- GDP possibly accelerating in H2 2016 to 2.5% - 3.0%; likely to revert to trend 2.0%+ in 2017
- Outlook dependent on the consumer continuing to spend; capital spending to remain weak
- Housing market anticipated to make steady progress helped by solid employment trends and low rates
- Despite the probability of a December Fed rate hike, tightening cycle to be the tamest on record
- We remain relatively positive on U.S. equities
Market & Economy
How is the U.S. economy performing this year? In this political season, it depends on who you ask and which data you look at. GDP remained sluggish in the first half of 2016 and averaged just 1.0% annualized for three consecutive quarters, including the final quarter of 2015. However, growth has perked up to approximately 2.5% - 3.0% in the September quarter. Overall, we have trimmed our full-year 2016 GDP growth forecast to a range of 1.5% - 2.0% growth from a prior range of 2.0% - 2.5%.1
On the bright side, employment is robust. For the first 8 months of the year, the U.S. economy added an average of 181,500 jobs per month, well ahead of the number needed to absorb new entrants into the labor force. Job openings are near record levels and weekly jobless claims, a leading indicator, are hovering near record lows.
Personal income is also moving in the right direction. Real incomes grew 5.2% in 2015 and real disposable income was 2.7% higher in July 2016 over the prior year, as low inflation boosted purchasing power.2 Wages are also gaining traction, as employers compete for skilled workers and minimum wage increases help those on the bottom rung.
Consumer balance sheets have improved as well. Household net worth increased by over $1 trillion to a record $89 trillion by end of the second quarter 2016.2 Debt service relative to income remains near a multi-decade low. The savings rate at 5.7% is lofty by historical U.S. standards.
These positive trends should allow for continued growth in consumption, which is the largest sector of the U.S. economy at close to 70% of GDP. Consumer confidence hit a post-recession high in September, and consumer spending should grow at around 3% for the balance of the year. Businesses should need to restock inventories drawn down in recent quarters, giving a further boost to GDP. Lastly, low interest rates, changing demographics and short supply suggest that the positive housing cycle has room to run.
Although the consumer is thriving, manufacturing continues to struggle. Capital spending and business investment remains soft. Given tepid global growth, exports are weak and trade remains a drag. Yet even these headwinds seem to be abating to some degree. The dollar, which surged during 2014 and 2015, has been range bound in 2016 and has even weakened modestly to date. Recent trade data, while still deep in the red, has improved. In the energy sector, with oil prices well off their lows, drilling activity appears to have bottomed at long last. While no quick turnaround is apparent for either exports or energy, the worst is likely behind us.
Another sector, often overlooked in importance these days, is government. After the initial stimulus, government spending was missing in action for much of the recovery. State and local governments are generally on a sounder footing today as tax receipts have recovered, although long-term pension issues still lurk. At the federal level, the 2015 budget compromise allows for modest increases in both domestic and defense spending for both 2016 and 2017. Even limited improvement in these lagging sectors should allow 2017 GDP growth to return to a trend of 2.0% - 2.5%.
Qtr./Qtr. Growth Annualized
Finally, major overseas economies are growing - just not fast enough. GDP in the much-maligned Eurozone has advanced this year and growth is anticipated to be in the 1.5% - 2.0% range in 2017.3 The rising Yen is a major headwind to Japan’s export-dominated economy, and we think further stimulus could emerge in 2017. Thanks to the uncertainties of Brexit, GDP is expected to trail off in the U.K. but should remain in positive territory. Of greater importance, China appears to have averted a hard landing as growth edges lower toward a more sustainable level. Overall, however, global growth is likely to remain sluggish in the vicinity of 2.5% - 3.0%.3
Financial conditions remain broadly supportive of the economy and markets. The timing or even necessity of the Federal Reserve’s next rate increase has been the subject of endless debate. Federal Reserve officials have stated that the case for tightening has strengthened, but despite the hawkish tone, the Fed elected to stand pat at its September meeting. Should the Fed tweak the Fed Funds rate at its December meeting to a range of 0.5% to 0.75% as we expect, an entire year will have elapsed since the previous rate hike.
If so, it appears that we are on track for the gentlest “tightening cycle” in history. At the beginning of the year, investors expected four rate increases in 2016 and stock and commodity markets swooned. Now, there will be just one increase this year at most. The Fed’s own projections for the level of the Fed Funds rate at the end of 2017 and 2018 have fallen sharply, anticipating only two rate increases in 2017 and three in 2018, bringing the rate to 1.9%. One year ago, the Fed consensus was for a Funds rate of 2.6% and 3.4% at year-end 2017 and 2018, respectively.4 Little wonder financial market volatility has ebbed. Of course, these projections remain subject to change.
Against this backdrop of rate stability, bond yields rose only modestly during the quarter as the yield on the 10-year Treasury note edged up to 1.6%. We expect the 10-year will conclude 2016 in the 1.75% -2.0% range, more than half a percent lower than when we entered the year. Bond yields are likely to continue to gradually increase, but benign inflation and continued expansionary central bank policy overseas will result in a ceiling on yields here at home.
With only a slight increase in anticipated Treasury yields, fixed income investors remain challenged to find returns. With inflation unlikely to hit the Fed’s 2% target until 2018, the real, inflation-adjusted return on Treasuries is minimal. Furthermore, credit spreads have contracted during 2016. The spread over Treasuries for high yield bonds peaked early in the year at 8.4%.3 It is now below 5%, while economic fundamentals do not appear to have materially improved. Spreads have also declined for investment grade debt. In short, the asset class is not especially compelling and we remain focused on quality and liquidity within our fixed income sectors.
