This has been an eventful year, to say the least. Some of our readers will be glad to turn the calendar on 2016 and wish the year a hearty “good riddance,” whereas others are undoubtedly celebrating milestone accomplishments realized over the past 12 months. Regardless of your mood this December, as a year fraught with uncertainty, disruption and change comes to an end, we offer the following 10 reasons to be jolly this holiday season.
1. People have jobs.
Of course, not everyone has a job, and long-term unemployment remains an economic challenge, but the headline unemployment rate stands at 4.6% as of November, the lowest level since summer 2007. Unemployment for workers with a bachelor’s degree or higher is a mere 2.3%, indicating that 97.7% of the college graduates who want a job have one. The economy has added close to 15 million jobs over the past 74 months, the longest uninterrupted stretch of job creation on record since the Bureau of Labor Statistics started tracking monthly data in 1939. Initial claims for unemployment are at their lowest level since 1974. Despite repeated claims to the contrary, the labor market is in good shape. We believe that this strength will lead to wage growth acceleration in 2017, to the benefit of consumer spending, and therefore economic activity.
2. Housing prices have recovered.
Whereas the labor market is the primary driver of household income in the United States, the housing market is the primary store of household wealth. The collapse of home prices was the precipitating event of the 2008 to 2009 recession, and prices are just this year back to where they were prior to the onset of the financial crisis. The median price of a home in the United States peaked at $230,300 in July 2006 and only reattained that level in April 2016. The recovery has been modest but sustainable. As the accompanying graph shows, housing prices have risen at an annual pace of around 6% for the past several years – a rate of increase that shouldn’t lead to the excesses that triggered the last downturn. In 2017, we will see how higher interest rates affect the housing market. Our expectation is that the rise in mortgage rates will be gradual enough to allow the modest improvement in housing prices to continue.
3. Consumer confidence is rising.
Perhaps because of continued improvement in the labor and housing markets, consumer confidence has likewise risen to new cyclical highs. Confidence in the future (measured by the blue line in the accompanying graph) stands at levels not seen since summer 2005. The psychology of confidence is important to the economy: If rising incomes and wealth increase the ability to spend money, then rising confidence increases the willingness to do so. Personal consumption accounts for around 70% of gross domestic product (GDP), so confidence is more than a mere measure of psychological well-being: It’s a tangible indication of future spending. Importantly, the last two monthly surveys captured in the nearby chart were taken after the U.S. election.
4. Economic activity is improving.
If we broaden our economic viewpoint beyond the all-important domestic consumer, other sectors have been inconsistent contributors to GDP growth. Business spending has been hampered by regulatory uncertainty, net exports have been held back by economic weakness abroad, and government spending is constrained by budgetary challenges at the state and local level. In the third quarter of 2016, however, all four major economic sectors contributed to economic activity, driving annualized GDP growth of 3.2%. This marks the best quarter of growth since the third quarter of 2014, which was not coincidentally the last time that the economy was running on all four engines. Continued strength in personal consumption is critical to economic activity, but contributions from the other parts of the economy will help to accelerate activity.
5. Leading indicators point to continued improvement.
The Conference Board’s index of leading indicators implies that this economic improvement is likely to continue – at least for the near future. This index aggregates data from the manufacturing, labor, housing, financial, banking and consumer sectors to arrive at a forecast of near-term economic conditions. As the nearby graph illustrates, the measure has proved to be a reasonably reliable indicator of future economic activity. Historically, the index declines for an average of five consecutive months prior to the onset of a recession (shaded in gray in the graph). At present, the index is rising slowly, in keeping with a modest economic expansion, but has nevertheless expanded for 83 consecutive months and indicates that the near-term risk of recession is low.
6. The Federal Reserve is raising interest rates.
Gratitude may seem to be an odd response to higher interest rates, but investors should welcome a gradual return to more normal monetary policy. A very stimulative Fed policy that was originally a reaction to the sharpest economic decline since the Great Depression became standard operating procedure, to the detriment of savers, conservative investors and the ability of financial markets to effectively price assets. The Federal Open Market Committee (FOMC) voted unanimously to raise the target for the fed funds rate at its December meeting, citing a labor market that “has continued to strengthen” and economic activity that “has been expanding at a moderate pace since mid-year.” Furthermore, a poll of voting members of the FOMC indicates the likelihood of three more interest rate increases in 2017, which would bring the fed funds rate to around 1.25% by this time next year. This is, of course, no guarantee, as economic developments will continue to determine the pace and direction of interest rates, but we welcome the growing confidence in economic activity and the prospect of earning an appropriate rate of return on savings.
