February, 2017

2 shoes on feet facing in the direction of 2 arrows pointing opposite directions labeled 2016 and 2017 respectively

“It would be helpful to see fiscal policy play a larger role”

Janet Yellen March 29, 2016

During her Q&A remarks at a speech to the Economics Club of New York last year, Fed Chairperson Janet Yellen commented the Federal Open Market Committee (FOMC) had not gotten a lot of help from Congress in terms of fiscal policy. In 2017, that dynamic is poised to change as the FOMC expects to get more than a little help from Congress. This will be the big story for 2017.

In this our first edition of Market Monthly, we strive to provide broad market commentary with key themes that we see taking shape. For brief updates on current topics of interest, we will provide timely coverage through Market Spotlight.

Key Themes for 2017:

  • Global economic growth is improving and gaining momentum
  • Expansionary fiscal policy slowly takes the reins from extraordinary monetary policy
  • U.S. stocks will be driven by economic fundamentals
  • International stocks are becoming more attractive but the dollar matters
  • Bond returns will be tied to fed policy and tax-reform policy

Global Economic Update:

U.S.:  After starting 2016 with a whimper, gross domestic product (GDP) finished strong with momentum carrying into 2017. GDP is expected to grow at 2.2%-2.7% after growing at 1.9% in 2016. Enthusiasm about anticipated tax and regulatory reform must become policy to sustain recent improvement.

Japan:  Easy monetary and fiscal policy led Japan out of recession certainty in 2016. Japan is seeing better growth in part due to its weak currency and improving trade balance. They are in their sweet spot for this economic cycle despite highly unfavorable demographics.

Eurozone:  Concerns of deflation have turned to hopes of reflation in the European Union (EU). Its PMI (Purchasing Managers Index) of 55.1 in January reflects the best manufacturing sentiment in five years. Brexit, Trump and the Chicago Cubs have shown us anything can happen. Potential instability with upcoming French and German elections and an uneven recovery among EU member nations remain primary risks.

UK:  The U.K. has been surprisingly resilient, demonstrating broad economic strength despite the June Brexit referendum. Prime Minister Theresa May will trigger a hard Brexit in March by initiating Article 50 expressing their formal intent to exit the EU. Inflation remains a risk for the U.K. due to their weak currency and trade deficit status. Brexit negotiations will be crucial.

China:  China is rivaled by only the U.S. and the Eurozone in its share of World GDP. Last year GDP growth was aided by easier lending standards, which propped up real estate values. As standards tighten, this becomes a risk along with uncertainty about Trump’s trade policies toward China.

Bottom Line:  World GDP continues to improve with little risk of recession. Easy monetary policies will be aided by expansionary fiscal policies as reflation displaces deflation. The global economic growth we have seen has been balanced but cannot be called robust by any means. Global economic recovery raises the outlooks for global markets.

Fiscal Policy:

Great Expectations:  Tax reform and deregulation are expected to nudge the U.S. back toward a more normal business cycle in 2017-2018, adding as much as .5% to GDP growth. Though the Fed may be raising rates, policy remains in a low rate accommodative posture. Expansionary fiscal policies that encourage capital spending and infrastructure spending are vital to job and income growth. Three risks to fiscal policy reform are:

  1. Unexpected inflation could prompt the Fed to raise rates more aggressively than expected
  2. Protectionist trade policies could counterbalance the positive effects of tax reform
  3. Deep political divisions could dilute or delay the impact of meaningful reform causing Washington to overpromise but under-deliver.

It is likely that any positive economic impact to policies passed in 2017 will not be felt until 2018.

Corporate Tax Reform: Proposed tax-reform policies are thought to be a nudge for pro-growth corporate investment behavior and positive for corporate earnings. Deep corporate tax rate cuts are unlikely without corresponding limitations on the deductibility of corporate interest expense. A cut-rate repatriation tax on profits held overseas by U.S. corporations could be a welcome windfall that contributes to infrastructure spending, share buybacks, dividend increases or even special dividends by large tech companies. The more complicated and controversial Border Adjusted Tax (BAT) may struggle to gain traction even among House Republicans.

