November 2017 Monthly Outlook
The economy’s forward momentum remains in place as we approach year end. Worker productivity (the highest in three years), retail trends (including vehicle sales, which were helped by Black Friday deals and strong consumer confidence), and activity in major industrial categories (particularly manufacturing) all point to moderate GDP improvement as we close out December. In addition to these factors, we’re seeing record-high stock prices, increased personal income and personal consumption expenditures, and still-rising home prices. Businesses and consumers seem sufficiently motivated to keep GDP growth in the range of 3%, or better, for the full quarter.
The Conference Board Leading Economic Index® (LEI) for the U.S. increased 1.2% in October to 130.4, following a 0.1% increase in September, and a 0.4% increase in August. “The U.S. LEI increased sharply in October, as the impact of the hurricanes dissipated,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. “The growth of the LEI, coupled with widespread strengths among its components, suggests that solid growth in the U.S. economy will continue through the holiday season and into the new year.”
Indicators point to the U.S. economy accelerating in the short term to 3% annually from a long term rate of ~2% annually. We remain in the late stages of a long business up-cycle and are starting to see signs of major excesses that have brought down some prior economic upturns.
U.S. Stock and Bond Commentary:
U.S. stocks continued their steady uptrend as the S&P index increased 3.06% in November. Despite the record run-up in U.S. markets, International equity markets have outperformed U.S. markets in 2017, suggesting the U.S. is benefiting from accelerating global economic growth.
The big news currently affecting U.S. equity markets is tax legislation that passed the house and senate but still needs to be reconciled between the two legislative branches. At a high level, this tax legislation is predominately a business and corporate tax cut, so its impact will tie directly to corporate profitability, and ultimately the stock market. Currently, the effective tax rate of a company on the S&P index is ~23%. I expect the proposed tax cut that decreases the headline rate to ~20% (from 35%) will result in an effective tax rate of 14%. This would cause earnings of the S&P500 index to increase 17% based solely on this proposed tax cut.
The big question is whether the markets reward the companies for these increased earnings or reduce the valuations for this event once it becomes history. The markets are a forward looking mechanism that generally view earnings power of companies on a pretax basis because taxes are a factor the business and its management cannot control. Once this tax law becomes enacted, there will no longer be this gift to look forward to and investors will look forward to try to ascertain the real earning power underlying the companies.
While there is no shortage of economic and political noise right now, we continue to monitor the yield curve, as we believe this is the best predictor of future imminent economic recessions. Currently the yield curve (shown on economic metrics by subtracting the 10 year rate by the 3 month rate) is not inverted so we continue to tactically overweight stocks vs. bonds.
In the short term (1-3 years), until the Federal Reserve raises interest rates to a level that incentivizes investors to take less risk (vehicles like savings accounts, money markets, CD’s), investors will probably continue to put more funds into risky assets such as stocks and real estate pushing up the price levels and valuations on these asset classes. Over the longer term, investment in businesses (i.e. stocks) should provide superior returns to all other classes.