Given the uninspiring outlook for bonds, equities are likely to remain in favor. Income investors may continue to find the 2.1% dividend yield of the S&P 500 index attractive, as it exceeds the 10-year Treasury yield by 1⁄2% and offers an income stream that is likely to grow. Looking ahead, we estimate high single digit earnings growth for the S&P 500 in 2017, driven more by the tamer dollar and steadier energy prices rather than a surging economy. Valuation is not inexpensive at 16.7x 2017 earnings, which exceeds the historical average.3 However, under our current interest rate and inflation forecast, the price/earnings multiple could actually expand, extending the life of an aging bull market. Because of currency and political risk overseas, our weighting preference for U.S. equities remains in place.
The preeminent risks in the near term remain political and geopolitical. The anti-free trade view expressed in many election campaigns around the world this year, including in the U.S., may prove to be a winner politically but could threaten global growth. While the fallout from Brexit was overhyped, uncertainty has slowed investment in the U.K. and the growth outlook there is considerably diminished as a result. Conflict in the Middle East remains a concern, as do flash points in North Asia and the South China Sea. We note that global growth of 2.5% - 3.0% is subpar and close to a level that is considered recessionary, raising the economic risk from unexpected surprises.
The U.S. election is another potential source of market instability. The consensus view is that investors would prefer a Clinton victory, i.e. a continuation of the status quo as it is presumed that Republicans will retain control of the House, if not the Senate. We do not regard this as a matter of policy, ideology, or even temperament. With the bull market now in its eighth year, markets have grown quite comfortable with divided government. For better or worse, gridlock in D.C. has produced excellent investment returns. A Trump win would heighten uncertainty and markets would likely respond accordingly.
In financial markets, investors have grown comfortable with the gradual path of tightening suggested by the Fed’s own interest rate projections. A more aggressive Fed trajectory could be problematic for both financial markets and the modestly growing economy. While the U.S. banking system is sound, undercapitalized European banks could become a greater issue for Eurozone growth projections.
Lastly, our optimistic view of the U.S. economy is predicated on solid growth in consumer spending. While we believe that conditions remain supportive, there is no guarantee.
Employment and retail sales will be key data points in assessing the viability of our forecast. Even a slightly more expansionary fiscal policy would help allay some of the concern of overreliance on the consumer.
Cyber security Planning
Is cyber security topping your list of concerns? Not likely – you might know this needs attention, but cyber security probably doesn’t make your list until something happens. For instance you receive an aggressive phone call from someone who identifies themselves as an IRS agent saying pay up or be arrested, or an e-mail pops up with a suspicious looking link, or a letter from your credit card company arrives in the mail asking you to verify a series of purchases from places you have never been.
These communications are our “new” normal. So what should we do?
- First and foremost, be vigilant.
a. Review investment statements and credit card bills regularly.
b. Check your credit report at least twice a year to review your credit history, list of active credit cards and your credit score.
c. Always shred historical personal financial data and tax returns.
- Be cautious about where and how you connect to the Internet when accessing your financial data through public or third party WiFi, (particularly overseas). Public libraries, hotels, and restaurants may not have up-to-date security software.
- Use one secondary credit card for online purchases only. Review your statements monthly, especially if you do not receive paper statements and/or use an automatic payment program.
- Only make purchases from secure sites. When banking or shopping online, look for a padlock symbol on a page (that means it is secure) and "https://" at the beginning of the Web address (signifying that the website is authentic and encrypts data during transmission).
- Ignore unsolicited emails asking you to open an attachment or click on a link if you're not sure who sent it and why. Cybercriminals are good at creating fake e-mails that look legitimate, both at home AND at work. Opening these e-mails could install malware on your computer.
- Use the most secure process you can when logging into financial accounts. Create "strong" passwords that are hard to guess, change them regularly, and try not to use the same passwords or PINs (personal identification numbers) for several accounts. Understand the benefit of dual-authentication, which providers are increasingly implementing. This safety measure requires extra steps for you to log into accounts when do so from a different device for the first time. These steps include answering challenge questions or entering a code sent to your mobile device.
- Be discreet when using social networking sites. Criminals comb those sites looking for information such as someone's place of birth, mother's maiden name or a pet's name, in case those details can help them guess or reset passwords for online accounts.
- Be careful when using smartphones and tablets. Don't leave your mobile device unattended and use a device password or other method to control access if it's stolen or lost.
- Include children in your cybersecurity planning. Talk with your children about being safe online, including the risks of sharing personal information with people they don't know, and make sure the devices they use to connect to the Internet have up-to-date security.
- Be watchful across the generations. Look for telltale signs that your kids are being hacked or that your elderly parents are providing personal information to callers. Also, contact social security when someone dies to place the deceased's person’s social security number in their Deceased Master File.
- Know what your financial partners and custodians are doing to safeguard your personal information, and keep your advisor in the loop if you suspect that your personal data has been compromised. Your advisor will help by adding an alert to your accounts to notify providers and custodians to be on the look-out for suspicious activity. Fortunately, the ability for an imposter to access your managed funds is difficult due to the fact that there are multiple layers of security provided by both your advisor and the custodian of your funds.
Sources: (1) Washington Trust Wealth Management; (2) U.S. Bureau of Economic Analysis; (3) Bloomberg; (4) Federal Reserve of St. Louis
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.