We remain mindful of the impact of these policies and will cover them in more detail as the debate begins in Washington.

Personal Tax Reform:  There are two plans for Personal Tax Reform:  The Trump Plan and the House Blueprint. Since more details are available on the House Blueprint, we will focus there for now.

Key Points:

  • Condense seven tax brackets into three (12%, 25% and 33%), lowering the top tax rate from 39.6%
  • Eliminate the alternative minimum tax
  • Raise the standard deduction from $12,600 to $24,000
  • Limit deductions for most items except mortgage interest and charitable contributions
  • Reduce tax on interest income, capital gains and dividends to half of investor’s tax rate

Bottom Line:  We remain hopeful that meaningful tax reform could generate corporate cash and promote capital investment, leading to economic growth. Markets will watch how quickly Washington can pivot by changing the recent debate to a clearer focus on tax and regulatory reform. Markets want it sooner rather than later. Expect renewed debate about the Federal deficit to re-emerge in March when the House/Senate unveils future budget projections.

Equity Update:

U.S. Stocks:  U.S. stocks are no longer rising and falling on the Fed’s tide. Instead, anticipated tax reforms and de-regulation are causing sectors and stocks to behave more independently based on their own fundamental merits. This bodes well for skilled active managers for the first time in several years.

Below we take a look at how tax reform may impact S&P 500 earnings.

BBT-perspectives-market-monthly-february-2017-equity-update-chart

Given that any new tax policy is months away, we show the highlighted area above as a sample base case for U.S. equities under two tax proposals expected to pass. Under this scenario, a cut in the top tax rate for U.S. corporations to 20% of domestic income coinciding with the elimination of interest expense deductions would result in an 8% increase in earnings for the S&P 500. Due to the fact that Small Cap stocks tend to be in higher tax brackets and do most of their business in the U.S., they stand to benefit even more than large companies. Tax-reform benefits all companies but especially small caps.

Key Points:

  • The S&P 500 is valued at the 89th percentile of historical valuations during the last 40 years (negative)
  • Trading sentiment remains in an “extreme optimism” position (negative)
  • Earnings continue to improve and are no longer in recession (positive)
  • Corporate tax reform should be accretive to earnings (positive)
  • Sectors positively impacted by tax cuts are those in high tax brackets (energy, telecom, consumer discretionary, utilities)
  • Sectors positively impacted by profit repatriation are those with high overseas sales (technology, materials, energy, industrials)
  • Financials are best positioned to benefit from rising interest rates
  • Improving fundamentals could make 2017 a comeback year for International stocks
  • A flat or declining dollar helps international stock returns for U.S. investors

Bottom Line:  We remain cautiously optimistic in our outlook for global equities. Improving economic and earnings fundamentals with pro-growth fiscal policy are the catalysts needed to advance this bull market past the eighth inning. High U.S. valuations and bullish sentiment (often a contrary indicator) give us near term concern. It is unlikely those two factors alone could cause more than a 3%-5% selloff. Risks to our positive outlook are:

  • Fiscal policy missteps could dampen the post-election market enthusiasm
  • Geopolitical uncertainties are known unknowns
  • Rising rates or protectionist trade policies could offset any benefit to expansionary fiscal policy

Bond Update:

We continue to favor investment grade corporate bonds and municipal bonds. Fed policy and personal tax reform are the two catalysts that will drive bond returns this year. We expect gradual rate increases to move us toward 2.75%-3% in the benchmark 10 Year U.S. Treasury Note by the end of 2017. In its proposed form, the GOP Blueprint Plan maintains the tax exempt status for municipal bonds. However, the proposed reduction in taxes on other interest income by 50% could cause investors to reconsider their bond strategy depending on the tax characterization of their investment income. This is something to think about proactively but is not something to be alarmed about. We will take a closer look at this once the debate on tax reform becomes more substantive.

