The only things we forget faster than year-end prognostications by Wall Street pundits are people's New Year's resolutions to lose weight and exercise more. Yesterday, a former member of the Federal Reserve Board's Open Market Committee should have been ashamed of himself for cautioning on national television that today's optimistic market is analogous to the bullish sentiment greeting Reagan's election and might be just as short-lived. Although the stock market rallied from the election of Ronald Reagan in 1980 until his inauguration on January 20th, 1981, this former central banker warned viewers of this well-known financial news network that it declined 20% during the rest of 1981. What he forgot to mention was the fact that beginning in late 1979, Fed Chairman Paul Volcker had embarked on a policy of extreme monetary tightening in order to break the back of double-digit inflation, a legacy of the Carter Presidency and the Burns/Miller Fed. A steeply inverted yield curve precipitated the market decline and the brief recession which followed. Of course, this paved the way for a long period of declining inflation and a thirty-five year bull market in fixed income securities, which is now just about over.
To equate the circumstances surrounding the election of Trump to those of 1980-81 is shortsighted at best. First of all, low inflation caused by excess capacity and lack of demand is the major economic issue of the day. The yield curve from 2-year Treasury Notes out to 10 years has become progressively steeper since Trump's election, as in all likelihood, numerous pro-growth economic policies will be implemented over the course of the next year. Also, part of the reason for the rise in the yield of the 10-year Note since the election reflects the liquidation of bonds by yield hungry investors who have held on too long and are now running for the exits. Fear of inflation as a result of new growth initiatives is misplaced for several reasons. First of all, there is still ample slack in the labor force, as well as a steady flow of new entrants, and secondly, there is still vast excess capacity on a global basis. Moreover, it will be many months before tax reform, deregulation, increased infrastructure spending and higher defense spending are both authorized and implemented. At this point, no one knows the extent of the legislative compromises which will be required, because even amongst the Republican Party there are many strongly-held, differing viewpoints. As we assess Trump’s choice of advisors and Cabinet members we have become less concerned about a reversion to protectionism leading to trade wars and massive job losses. We do expect, however, some favorable renegotiation of NAFTA and our trade relations with China. In short, the Trump agenda should be viewed as a four-year plan, not a 100-day wonder.
The growth rate of GDP equals the growth rate of the workforce (adjusted for hours worked) plus the increase in productivity. The Bureau of Labor Statistics projects that between 2012 and 2022, the workforce will grow by only 0.7% annually, in large part due to the ongoing retirement of the baby boomers. Forecasting productivity growth is more problematic, but given the current operating rate in manufacturing, at 75% of capacity, it is unlikely that more than a modest pickup in productivity enhancing capital expenditures can be expected in the near to intermediate term. Moreover, there are headwinds with which the economy must contend next year including a strong Dollar, rising mortgage rates, increased corporate borrowing costs, and a higher oil price. Although wages are increasing at a modest pace, consumers are still deleveraging and spending at a pace within their incomes. Simply put, GDP growth in 2017 is likely to remain in the 2%-3% range, and inflation is not likely to reach the Federal Reserve Board's 2.0% target during the year.
Corporate profits, on the other hand, have begun a renewed upturn after six calendar quarters of decline. In recent years, the consensus earnings estimates for individual companies produced by Wall Street securities analysts have essentially mirrored the guidance disseminated by corporate managements at their quarterly conference calls or investor days. Few analysts are willing to venture forth with out of consensus forecasts. Accordingly, corporate managements have been understandably very cautious when giving out forward guidance in recent years, always hoping for an upside earnings surprise that will boost their stock prices. Not enough time has passed, nor have there been enough changes in Washington for managements to venture bolder forecasts for next year. Therefore, analyst estimates of 2017 profits are actually behind the curve at this time, which suggests that at nearly 2300 on the S&P 500 stocks are really cheaper than the 18 P/E ratio that current forward estimates imply. Moreover, if there is a large scale repatriation of profits trapped abroad, much of this will fund share buybacks and higher dividends.
Continued modest GDP growth accompanied by high single-digit profit growth and restrained inflation is likely to keep the Federal Reserve from tightening monetary policy next year, although a couple of boosts in the Federal Funds rate, bringing it up to 1%-1.25% should be expected. This will not significantly impede further gains in stock prices over the months ahead, although January is likely to witness some profit taking by individual investors, hoping lower tax rates will be enacted next year. By late 2017, and into 2018, if there is a meaningful surge in growth accompanied by rising inflation, that will clearly be troubling for the financial markets. However, those forecasters fearing an imminent, serious correction in equity values should relax and begin to reallocate their exposure to companies, particularly those domestically oriented, which will benefit from new economic initiatives.