Monday, January 23, 2017

Newsletter 1/23/2017

Note: Click on graphs to enlarge for easier reading.


The Economy

The US economy is improving at a healthy pace. The GDP growth is at 3.5 percent in the third quarter of 2016.



The unemployment rate is the lowest it has been since 2009 at 4.7% in December, 2016.


The latest Inflation data shows inflation rose above 2% in January, 2017, the level that is a target for the Fed.  


The U of M consumer sentiment index climbed above 100 as illustrated in the following chart.


The Federal Reserve board (Fed) raised interest rates in its last December meeting by 0.25 % and stated that it will raise rates further in 2017. In my opinion, the Fed should raise rates to counter higher inflation. Raising interest rates while central banks around the world are keeping rates unchanged has the undesired effect of strengthening the dollar against other currencies and lowering overseas earnings. It is estimated that 30% of the S&P 500's earnings are from exports which will suffer if the dollar strengthens. The US dollar has been going higher against other currencies. China devalues their currency to achieve greater exports intentionally.

Politics

Donald Trump surprised everyone and won the presidential election in November, 2016. He also brought with him a republican government controlling both the House and the Senate.  In his inaugural speech on 1/20/2017 Donald Trump reiterated what he said in his campaign would make America "Great Again." He said he would stop the transfer of American jobs from America, will increase employment in America by spending on infrastructure, and will build a wall in the Southern border with Mexico to keep illegal immigrants out. This policy will have both a positive and a negative impact on the economy as follows.

1) In Economics 101, we learned about David Ricardo's law of comparative advantage that states free trade is good for both economies and raises the standard of living in both economies. Corporate profits are higher and therefore stock prices are higher with free trade. A trade war would be bad for both economies of the trading nations. Although Donald Trump has not stated he will wage a trade war and his appointed advisors and secretaries like Larry Kudlow and Wilbur Ross believe in free trade, one worries about the rhetoric and the possibility of a trade war. Hopefully a renegotiation of the free trade agreements will be sufficient.

2) Spending on infrastructure at a time when employment is full can only lead to inflation. Higher inflation leads to higher interest rates. This will lead to lower existing bond fund prices, higher future bond and other fixed income returns, and lower equity prices. The higher interest rates will lead to lower equity prices because the dividend growth model that uses the interest rate in the denominator would dictate a lower price for equities.

3) Slowing illegal immigration to the US will lead to higher food inflation and the higher interest rate consequences discussed in the point above.

4) Although there was no emphasis on tax reform during his inaugural speech, Donald Trump has promised a tax reform to give the upper income earners and the middle class a tax cut. He also promised a reduction of the corporate tax rate and an elimination of the tax on oversees cash repatriated home in the US. These are Republican ideas aimed at giving incentives to invest in the US economy and are referred to as trickle down economics. Democrat critics of this policy point to the past trials of this policy and allege that this tax policy leads to deficits. During the Presidential debates, Hillary Clinton predicted that this tax policy would lead to an additional $20 trillion in US national debt. Such a larger debt may lead to US debt downgrades which would be a disaster for the stock market.



5) Also, there was no emphasis on rolling back regulation that hinders business, another Presidential campaign promise from Donald Trump. Eliminating regulation such as environmental regulation will have the effect of increased profits, higher employment, higher inflation, and higher interest rates.

In conclusion one can predict higher interest rates and therefore higher fixed income returns with a Trump Administration. One cannot predict with a high degree of confidence equity prices because so much goes into equity prices including market psychology.
 
 

Markets

Markets around the world performed in 2016 according to the following chart.


Investment Strategy


Given the above one must be aware of the impact of the Trump Presidency and the Republican congress on the economy and the stock market in the US and the world. We are starting from a good point. Stocks are trading at all time highs, employment is full, and inflation is low. Any economic stimulus is likely to raise interest rates and there is plenty of stimulus in the pipeline coming. Therefore a balanced allocation between stocks and bonds is recommended. Here it is important to distinguish between bond funds and bonds. Bond funds will go lower in a rising interest rate environment while individual bonds will only go low when the bond is sold. Individual bonds are more appropriate and they would be available in the E*TRADE platform.

Mike Katto
CERTIFIED FINANCIAL PLANNER™
Registered Investment Advisory Representative