BBT-perspectives-market-monthly-february-2017-Bond-update-chart

February, 2017

2 shoes on feet facing in the direction of 2 arrows pointing opposite directions labeled 2016 and 2017 respectively

“It would be helpful to see fiscal policy play a larger role”

Janet Yellen March 29, 2016

During her Q&A remarks at a speech to the Economics Club of New York last year, Fed Chairperson Janet Yellen commented the Federal Open Market Committee (FOMC) had not gotten a lot of help from Congress in terms of fiscal policy. In 2017, that dynamic is poised to change as the FOMC expects to get more than a little help from Congress. This will be the big story for 2017.

In this our first edition of Market Monthly, we strive to provide broad market commentary with key themes that we see taking shape. For brief updates on current topics of interest, we will provide timely coverage through Market Spotlight.

Key Themes for 2017:

  • Global economic growth is improving and gaining momentum
  • Expansionary fiscal policy slowly takes the reins from extraordinary monetary policy
  • U.S. stocks will be driven by economic fundamentals
  • International stocks are becoming more attractive but the dollar matters
  • Bond returns will be tied to fed policy and tax-reform policy
Global Economic Update:

U.S.:  After starting 2016 with a whimper, gross domestic product (GDP) finished strong with momentum carrying into 2017. GDP is expected to grow at 2.2%-2.7% after growing at 1.9% in 2016. Enthusiasm about anticipated tax and regulatory reform must become policy to sustain recent improvement.

Japan:  Easy monetary and fiscal policy led Japan out of recession certainty in 2016. Japan is seeing better growth in part due to its weak currency and improving trade balance. They are in their sweet spot for this economic cycle despite highly unfavorable demographics.

Eurozone:  Concerns of deflation have turned to hopes of reflation in the European Union (EU). Its PMI (Purchasing Managers Index) of 55.1 in January reflects the best manufacturing sentiment in five years. Brexit, Trump and the Chicago Cubs have shown us anything can happen. Potential instability with upcoming French and German elections and an uneven recovery among EU member nations remain primary risks.

UK:  The U.K. has been surprisingly resilient, demonstrating broad economic strength despite the June Brexit referendum. Prime Minister Theresa May will trigger a hard Brexit in March by initiating Article 50 expressing their formal intent to exit the EU. Inflation remains a risk for the U.K. due to their weak currency and trade deficit status. Brexit negotiations will be crucial.

China:  China is rivaled by only the U.S. and the Eurozone in its share of World GDP. Last year GDP growth was aided by easier lending standards, which propped up real estate values. As standards tighten, this becomes a risk along with uncertainty about Trump’s trade policies toward China.

Bottom Line:  World GDP continues to improve with little risk of recession. Easy monetary policies will be aided by expansionary fiscal policies as reflation displaces deflation. The global economic growth we have seen has been balanced but cannot be called robust by any means. Global economic recovery raises the outlooks for global markets.

Fiscal Policy:

Great Expectations:  Tax reform and deregulation are expected to nudge the U.S. back toward a more normal business cycle in 2017-2018, adding as much as .5% to GDP growth. Though the Fed may be raising rates, policy remains in a low rate accommodative posture. Expansionary fiscal policies that encourage capital spending and infrastructure spending are vital to job and income growth. Three risks to fiscal policy reform are:

  1. Unexpected inflation could prompt the Fed to raise rates more aggressively than expected
  2. Protectionist trade policies could counterbalance the positive effects of tax reform
  3. Deep political divisions could dilute or delay the impact of meaningful reform causing Washington to overpromise but under-deliver.

It is likely that any positive economic impact to policies passed in 2017 will not be felt until 2018.

Corporate Tax Reform: Proposed tax-reform policies are thought to be a nudge for pro-growth corporate investment behavior and positive for corporate earnings. Deep corporate tax rate cuts are unlikely without corresponding limitations on the deductibility of corporate interest expense. A cut-rate repatriation tax on profits held overseas by U.S. corporations could be a welcome windfall that contributes to infrastructure spending, share buybacks, dividend increases or even special dividends by large tech companies. The more complicated and controversial Border Adjusted Tax (BAT) may struggle to gain traction even among House Republicans.

