January 2017

Just over a year ago, the US Federal Reserve ended a zero interest rate policy which lasted seven years. Last month, the Federal Reserve made its second interest rate increase in 10 years (from ¼% to ½%). This one year interim between rate increases was the longest period between the first and second rate increases in an economic cycle. Interest rates on most savings and checking accounts will remain about zero percent.
Longer-term interest rates also rose during this past quarter and now exceed rates of a year ago. The 10 and 30 year US Treasury note and bond ended 2016 yielding 2.45% and 3.06% compared to 2.27% and 3.01% respectively at the end of 2015.

Historically, rising bond yields signal a growing economy and/or rising inflation expectations. 10-year US Treasury rates have had a positive correlation with the stock market when rates are below 5% and vice versa. This infers that as bond rates rise toward 5%, the stock market may rise.

ECONOMIC OUTLOOK: POLITICAL UNCERTAINTY SHIFTS OVERSEAS

Consumers, business leaders and the stock market do not like uncertainty. As the tumultuous domestic election, recounts and appointments conclude, uncertainty diminishes.

Jobless claims fell to the lowest levels since 1973. As the labor market tightens, voluntary job separations rise, signaling that workers can find higher paying jobs. Eventually, employers may need to provide raises to retain their best workers.
Tighter employment, wage increases, and increased wealth (via higher stock and home prices) have helped push consumer confidence to a new 15-year high. Business leader confidence tends to follow, which may finally lead to increased business investment and further economic growth.

Meanwhile, political uncertainty has moved overseas. The indeterminate timing of Brexit, recent loss of an Italian constitutional referendum, Presidential impeachments in Brazil and South Korea, Columbian rejection of a peace deal, various upcoming elections and active Russian troops add to international turmoil. The French President does not dare run for re-election while the German Chancellor may lose her position.

While uncertainty weighs on many foreign markets, some of these markets should eventually benefit as items are resolved.

FINANCIAL MARKET OUTLOOK: POTENTIAL EFFECTS OF GOVERNMENT CHANGE

The recent US election and resulting policy changes can have both positive and negative consequences for financial markets.

Lower personal and corporate tax rates could result in increased disposable income and corporate earnings, which in turn may boost spending. The related tax reform phase-out of deductions also has consequences. Lower deductibility of charitable donations could result in lower funding of non-profits. If mortgage interest deductions are removed, real estate activity and prices could be pressured.

The thought of lower tax rates has reduced the perceived tax-advantaged value of municipal bonds. The potential for faster growth of government debt and inflation pressures from a stronger economy can result in rising long-term interest rates, lessening the market value of fixed interest rate bonds. Some policy changes could take years to implement and affect the economy. Increased defense spending, new infrastructure projects and fewer regulations could benefit different industries in the future with limited short term impact in 2017.

Less immigration may result in a tighter labor market, rising wages and rising prices. Some crops could rot on the vine without cheap labor to harvest, leading to higher production costs.

Repatriating over $1 trillion of US corporate foreign profits at a low federal tax rate, would greatly help states which will not lower their tax rate. Bringing these funds back to the US may also further strengthen the dollar.

A stronger dollar, import tariffs and potential trade disruptions would have a mixed impact. A strong dollar could hurt exports as items produced in the US would be more expensive for those with weak currencies. A strong dollar makes imports cheaper, but this benefit could be more than offset by import tariffs and trade disruptions raising import costs.
As smaller companies are less global, they might not be hurt as much by these trading costs. Many larger companies are more dependent on global sourcing. For example, a Chinese assembled Apple iPhone may contain US software, Japanese memory, a Korean screen, Taiwan Wi-Fi and French sensors. Planes and cars have similar global sourcing. Global trade disruption or new tariffs could raise the cost of these items or lower corporate profitability.

During December, OPEC and others agreed to cut oil production resulting in higher energy prices. While this should increase overall inflation in 2017, the higher prices also encourage more domestic energy production. The resumption of domestic energy programs may reduce gas prices in future years.

FUTURE CHANGES: WHERE TO INVEST

While recent election results impact the economy, other overriding long-term economic trends remain significant. Technological advancements and healthcare innovation are creating some vast improvements and other dramatic changes, including making some products and businesses obsolete.

Demographics should also have dramatic long-term effects as retiring baby boomers are eclipsed by a larger generation, the millennials. The 80 million millennials in the US are already spending $600 billion annually. Some millennials spent the great recession years living in their parents’ basements. With prospects of better jobs and greater confidence, they might move out and start their own families. As baby boomers’ healthcare spending rises, broad consumer spending could be propelled by the millennials.

Global demographic trends are even more noteworthy. Within a decade, for the first time ever, over half of the world’s population will be consumers. Within global and domestic discretionary spending, there is a significant change from buying things to buying experiences, such as trips. For example, over the last four years, Chinese tourist outbound travel has tripled to about 70 million tourists spending $300 billion. Airlines, cruise lines, gaming companies and hotels are primary beneficiaries of this global trend.

Incorporating newer trends, rising inflation and interest rates together with current valuations result in a select assortment of diversified investment opportunities.

Investors should remain cautious of companies hurt by rising input costs, wage increases and higher interest rates. Overvalued stocks should also be avoided as expectations of some companies may be too high and their valuation multiples may decline.

While index funds still invest in companies with these warning signs, active portfolio management can focus on those stocks that benefit from current multi-year trends, including niche leaders in advertising, hardware, insurance and lithium.