We started 2016 with the hope that it would be the year the economy normalized. But between the stock market pullback early in the year after the surprise Chinese devaluation; the political theatre surrounding the primaries and general election; the ongoing volatility in the oil market; and the sudden surge in the dollar, which hit exports and manufacturers, we never really seemed to get there.
As the year ends, however, and in the aftermath of the election, we may be finding that we are closer to normal than we thought. Despite everything, job growth continued strongly throughout 2016, bringing us very close to full employment. Wage growth accelerated; consumers are able to spend and increasingly willing to do so. Business confidence dropped but has since recovered—and is moving further into positive territory. Government may move from a headwind to a tailwind as fiscal stimulus and reduced regulations create the most favorable business environment we’ve seen in years. Even exports are adding to growth.
So, we now find ourselves in what can reasonably be called the new normal, but in truth it looks quite a bit like the old normal and will very probably act like it as well. As we look into 2017, I believe that the economy will finally really normalize, with normal employment conditions, normal interest rates, and normal markets. I expect growth to accelerate from 2016 levels to levels closer to what prevailed in the 1990s and 2000s—in other words, normal. The following constituents will fuel it:
- Employment is likely to continue to grow, albeit at slower levels than in 2016, as we get closer to what is considered normal employment.
- Housing is expected to appreciate at a level driven by constrained supply and a healthy growth in demand from household formation.
- Businesses may bring their investment back to normal as the energy sector stabilizes and the dollar steadies, albeit at a high level.
- Government spending patterns, now that the election is over and we have a unified administration, look likely to revert to growth.
As we get back to normal, the economy is poised for continued sustainable growth. All things considered, I expect to see economic growth of around 2.5 percent on a real basis, with the possibility of stronger results. With wage income growing at an accelerating rate, business investment poised to potentially rebound, and government spending growth potentially increasing, this figure appears both reasonable and achievable. Combined with inflation of around 2 percent for the year, nominal growth should be between 4 and 5 percent.
What Are the Risks?
For the economy, there are risks both ways. On the upside, if wage growth increases, consumer spending power could increase more quickly. If consumer borrowing were to pick up, spending could grow even faster. Business investment could respond to improving demand and rise more than expected. Local and state governments could increase investment and hiring more than expected.
On the downside, risks are primarily political. Here in the U.S., the Trump administration will have to come to terms with Congress over actions and priorities; while there is substantial overlap, there are also substantial differences. Abroad, changing U.S. policies will continue to rattle the world even as major players face their own internal challenges. China, for example, continues to grapple with an economic transition from investment-led growth to consumer-driven growth, which may be slower and will certainly use less in the way of commodities—with consequent damage to the economies of other countries. Europe continues to wrestle with the interests of the continent as a whole versus those of the nation states, most recently with the failed Italian constitutional referendum, which will potentially bring another anti-European party to the threshold of power. The French and the Dutch will be having their own elections as well. Any of these could result in systemic damage, with consequent negative effects on the U.S. economy and financial markets.
The other major domestic downside risk involves the effects of rising interest rates now that the Federal Reserve (Fed) appears to have restarted the increase cycle. It has been a year since the initial rate increase, but the Fed decided on December 14 to raise its target range from 0.25 percent to 0.5 percent to 0.5 percent to 0.75 percent. And expectations are for at least three increases in 2017. Should rates rise too far too fast, the economy could slow. The Fed is aware of this, however, and is determined to remain part of the solution rather than becoming part of the problem, so the most probable case remains very slow rate increases that support continued economic expansion.
For the stock market, 2017 could be quite exciting, in both a positive and a negative sense. I expect the U.S. equity markets to end the year with moderate appreciation from current levels at the end of December—around 2,400 for the S&P 500 as a base case. On a relative basis, earnings growth should continue to improve after moving back to positive growth in the third quarter; earnings may also benefit from a reformed corporate regulatory and tax system. With the potential for faster earnings growth, valuations may expand over the year, although expansion may be limited, as we start the year with pricing already high. Another headwind for potential multiple expansion is the expected rise in interest rates, making bonds more attractive as an investment and lowering the present value of the slowly growing earnings stream even more.
There are certainly risks to the market on the downside. Valuations are high—higher than they were in 2007, for example. Profit margins are close to historic highs, and the tailwinds that got them there are disappearing as wage growth continues to pick up and stock buybacks stabilize or decline. Unlike in the real economy, market-related debt has increased back to 2007 levels and above. All of these factors will contribute to a more volatile market in 2017—which, however, is a return to normal. Absent the Fed’s security blanket, the market should be more volatile, and I believe it will be.
That said, there are also upside risks. With faster growth and rising consumer confidence, there is a real possibility of a shift in investor sentiment that could drive prices even higher. This “bubble effect” would drive valuations even farther above historic norms. Although this could certainly happen in 2017, it would only set the stage for a more severe adjustment later on.
Continuing to Get Back to Normal
2016 was the year that the U.S. economy continued to normalize despite considerable turmoil, both political and economic. From a fundamental perspective, we end the year with employment at normal levels, consumer spending growing steadily, and the Fed finally recognizing that normalization by raising interest rates. This normalization should continue, and even accelerate, in 2017. Low oil prices are likely to continue to support the global economy, allowing China and Europe to continue their recoveries over the year. This, in turn, will reduce the perceived risk level and potentially support global markets. As the economy normalizes, the Fed will continue to step back, which should lead to slowly rising interest rates.
Any interest rate increases will be constrained by the continuing policy and monetary stimulus in countries around the world, as well as by ongoing political turmoil in Europe and potentially in Asia. Low rates abroad will support U.S. growth, however, and the strengthening dollar will make the U.S. even more attractive as an investment destination. The U.S. continues to remain the primary global growth engine and stable haven, which should add more support to U.S. markets.
Although U.S. financial markets are reaching new records as the year ends, improving fundamentals and sentiment still support further potential appreciation from current levels. As of the end of December, continued improvement remains probable, with earnings growth likely to accelerate in 2017 and valuations anticipated to quite possibly increase, in general, with an improving economy. The outlook for foreign markets is more uncertain, however, as the effect of quantitative easing on those markets has been to increase valuations above historic norms, and both political and economic risks remain substantial.