, in particular, has been strong, at levels last seen in the immediate recovery from the financial crisis.

10 Strong revenue growth should also support growth in earnings, with the rest of 2017 expected to be quite strong. High levels of consumer and business confidence historically drive valuations higher, which is what we have seen so far in As confidence levels moderate, however, we can expect valuations to drop back a bit, although they are likely to remain high by historical standards, as shown in the chart below.

11 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. This is usual when the underlying fundamentals are sound, and they are. The sound fundamentals should continue to support markets through 2017, perhaps driving them even higher. None of this is guaranteed, of course. 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. The biggest risk, at this point, appears to be the debt ceiling. This will require action by late summer, most likely. Should Democrats and Republicans be unable to agree, it could rattle financial markets. Even if we do get a debt ceiling face-off, or any of the other potential issues, known or unknown, the underlying strength of the economy is likely to limit the damage. We ve seen many situations in the not-so-distant past that were equally as scary and they didn t knock the economy or markets off their path. The biggest risk, given that strength, is that the expansion cycle has been much longer than usual, and the supporting trends are starting to decay. Still, based on history and current conditions, growth is likely to last through the end of the year.

12 While the risks are real, then, and growth will not last forever, the rest of 2017 looks likely to bring more of the same. More economic growth, slow but steady; more market appreciation, ditto; and more normalization across the board. After the turmoil in recent months and years, this is not a bad place to be. Disclosures: 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. 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. ### Authored by Brad McMillan, CFA, CAIA, MAI, senior vice president, chief investment officer, at Commonwealth Financial Network Commonwealth Financial Network