Normalizing Under Uncertainty

2017 Midyear Market and Economic Outlook

Going strictly by the news feeds, very few would characterize 2017 as a "normal" year so far. Whether it was overseas elections, the timing of domestic policy initiatives or the scope of central bank actions, the macro backdrop received plenty of media attention. In a social media context, much of the discussion could have been tagged "#uncertainty."

Policy uncertainty is typically a headwind for economic growth, but it actually served as a bullish influence on the stock market, offsetting investor sentiment measures that tilted at times toward excessive optimism. And despite the lingering uncertainty in our political environment, there are indications that a more normal macro investing environment may be emerging.

The Weight of the Evidence 
We saw some disappointing data (relative to expectations) in the first half of 2017, yet underlying economic fundamentals remain positive overall at the midyear point. And even though interest rates have increased twice this year on the heels of a small December hike, inflation remains low. Valuations remain bearish and speak to elevated risk in the current environment, but the broad range of stocks and sectors participating in the current rally is encouraging. The other factors we watch when evaluating the Weight of the Evidence remain neutral for now.

Looking ahead to the second half of 2017, we are focused on three developing dynamics: the impact of continued tightening by the Fed, the outlook for economic growth at home and abroad and how well the stock market is able to absorb a rotation in leading stocks and sectors. 

The Path of the Fed
The Fed has already raised rates by 50 basis points in 2017 and, according to their most recently published dot plot, the median expectation is for one more 25 basis point rate hike this year with a continued gradual path of policy normalization over the next two years. While rates are moving higher, the deliberate pace of normalization has kept this from being a headwind for stocks.

Labeling the rate trend "normalization" rather than "tightening" isn't just a question of semantics. It reflects the still low absolute level of interest rates. The 3-month T-bill yield in June rose above 1% for the first time since 2008. And while plans for the Fed to draw down its balance sheet have been laid out, it still shows more than $4 trillion in assets. Continued normalization in the second half of 2017 may mean actually starting that drawdown process.

So far, the Fed has done a great job of telegraphing its intentions and guiding market expectations. But economic growth will likely have to improve in the second half if the Fed is going to stay true to its announced plans.

Measuring Economic Growth
While economic data has been generally disappointing (relative to expectations) in the first half of 2017, there have been clear pockets of strength – notably the labor market and consumer confidence. The Philly Fed index and other monthly business surveys have shown relatively robust activity. One of the most hopeful developments was an 11% surge in nonresidential fixed investment spending in the first quarter. 

It's worth noting that disappointing economic growth is not new to 2017. It has been a feature of this recovery from the beginning. Over time, however, forecasts for growth have been moving lower. The Fed's forecasts for growth for this year and the next now assume no acceleration from the current pace. And with expectations now catching down to reality, the opportunity for a meaningful upside surprise becomes more significant. 

Also worth noting  in five of the past seven years, growth in the second half of the year has been stronger than the first half. If growth for the first half overall comes in near 2.0%, an even modest acceleration in the second half could push growth for 2017 overall above the Fed's forecast. 

Changing Market Leadership
The popular narrative that only a handful of stocks were supporting the rally in the first half of 2017 was never really based in reality. While the percentage of industry groups in uptrends waned, it never broke down to a troubling level, and the breadth of rally participation stayed generally strong. More recently, while the mega-cap Technology names that dominated the narrow-leadership theory seem to have stalled, overall breadth has been improving and the percentage of industry groups in uptrends has expanded.

Broad participation is not just a domestic theme. Most markets around the globe have been in rally mode in 2017. This is the mark of a strong bull market. Currently better than 85% of the markets that make up the All Country World Index (ACWI) are above their 200-day averages. The bottom line here is that strength in the S&P 500 has been and continues to be supported broadly within the index and around the world.

Not coincidentally, 2017 has started to see more normal trade-offs between risk and return and demonstrate the benefits of a globally diversified portfolio. For U.S. investors, the past few years have been a case where staying at home in terms of investments provided the best risk/return trade-off. The re-emergence of a more normal asset allocation environment in 2017 is a healthy development that we expect to continue.

Click here for a more detailed and technical analysis of the factors we consider in developing our outlook.