7. Bonds are beginning to offer more appealing returns.
The prospect of a more active Federal Reserve has propelled market interest rates higher as well. The nearby chart illustrates the rise in two- and 10-year government bond yields over the past five years, with a notable spike in the past several weeks. Since early November, the two-year yield has risen by 40 basis points, while the 10-year yield is up 74 basis points – remarkable moves in a relatively short period of time. This is partially due to the expectation of tighter Fed policy, but is also a reaction to the likelihood of higher government spending and rising deficits under the initiatives outlined by the incoming administration. Fixed income has played a limited role in investment portfolios over the past decade, but as rates continue rising, at some point the tradeoff of risk and return in traditional fixed income will become more appealing. We welcome the growing likelihood that traditional investments in quality municipal bonds will once again offer investors a real return after inflation and fees.
8. Corporate earnings are growing again.
After seven consecutive quarters of decline, the year-over-year operating profitability of the S&P 500 turned positive again in the third quarter. Corporate earnings have been dragged down in part by weakness in the energy sector, but the pain has been widespread throughout the market. Companies have generally struggled to grow earnings in an environment of modest economic growth and little pricing power, but that seems to be turning around. We expect better economic activity and consumer spending to propel earnings higher next year as well. This is an important development if equities are to continue rising in 2017. In the short run, the market is a voting mechanism, as investors vote with their dollars and cents and move prices up and down on a daily basis. In the long run, however, the market is a weighing mechanism, valuing the earnings that companies generate. The third-quarter earnings rebound is therefore a welcome sign that the equity market cycle still has fuel in the tank.
9. The stock market is at an all-time high.
Perhaps in response to this acceleration in earnings, the equity market has broken out of a long trading range to establish new highs as the year comes to a close. As of December 19, the S&P 500 is up 13% year to date (including dividends), and the smaller capitalization Russell 2000 is up more than 22% over the same period. The bad news is that the market rally is rather narrow. As the nearby graph illustrates, only a small handful of companies is driving the rally in the S&P 500: In fact, just 16 of the 500 stocks in the index are closer to their 52-week high than the index itself. Narrowly led markets tend to be volatile, and we believe that this volatility will be realized in 2017. The good news is that plenty of value opportunities remain in the market, even though the index level itself might not lead to that conclusion. An active approach to value identification ought to add value in a market characterized by narrow leadership and disparate pricing.
10. We haven’t mentioned politics until No. 10 on the list!
Without expressing an opinion on the outcome of this year’s presidential election, we are nonetheless relieved that an unprecedently bitter campaign has ended. Now the hard part: governing. Every new administration spends time prior to the inauguration building a team, establishing priorities and laying out plans for the first days, weeks and months of the new term, and the Trump administration is no different. The economic and market trends presented earlier in this essay are larger than any occupant of the Oval Office, but policies do matter, and they matter more than usual in the advanced stages of a cycle. The feature article in the first quarter issue of InvestorView will analyze the implications of Trump’s policies on the economy and markets in more detail, but in the meantime he seems to be prioritizing initiatives such as tax reform, deregulation and infrastructure spending that would boost nearer-term economic growth. Details to follow.
We end 2016 and start 2017 in good shape. The economy is performing well, with the prospect of acceleration in the quarters to come. Falling unemployment should lead to growing wages, to the benefit of personal consumption, and therefore economic activity. Corporate earnings are recovering, and rising interest rates should create opportunities in traditional fixed income. The Trump White House will be a factor in 2017 and will likely be a source of occasional disruption and market volatility. Prudent and practiced investment discipline will be more important than ever.
On behalf of my colleagues at Brown Brothers Harriman, we wish you and your family a happy, healthy, prosperous 2017.
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