Every new year begins with a mix of expectations followed by unexpected surprises. However, Donald Trump’s ascendancy to the U.S. presidency promises more than that – most notably, reform and upheaval in the country’s economic and social policies.
Trump faces an unusual conjunction of daunting prospects: a sluggish economy with millions of employment dropouts, a soaring greenback, a stock market promising to drop into bear mode and interest rates beginning a secular rise. All this could lead to disappointment in Trump’s early going.
The challenge is in figuring out what his administration can achieve in the short term to stimulate the U.S. economy and what policies will work in the long term. Specifically, Trump may be able to cut back the jungle of regulations that the outgoing Obama administration imposed that has hurt small businesses in particular. In addition, Trump promises to untangle Obamacare and the Dodd-Frank Wall Street Reform and Consumer Protection Act.
However, political promises sometimes founder on the rocks of practicality and feasibility. Change will take time, perhaps delayed by appeals to the courts by the shell-shocked Democratic opposition.
Meanwhile, economic growth projections are modest. The Federal Open Market Committee’s (FOMC) median real gross domestic product (GDP) annual growth forecasts for the U.S. are 2.1% for this year and 1.9% in 2018-20. Real GDP grew by 2.6% in 2015, but slowed to 1.3%-1.6% in the nine months ended Sept. 30, 2016, because of lower industrial production.
As well, after-tax corporate profits as a share of GDP are dropping. Profits peaked at yearend 2011 at 10% of GDP, hit a low at 7.6% in fourth quarter of 2015 and were just 8.4% in third quarter of 2016.
Inflation may not be a problem. Growth in consumer prices accelerated in 2016 to an estimated 1.1% vs a scant 0.1% rise in 2015, but the 2016 figure still is very low. Unless economic growth takes off, there’s little likelihood of inflation moving much higher than the U.S. Federal Reserve Board’s 2% target.
Furthermore, the Fed raised short-term interest rates in December. At the same time, a nine-year downtrend in bond yields was broken, with yields rising to 2.5% in mid-December from a low of 1.38% in July. A further rise in the 10-year bond yield to 3% and then to 4% would indicate the bond bull market, which began in 1981, has indeed ended. In its place will come a bond bear market, with bond prices dropping for the long term and yields rising. This could complicate the Trump agenda because of the bear’s initial negative impact on economic growth.
The U.S. dollar (US$), as measured by the Fed’s trade-weighted dollar index, moved sideways throughout most of 2016. Like the stock market, it took off after the presidential election, reaching a 13-year high. It was a parabolic rise, inviting a sharp reaction. As with the US$’s high in 2009, it reflected panic buying against possible collapse or devaluations of other currencies – in particular, the euro. This brought the US$ to a level that markets may not want to breach, potentially bringing a welcome halt to the surge.
Moreover, the bull market in stocks is old, as it’s now into its seventh year. The stock market’s post-election surge smacks of a final rise to a new high, as history shows that stocks usually drop in the first year of a new president’s mandate.
Stock market yields are low, at 2.1% for the benchmark S&P 500 composite index. Low stock market yields of this nature usually suggest modest market returns in the following decade.
Despite unimpressive earnings and sales growth, stocks are trading at very high price multiples. The S&P 500 composite index is trading at 26 times earnings – and 20 times earnings often marks a bull market’s peak. More dangerous, the S&P 500 industrial composite index (the S&P 500 composite index minus financial, utility and transportation stocks) is trading at 30 times earnings and four times book value.
Trump’s promise to invest in infrastructure boosted manufacturing stocks and the entire industrial sector. The new administration also favours the energy industry, the stocks of which also rose. As well, the rally in financials accelerated after the election.
Fundamentals reveal the sluggish, uneven progress the U.S. economy has made in the recent past. For companies in the S&P 500 composite index, annual sales growth averaged only 2% over the five years ended Sept. 30, 2016. However, the companies’ profit growth could not match this rate, as S&P 500 composite index companies reported their earnings grew by 1.1% a year during these five years.
At the end of 2016, consumer staples, consumer discretionary, health care, real estate and utility stocks were underperforming the broad market.
Taking into account economic, fundamental and technical considerations, S&P Capital IQ’s U.S. investment policy committee recommends overweighting consumer discretionary, industrials and materials and underweighting consumer staples, energy, real estate and utilities. IE
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