The Ten Surprises of 2017 have a generally constructive tone. President Trump campaigned promising significant change to the American people. He raised expectations, and that’s why he won. Now he has to get his pro-growth agenda implemented. The key elements are tax cuts for corporations and individuals, dismantling regulation and improving the country’s infrastructure. If he is moderately successful in putting his plan in place, I believe we will see a better economy this year and the financial markets will reflect that improvement. Investors are ambivalent because they are concerned that we won’t see the significant positives until 2018, but I think favorable results will appear before then.
The definition of a Surprise is an event that I believe is probable, having a better than 50% chance of taking place, while the average investor would assign only a one out of three likelihood of it happening. Usually I get five or six of the Surprises more or less “right,” but I don’t compile the list to get a good score. The objective is to stretch my thinking and, hopefully, the thinking of others.
The first Surprise is that the President backs away from the more extreme positions he put forth during the campaign. He talked about tearing up some trade deals and various other international agreements, like the Iran nuclear weapons deal, as well as some domestic legislation, including the Affordable Care Act, on his first day in office. I believe he will move more deliberately on these policy shifts and that his wastebasket will be empty as he completes his first day of work. I think he will find that some of our trade agreements actually create jobs rather than eliminate them. In certain cases, like NAFTA, these involve many countries, and unilateral withdrawal would complicate diplomatic relations. As for the Affordable Care Act, 20 million people have signed up for insurance, so repeal without a replacement would be very unpopular. Repeal and delay is not a workable option. In any case, his cabinet and many members of Congress oppose an abrupt termination of the existing healthcare program.
Trump has assembled a cabinet and set of advisors who are controversial and inexperienced in government. I believe, however, they will work effectively to make sure that radical, disruptive and unsettling changes do not take place. The new president will strive to maintain a high approval rating and he will try to establish confidence among the American people during his first few months in office. As a result he may defer his more divisive agenda items until later in the year.
In the second Surprise I said that a combination of pro-growth initiatives would result in a real GDP increase in the United States in excess of 3%. Since the beginning of expansion in 2009, growth in this cycle at less than 2% has been slower than typical post–World War II recoveries. This is consistent with the observations of Ken Rogoff and Carmen Reinhart in their seminal book on 800 years of business cycles This Time is Different. They concluded that when you have an economic recession and a financial collapse at the same time, the recovery is more prolonged than normal. When business is improving, productivity usually rises because companies don’t hire as fast as the new orders come in. In a slowdown the opposite is true: generally managers are reluctant to lay off workers. As a result, I expect to see better productivity numbers as we move through the year.
In the third Surprise I believe Standard & Poor’s 500 earnings will be better than expected. For the past several years earnings have been trapped between $115 and $120. This year’s estimates by top-down analysts and strategists are between $120 and $125. As a result of stronger GDP growth, a reduction in the corporate income tax and some regulatory relief, I believe earnings for 2017 will be closer to $130. This would enable the market to move somewhat higher; my target is 2500 on the index, about 10% above present levels. The possible negative in Trump’s economic plan is that the budget deficit would increase as a result of the tax reduction. The Trump economic team employs the analytic tool of “dynamic scoring,” which is based on the concept that if economic growth and earnings for corporations and individuals improve, taxes collected will also rise. I believe the concept is reasonable but I think the increase in government revenues may lag the reduced income from the tax relief. I have another worry about Trump’s economic program. If he slaps punitive tariffs on imported goods and other countries retaliate, that obviously will have a negative effect on business activity. This is one of the extreme positions he talked about during the campaign that I believe he will modify.
The fourth Surprise is that the strength in the dollar continues. I have it going to 130 against the yen and 1.10 against the British pound, and the euro dropping below par. The United States is slated to grow faster than any other major industrialized country except China in 2017 and that should attract investors, particularly if there is a perception that investments in other countries will not do as well. The strong dollar is dependent on the Trump pro-growth agenda gaining traction. If important parts of it do not get through Congress or do not stimulate the economy as I expect, the strengthening of the dollar may lose momentum.
We are unlikely to have continued growth without a pick-up in inflation. The labor market is already tight. In December, average hourly earnings increased 2.9% year-over-year compared to previous monthly readings of 2.5%. With the unemployment rate below 5%, we cannot expect an increase in growth to take place without an inflation impact. For the fifth Surprise I have the 10-year Treasury yield increasing to something above 3%, perhaps approaching 4%. Clients have questioned how higher rates will affect the equity market. I trotted out my dividend discount model concept from the 1980s and 1990s to gain an insight into that issue. At current yields of around 2.5%, the equilibrium point where stocks and Treasurys are equally attractive, using $130 in earnings, is about 2800 on the S&P 500. If yields rise to 3%, the equilibrium point drops to the present level of about 2250. If the 10-year Treasury goes to 4%, equities would be in trouble, but knowing where the inflection point kicks in is difficult. After Trump’s election the 10-year Treasury yield rose from 1.4% to 2.5% and the S&P 500 rose 10% because bonds were not viewed as competition for stocks at very low interest rate levels.