Markets are always in a rush. They rush to price in a new fiscal policy. They rush to price in inflation. In short, they rush to price expectations of higher growth. Since the election on November 8, markets have reacted to campaign-trail rhetoric of strong fiscal spending and tax cuts that could well add up to a notable boost to GDP over time.
In reality, details are still thin and the President-elect has yet to take office; we are in a time of high policy uncertainty. The counterweight to expectations is perspective, and it is important for investors to leverage perspective for this long-term race we call investing. I think we all remember how the story of “The Tortoise and the Hare” ends.
We highlight three critical perspectives that will be important in 2017 and beyond.
Perspective 1: The 2017 economy will most likely have a growth profile similar to the 2016 economy.
In 2016, the economy was driven almost entirely by consumption, as business investment remained weak and the impact from government spending was neutral.¹ The Federal Reserve projects the U.S. economy to post growth of 1.9%–2.3% in 2017, right in line with the average since 2010 of 2.1%. Any expected fiscal policy, tax policy and trade policy changes, particularly fiscal stimulus, need to run the legislative gauntlet. Therefore, we would expect that the impact of any additional fiscal stimulus won’t be felt in the broader economy until late 2017, at the earliest, and would truly impact growth in 2018.
Perspective 2: The post-election rise in U.S. interest rates has been notable, but by virtually any historic measures, interest rates are still exceptionally low.
Since November 8, the yield on the 10-year government bond has risen 64 basis points,² leaving yields in the range they have maintained over the past five years (see the chart). Yet with 10-year yields below 3.0% and 5-year yields below 2.5%,³ interest rates are still close to the lowest levels markets have seen stretching to the 1950s.⁴
10-year government yield
Sources: Bloomberg, FS Investments
On the short-term end of the interest rate spectrum, the low interest rate environment is even more noteworthy. The Fed raised rates 0.25%, or 25 basis points, on December 14, 2016, increasing the Fed funds target rate range to 0.50%–0.75%. The FOMC’s economic projections included a median expectation of three more rate hikes (75 more basis points of tightening) in 2017, and reiterated that the removal of policy accommodation would be “gradual.” Even in a more aggressive scenario where the Fed raises rates twice as fast as they currently expect – six rate hikes next year – the Fed funds rate would settle just above 2% by the end of 2017.
Through the lens of history, either of these scenarios adds up to an exceptionally low rate outlook. Since the 1980s, mature economic expansions, characterized by the U.S. economy growing at or above its potential, have coincided with a Fed funds rate over 5%.⁵ By virtually any metric, and even including the recent rise in rates, U.S. rates remain near historic lows and investors may be facing a low income environment for some time.
Perspective 3: Understanding what the president can (and cannot) control.
There are several challenges facing the U.S. economy that President-elect Trump has very little ability to impact. First is the significant slowdown in U.S. labor force growth as the baby boomer generation retires. Second is the decade-long trend of falling productivity growth. Both of these trends hold down potential U.S. growth. If fiscal stimulus could add a full 1% to GDP – which would be a huge addition and a very optimistic projection – it will mean that the new, supercharged growth rate would only be at the low end of historic growth rates in expansions relative to the 1980s, 1990s and 2000s.⁶
Conclusion
2017 will be a year of changing expectations – at times, rapidly changing expectations. Equity markets have been quick to price in higher growth, and bond markets have been quick to price in inflation. But investment decisions need to be anchored by perspective. Fiscal stimulus could add a welcome boost to growth, but the impact on the actual economy will take time to trickle through. More importantly, long-term structural challenges may more than likely limit the upside for higher growth. Interest rates, while modestly higher, still have a long way to go before they are anything resembling our concept of “normal.” This will most likely challenge investors looking for income solutions well into next year. When it comes to 2017, be the tortoise, not the hare.
