Since the election, markets have responded positively to a growing emphasis on fiscal policy over monetary policy. We share the view that an increased focus on fiscal policies is likely to be a long-term positive for the economy and markets. The stagnant economic conditions of recent years demonstrate the limits of monetary policy, while history has shown that pro-growth fiscal policies can provide tailwinds to move the economy into a stronger growth phase.
During the first quarter, investor sentiment was upbeat (see Market Review below). Markets cheered the prospect of more business-friendly fiscal policies in the U.S., while a weakening dollar provided a welcome tailwind around the world and particularly for emerging markets. We see a growing likelihood for sustained and balanced global GDP growth through 2018. The U.S. economy appears positioned for measured expansion, with growth picking up a bit of steam as the year progresses. Recovery is taking hold in Europe and a number of emerging market economies have moved from negative to positive growth.
While markets have risen briskly since the election, we do not believe the potent mix of tax reform and less regulation has been fully priced into equities. Even so, stocks may well move sideways until there is greater clarity around U.S. fiscal policy implementation and as economic data ebbs and flows. Markets will remain sensitive to political developments as the U.S. administration tries to propel its agenda and major elections approach in Europe. In this highly charged environment, we expect periods of market rotation and attention to valuations remains essential. Earnings expectations may be up overall, but in many cases this is a reflection of easy comparisons. We will be closely watching for the quality of earnings releases in the coming weeks.
Leading indicators point to a fundamentally improving economy, modest inflationary pressures have replaced deflationary concerns, and unemployment continues to fall. We expect the Federal Reserve to raise short-term rates at least two more times this year. This return to a more normal interest rate environment is a positive, given that increased rates would be a response to a healthier economy.
Still, it is important to acknowledge that many “hard” economic measures (such as government-reported retail sales and durable goods manufacturing) have been less robust than readings for “soft” economic measures (such as surveys of business and consumer confidence). We believe fiscal policy implementation can greatly influence how the soft data carries over to hard measures. If the administration can coalesce enough support to advance some of its pro-business policies, even conditional wins could help bridge the disconnect between soft and hard data, thereby catalyzing stronger growth and the animal spirits in the economy.