VALUE LINE ECONOMIC AND STOCK MARKET COMMENTARY

As we opined three months ago, inconsistency is still a hallmark of this long and winding economic expansion. At the time, we had noted that “the upturn’s choppiness has been a long-term affair, having been the case in both 2014 and 2015.” We also had suggested then that such inconsistency likely would prove to be the rule in 2016. Thus, after the economy had grown just nominally in the first and second quarters, tallying gains of 0.8% and 1.4%, respectively, the tide would turn abruptly over the summer, as growth would surge by 2.9% during the third quarter, getting a boost from inventory restocking, a rise in exports, and an uptick in federal government spending. Importantly, the latest quarter would mark the first time in a number of periods in which growth would exceed the average forecast. Now, after that impressive breakout performance, the trends are pointing to additional healthy gross domestic product growth in the closing three months of 2016. Specifically, recent weeks have seen rising levels of retail spending (with total sales up a strong 0.8% in October on healthy gains at U.S. car dealers and on the Internet), a notable strengthening in the housing market (with construction surging in October) and continued modest gains in the leading indicators. All of this should keep GDP growth above 2% in the current three-month span. Such a solid close would prove reassuring and likely set the stage for further decent gains to start 2017. In fact...

Efforts at greater stability, albeit desirable, may well continue being hard to achieve. True, the suggested better second half this year does offer hope. That is especially so as it will probably be accompanied by a better tone in housing and gains in retailing (which would aid an array of related industries), by steady job growth, low unemployment, and an acceleration in wage increases, by benign inflation and accommodative Federal Reserve policies, even as the central bank likely prepares to push up interest rates as early as this month.

Based on the industry and sector trends cited above, the economy is likely on track to grow by 2.0%-2.5% over the coming year given the lack of excesses that can prematurely end an upturn. Also, as noted, GDP rose by 2.9% in the third quarter, the best pace since the third quarter of 2014, in part on a restocking of inventories. In all, following five quarters in which inventory declines had subtracted from GDP, inventories reversed course and contributed about 20% of the 2.9% rise in output in the latest period. We now anticipate a possible further, although relatively minor, overall restocking of inventories over the next several quarters, assuming no major shift in business sentiment. That figures to incrementally underpin growth, as well.

Of course, this scenario assumes much goes right in the year to come, which will introduce a new President, and perhaps conflicts with Congress on spending philosophies, trade, taxes, and foreign policy. There also could be a series of modest increases in interest rates (for the first time in a decade), and the resultant uncertainty this latter initiative can engender.

Even assuming some increase in consistency, the upturn is likely to remain understated. Our sense is that the new target for growth, even in rather good times (given the modest rates of inflation) might be upwards of 3%-4%—not the 4%-5% we had seen in prior up cycles when price stability was notably less ingrained. Still, even this rate of growth, which would be a best-case scenario so late in an up cycle, might be hard to sustain.

As always, there are risks to our forecast, most prominently, we think, on the international front, where a new Administration could introduce revised rules on global relations that might favor revisions in trade policy. Such changes may lead to further gyrations in the world’s energy markets, as well as engender possible currency crises and fiscal policy adjustments.

SOME SPECIFICS

Economic Growth: As noted, after a difficult first six months this year, the economy rebounded in the third quarter, as growth stormed ahead by 2.9%. That was the best showing in two years and could be the jump start needed to propel growth forward in the current span and in 2017. To be sure, with hefty inventory building and surging exports (two major factors in the recent economic reawakening) unlikely to recur with any force in the coming quarters, that 2.9% tally may well turn out to be the high-water mark for a time. Still, with wage and income growth on the rise, and with home building and retail sales getting an early fourth-quarter lift, there may be enough strength in place, even without much help from inventories, for GDP to increase by 2.2%-2.5% this quarter.

Looking out to 2017, the election of Donald J. Trump as the 45th President of the United States could well mean sizable tax cuts, lessening in regulations, a toughened posture on trade, and a meaningful increase in infrastructure spending. In particular, this latter focus, which could lead to an overhaul of our roads and bridges, along the lines of what this nation saw in the Eisenhower years, as well as a promised increase in military spending, would potentially lead to even more growth. For now, though, and pending formal proposals and legislative action where necessary, we expect the upper end of prospective growth to be close to 2.5% next year.

