Slow, Steady Improvements for Economic, Corporate Profit Environments Expected in 2017

With the first quarter of 2017 behind us, it is both useful and entertaining to step back and take stock of what transpired over the
past three months. The start of 2017 was certainly much kinder to investors than the start of the previous two years given nearly all asset classes have produced steadily positive returns with many stock indices gaining greater than 5%. Depending on which media outlet one follows, this strong start to the year may or may not come as a surprise.

As we look back at the expectations voiced early in the year, there were some common overlapping themes. Below is a review of some of these widely-held assumptions and an evaluation of whether investors could have benefitted by positioning their portfolios accordingly:

Common themes entering the year:

1. Interest rates will continue rising sharply due to increasing growth and inflationary pressures.
2. An extremely turbulent political environment will lead to significant volatility in the market.
3. Financial, energy, and infrastructure-related sectors will continue out-performing as beneficiaries of the new administration’s policies.
4. Protectionist policies will lead to a rapidly appreciating dollar and hurt international economies and markets.

An assessment of how these predictions fared:

1. While the Fed again raised the benchmark Fed funds rate during their March meeting, the yield on longer-term bonds has actually decreased since the start of the year, reflecting a softening of inflationary expectations.
2. Volatility has been extraordinarily low in the markets. The 1% decline in the S&P 500 on March 21^st snapped a streak of 109 days without a 1% decline in a single trading day; the third longest streak of this nature over the past 36 years. Also, based on measures of average daily changes in price, the Dow Jones Industrial Average just finished the calmest quarter in 51 years.
3. Through the first quarter, energy and financials are two of the three worst performing sectors, while sectors expected to benefit from infrastructure spending (industrials and materials) also trail the broader S&P 500.
4. The U.S. Dollar has weakened slightly against most foreign currencies, while international emerging and developed market stocks are the top two performing areas of the market.

Through the first quarter, tactically shifting the portfolio based on these themes would not have helped investors. This is not to say the original expectations won’t eventually come true. It is simply another reminder to be careful when extrapolating recent trends and popular stories perpetuated by the media and tied to confident predictions of specific economic, political, or market developments. The majority of these expectations were directly linked to the anticipated policy changes the Trump administration would enact leading to over-confident declarations of the eventual winning and losing segments of the market.

The recent unwind of some of the so-called “Trump Trades” seems to illustrate the market taking notice that future policy and effect are not as clear as once thought. The difficulties faced so far in tackling campaign promises of immigration and healthcare reform are additional reminders of the uncertainty the future holds. The politically motivated who are declaring victory against the new administration should heed the same advice and be measured in drawing strong conclusions about how policy changes may unfold.

At McKinley Carter, we continually stress to clients the importance of avoiding the ‘noise’ of the headlines and urge them to instead focus on the underlying fundamental factors that drive the economy and markets.

• While traditional levels of valuations have become quite rich, when viewed within the context of dividend yields and low interest rates, markets appear fairly valued.
• Corporate earnings emerged from the recessionary trend in Q3 of 2016 and appear to be picking up momentum. Accelerating growth in this area will be key to sustaining this historic bull market.
• Interest rates, while higher than the lows experienced last summer, remain at extremely low levels. Future changes in rate levels and the reasons behind those movements will also be key areas we will monitor.

Putting these factors together, we see a slow but steadily improving economic and corporate profit environment, both domestically and around the world. Though with slightly elevated valuations and low interest rates, expectations of future market returns should be tempered.

Any healthy and sustainable increases in the market moving forward will likely rely on accelerating corporate profit growth. Managing risk will be critical — in both the portfolio and broader financial plan — as heightened risk for geo-political shocks remain. Properly constructed portfolios influenced by the bigger picture, objectives, and needs of the investor will be better prepared to navigate the clearly uncertain environment that awaits.