With 2016 coming to a close, we’re gratified that U.S. stock market returns for the year appear to be headed to better performance than most market strategists had predicted 12 months ago. At the end of 2015, we in the U.S. were in the midst of an earnings recession, were worried about the impact of an expected series of rate hikes, and were concerned about the impact of a struggling global economy. Perhaps as a testimony to the resilience of the free market system, U.S. companies have persevered and managed to provide rather healthy returns. In the meantime, events have unfolded that have made us more sanguine about the outlook now than we were a year ago.

ECONOMY – As we look ahead for the U.S. economy, we think that we’ll see an uptick in activity resulting in about 2.8% growth in GDP, which compares favorably to the 2.1% average we’ve seen thus far in the current economic expansion. We think this will be back-loaded in 2017 as a result of governmental stimulus spending hitting during that period. In addition, we think that expected deregulation of certain industries under the Trump administration could help expand availability of credit, and wage growth could result in increased consumer spending. At this point, we see a 0% chance of recession in 2017, which is down from the 20% probability we estimated a year ago for 2016.

Inflation is an issue that is getting more attention recently. As oil prices hit lows early last year, the prospect of higher inflation appeared distant. But as we enter 2017, the year-over-year comparisons begin to work against us. In addition, the lowering of the rate of unemployment to 4.6% brings into the picture the possibility of wage inflation. In the absence of significant productivity increases, wages seem primed to increase.

As for the global economy, overall we’re cautiously bullish. Like the U.S. economy, risks of a global recession are diminishing. With monetary policy remaining accommodative and fiscal stimulus programs expected to increase, we would expect stable to slightly faster growth in both developed and emerging economies. We think global growth will come in at about 3.4% in 2017. That said, we do see some risks in our outlook; subdued trade exacerbated by protectionist trade policies could impact activity. In addition, the political environment in Europe, a tenuous recovery in China, and the impact of each of these on emerging markets could throw sand in the gears.

CAPITAL MARKETS

FIXED INCOME – We have heard from several clients that they wish to avoid bonds, thinking that if rates rise their bond holdings will be hurt. While there are risks to be aware of, we think both rate and credit risks are being overestimated.

We divide bond markets into two general categories: rate sensitive and credit sensitive. Rate sensitive instruments are, in general, higher quality securities that present limited credit risk. For example, U.S Treasury securities are thought to have minimal default risk. Rates for these securities are highly correlated to economic growth and inflation, and we don’t foresee either spiking sharply higher.

Credit sensitive securities such as “high yield” corporate bonds are those whose values tend to be driven more by perceived default risk, and less so by changes in benchmark interest rates. We think that business and credit conditions will remain favorable, and will potentially improve.

So, as we move into 2017, we evaluate fixed income markets relative to expected changes in both interest rates and credit conditions.

In the area of interest rates, we think that they’ll move slightly higher through 2017 as markets and the Fed evaluate economic growth and inflation increases. We expect another two Fed rate hikes in 2017 (after the December 2016 hike), resulting in a Fed Funds overnight lending rate of slightly above 1% by year-end. Further out on the yield curve, we would expect the 10-year U.S. Treasury rate to reflect the higher rate of growth in GDP, coming in around 2.8% by year-end. We see no catalyst currently for significantly higher rates, and do not see rate increases as a significant risk.

As for credit sensitive bonds, we think that opportunities will still exist, as economic stability and growth mitigate default risks. As of the time of this writing, the yield spread between higher and lower quality bonds* is about 4.3%, slightly below its long-term average. At its extreme in February of 2016, that spread was 9.0%. This tightening of yield spreads indicates a level of comfort by the market in the ability of lower-rated companies to make good on their debt obligations. For individual investors, we continue to think an appropriate allocation to credit sensitive bonds makes sense heading into 2017.

EQUITIES – It has been stated that the current secular bull market is the least appreciated ever. That may be due to some extent to the impression that it has been driven by central bank policies. It may also be the result of investors who panicked in 2008 and didn’t participate in the recovery. Either way, this remains a bull market until proven otherwise. That said, we think that the next leg up will be based more on fundamentals and organic factors than on central bank programs.

The third quarter of 2016 represented a recovery to earnings growth on the part of S&P 500 companies overall, after six quarters of year-over-year declines. In spite of the drag placed on overall S&P earnings by the devastated Energy sector and a strengthening dollar, a return to earnings growth has been no small achievement. However, we think that at current market levels valuations are near their cyclical highs and present some risk. As we look ahead, while we expect a return to more average volatility early next year, we think that we can expect both earnings growth and overall equity valuations to increase in the high single-digits for the year.

Within equities, we think that a slight tilt toward the Value style in Large-Cap is practical. The earnings rebound mentioned above favors cyclical Value stocks that are leveraged to the economy. Lower current valuations, as well as breadth sector fundamentals also support this. To be sure, growth stocks have out-performed now for over 10 years. This is the longest stretch of growth out-performance seen. However, current fundamentals would favor this tilt.

We also favor a tilt toward small-cap and mid-cap equities. We recently invested in the Parnassus Mid-Cap Fund for many clients, and made a commitment to the Pax World Small Cap Fund about a year ago. We have benefitted from the recent burst in small-cap and mid-cap, so we are maintaining our current positioning. As we go forward, we will continue to evaluate this stance.

We recently established a position in the Energy sector. Price stability in oil along with cyclical economic improvements lead us to believe that the worst is behind us and that the intermediate-term outlook is positive. Valuations in the sector are improving, and the “upstream” segment of the industry (which historically responds to increasing oil prices) is showing signs of a rebound. We believe that energy will continue to improve in 2017, and an over-weight to the sector is merited.

Overall, we favor equities over bonds for the long term. Areas we are wary of include rate sensitive stocks, and would be cautious with areas that investors have recently been attracted to for their yields. We think that certain defensive sectors will be challenged in 2017, but will still warrant inclusion in a portfolio at a market weight or slightly less.

CONCLUSION – We think that trends are leaning bullish as we start the New Year, and that both the U.S. and global economies will improve in 2017, leading to a continuation of the already drawn-out economic expansion. Despite a couple of rate hikes, the Fed will largely remain accommodative in the context of an improving economy, longer-term rates should move only moderately higher, and credit conditions should remain stable or improve. Accordingly, we think that it makes sense to stay with this secular bull until such time as conditions begin to deteriorate.

As always, we enjoy hearing from our valued clients. If you have any questions about this or any other financial topic, please feel free to contact your Atlas Wealth Advisor.

ARTICLE WRITTEN BY:
John C. Ogle
Chief Investment Officer
View John’s Profile

* BofA Merrill Lynch US High Yield B Option-Adjusted Spread