In any case, even with the possible added infrastructure spending boost, which is too premature to attempt to quantify at this time, any meaningful lift might not occur until late 2017 or 2018. Also going forward, our sense is that consumer spending will slow over the next 3 to 5 years, although it should continue being supported by gains in jobs, income, and household net worth. A rise in business capital investment would potentially fill in most voids, with an uptrend in GDP of solid proportions being put into place.

Inflation: One of the constants in this long business upturn has been the persistence of low inflation. To wit, the Federal Reserve has been steadfast in noting that inflation has remained below its 2% target. What’s more, there was nothing in the latest inflation metrics to likely adjust Fed thinking. To wit, October’s Producer Price Index affirmed that the headline inflation number rose by a modest 0.3%. However, if we back out the notoriously volatile food and energy components, to get the so-called core PPI, we find that the increase was just 0.2%, or within the unchanged to up 0.3% core range sustained since March. The story is quite similar for the Consumer Price Index, where the October headline number was up a somewhat more inflationary 0.4% on a spike in energy costs. However, the core CPI increased just 0.1% for the month, or within the 0.1%-0.3% range in place since April. Our forecast for 2016 and 2017 shows little change of note. That said, the recent spike in bond yields, in which the return on the 10-year Treasury note has risen from 1.5% to more than 2.3% in a matter of two months is worrying and suggests an inflation risk down the road, especially if major infrastructure and military expenditure programs are adopted. The jump in Treasury rates, meantime, raises the chances of a Federal Reserve interest rate hike later this month.

Interest Rates: As noted, bond yields are climbing, with the 10-year Treasury’s return surging some 50% to just over 2.3%; the yield on the companion 30-year bond, meantime, is up to 3.0%, a similar proportionate rise. Moreover, the apparent rationale for this surge in rates, the expectation of a rise in infrastructure spending in the next few years, suggests that the Fed will probably increase short-term interest rates later this month and then on several occasions in 2017. Of course, it isn’t just the fiscal spending outlook, but also the brighter picture in employment, retailing, and housing that will likely influence Fed thinking. Longer term, we think that an uptrend in interest rates is probable. But at this time, we still believe that we are looking at a gradual normalization in rates over the balance of this decade, not a dramatic rise in costs.

Corporate Profits: In the latest quarter, like most of its predecessors, a majority of the companies domiciled in the S&P 500 Index had bottom-line results that exceeded expectations. Not surprisingly, the stock market generally handled the third quarter’s results well, although there was no shortage of negative reactions, some of which were quite severe, in fact, as a minority of companies surprised on the downside. Going forward, and with some of the earlier pressures coming off the energy and materials groups, as the price of oil and other commodities stabilize at recovery levels, results should strengthen. In all, our expectations are that 2016 will end on a decent profit note and that the somewhat better news will carry over into 2017, when earnings should be up nicely. Our long-range outlook is for generally moderate, sustained, corporate earnings growth.

THE STOCK MARKET

The long bull market is alive and well as 2016 winds down and we get ready for not only a new year but also a new Administration that may well break with tradition in some economic approaches, notably in its apparent embrace of economic policies that would tend to foster higher inflation and increased interest rates in the quest for faster economic growth. For now, however, the hope of better times resulting from possible aggressive fiscal spending endeavors is winning the day on Wall Street, where the Dow Jones Industrial Average and most other major indexes have hit record highs since the November election. Such strength would now appear to discount a somewhat higher rate of inflation over the intermediate term as well as a gradual tightening in Fed policies. Our current expectations are that the likely inflation and interest rate shifts will not throw the long up cycle prematurely off stride.

At the same time, the outlook for corporate earnings is brightening; the likelihood is that inflation will remain relatively benign, but move up closer to, or perhaps a bit beyond, the Fed’s long-term 2% goal, and that interest rates will increase gradually, but not sharply. That would be a welcoming scenario for Wall Street and may well be what our markets are discounting now as equity prices advance. And such an upbeat prospect may, in fact, be the outcome over the next several quarters. But, the market’s recent surge leaves little room for things to go wrong, suggesting there is a need for some wariness going forward.

Conclusion: We remain optimistic, but rather cautious at the same time.

Source:  Valueline.com