We remain mindful of the impact of these policies and will cover them in more detail as the debate begins in Washington.

Personal Tax Reform:  There are two plans for Personal Tax Reform:  The Trump Plan and the House Blueprint. Since more details are available on the House Blueprint, we will focus there for now.

Key Points:

  • Condense seven tax brackets into three (12%, 25% and 33%), lowering the top tax rate from 39.6%
  • Eliminate the alternative minimum tax
  • Raise the standard deduction from $12,600 to $24,000
  • Limit deductions for most items except mortgage interest and charitable contributions
  • Reduce tax on interest income, capital gains and dividends to half of investor’s tax rate

Bottom Line:  We remain hopeful that meaningful tax reform could generate corporate cash and promote capital investment, leading to economic growth. Markets will watch how quickly Washington can pivot by changing the recent debate to a clearer focus on tax and regulatory reform. Markets want it sooner rather than later. Expect renewed debate about the Federal deficit to re-emerge in March when the House/Senate unveils future budget projections.

Equity Update:

U.S. Stocks:  U.S. stocks are no longer rising and falling on the Fed’s tide. Instead, anticipated tax reforms and de-regulation are causing sectors and stocks to behave more independently based on their own fundamental merits. This bodes well for skilled active managers for the first time in several years.

Below we take a look at how tax reform may impact S&P 500 earnings.

BBT-perspectives-market-monthly-february-2017-equity-update-chart

Given that any new tax policy is months away, we show the highlighted area above as a sample base case for U.S. equities under two tax proposals expected to pass. Under this scenario, a cut in the top tax rate for U.S. corporations to 20% of domestic income coinciding with the elimination of interest expense deductions would result in an 8% increase in earnings for the S&P 500. Due to the fact that Small Cap stocks tend to be in higher tax brackets and do most of their business in the U.S., they stand to benefit even more than large companies. Tax-reform benefits all companies but especially small caps.

Key Points:

  • The S&P 500 is valued at the 89th percentile of historical valuations during the last 40 years (negative)
  • Trading sentiment remains in an “extreme optimism” position (negative)
  • Earnings continue to improve and are no longer in recession (positive)
  • Corporate tax reform should be accretive to earnings (positive)
  • Sectors positively impacted by tax cuts are those in high tax brackets (energy, telecom, consumer discretionary, utilities)
  • Sectors positively impacted by profit repatriation are those with high overseas sales (technology, materials, energy, industrials)
  • Financials are best positioned to benefit from rising interest rates
  • Improving fundamentals could make 2017 a comeback year for International stocks
  • A flat or declining dollar helps international stock returns for U.S. investors

Bottom Line:  We remain cautiously optimistic in our outlook for global equities. Improving economic and earnings fundamentals with pro-growth fiscal policy are the catalysts needed to advance this bull market past the eighth inning. High U.S. valuations and bullish sentiment (often a contrary indicator) give us near term concern. It is unlikely those two factors alone could cause more than a 3%-5% selloff. Risks to our positive outlook are:

  • Fiscal policy missteps could dampen the post-election market enthusiasm
  • Geopolitical uncertainties are known unknowns
  • Rising rates or protectionist trade policies could offset any benefit to expansionary fiscal policy
Bond Update

We continue to favor investment grade corporate bonds and municipal bonds. Fed policy and personal tax reform are the two catalysts that will drive bond returns this year. We expect gradual rate increases to move us toward 2.75%-3% in the benchmark 10 Year U.S. Treasury Note by the end of 2017. In its proposed form, the GOP Blueprint Plan maintains the tax exempt status for municipal bonds. However, the proposed reduction in taxes on other interest income by 50% could cause investors to reconsider their bond strategy depending on the tax characterization of their investment income. This is something to think about proactively but is not something to be alarmed about. We will take a closer look at this once the debate on tax reform becomes more substantive.

BBT-perspectives-market-monthly-february-2017-Bond-update-chart

Sources: Ned Davis Research, Strategas Research Partners, Goldman Sachs Global Investment Research, FactSet, Morningstar

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.