Bob Doll Says 2017 Will Be a Year of Transition

A year ago, Nuveen’s Bob Doll predicted the GOP’s retention of the House and Senate and its capture of the White House. What does he see for the coming year?

Here are his 10 predictions for 2017:

1. U.S. and global economic growth improves modestly as the dollar strengthens and reaches parity with the euro.

Doll concedes that correctly forecasting economic growth for the coming year looks to be more difficult than usual, with the aging business cycle, rising interest rates, climbing dollar and continued slow productivity growth all creating formidable headwinds. He notes that the recent election has unleashed a significant increase in consumer and business confidence, and so forecasts another relatively modest year of growth in 2017, somewhere around 2% real GDP growth.

2. Unemployment drops to its lowest level in 17 years as wages increase at the fastest pace since the Great Recession.

Doll notes that 2016 was a strong year for jobs growth, with average monthly new jobs averaging approximately 185,000. He thinks that the average will remain above 150,000 in 2017, noting that the current 4.6% unemployment rate could drop further next year to below the 4.4% rate reached in May 2007. Average hourly earnings growth bottomed at below 2% two years ago and could exceed the 3.1% level they hit in June 2009, he writes, noting that they are also watching to see if the participation rate experiences a cyclical pickup.

3. Treasury yields move higher for a third consecutive year for the first time in 36 years as the Fed raises rates at least twice.

Doll says we have clearly reached an inflection point with the Fed and with interest rates more generally. The 10-year Treasury yield peaked at 15.84% on Sept. 30, 1981, then declined irregularly to 1.37% on July 8, 2016, a point that Doll says marked the end of a 35-year bull market in bonds. Since the Fed moved the fed funds rate to the “emergency” level of zero during the Great Recession attempts at reflation in the U.S. and globally have been mixed, but finally seem to be working, Doll notes, going on to observe that as 2016 drew to a close, the Fed pointed to multiple rate increases in 2017 and 2018.

4. Stocks hit their 2017 highs in the first half of the year as earnings rise but price/earnings multiples fall.

As with economic forecasts, Doll notes that stock market prognostications for 2017 are tougher to make than usual. He comments that the post-election “animal spirits” environment has buoyed the stock market, and possibly more importantly, the market surge has also been driven by improving economic indicators since October. He expects pro-growth measures to be passed in 2017, but offers two caveats. First, he notes that passing them will not be as easy as the current euphoria suggests – and they are unlikely to take effect until Jan. 1, 2018. That, coupled with what he sees as a slow but likely increase in inflation, and “we think a tug of war between rising earnings expectations and eventual valuation (P/E multiple) deterioration will suppress equity prices.” Bottom line? The 2017 high in stock prices comes in the first half of the year.

5. Stocks outperform bonds for the sixth year in a row for the first time in 20 years while volatility rises.

It hasn’t happened in two decades, but Doll expects stocks to beat bonds for six years in a row. Noting that for much of 2016 before the year-end rally, stocks yielded more than bonds, he comments that this highlights both the overvaluation of Treasuries and the undervaluation of stocks relative to bonds. “In our experience, it is not uncommon to see stocks outperform bonds with stocks rising and bonds falling in the latter stages of a bull market,” he notes. “If real and nominal growth increase, it will likely be a difficult environment for fixed income. But it could also be favorable for equities. We also expect volatility in both asset classes to rise.”

6. Small caps, cyclical sectors and value styles beat large caps, defensive and growth areas.

Doll notes that this prediction would be easier if the rally in small caps, cyclicals and value stocks that began in the second half of 2016 and accelerated after the election hadn’t been so strong, but says he expects these trends will continue despite the gains. “After a period of noticeable underperformance, small cap stocks have begun to beat large cap stocks due to the rise in the dollar, expected tax changes and weakening global trade,” he explains. Finally, value over growth (which is positively correlated to cyclicals over defensives) should occur as growth accelerates and inflation rises.

7. The financials, health care and information technology sectors outperform energy, utilities and materials.

Financials have been the leader since the election and in Doll’s assessment should benefit from regulatory easing in 2017. He goes on to note that financials also feature cheap valuations, health care presents a good opportunity beyond headline risks, and information technology offers both good growth and value characteristics. Conversely, he doesn’t see global growth as providing the pricing power necessary for energy and materials to shine. Utilities, he says, represent the intersection of yield, perceived safety and low volatility – a combination that has underperformed recently and Doll thinks may continue to do so.

8. Active managers’ performance improves as flows into equities rise.

Doll says the period of extended significant inflows into bond funds and outflows out of equity funds may be ending, and that improvements in nominal growth argue for a reversal and relative valuations also look supportive. He notes that investors have experienced an unusual confluence of events – slow growth, deflation, macro-dominated markets, falling interest rates and high correlations within and across asset classes – that are likely fading, if not reversing. Finally he says that active equity managers have struggled in recent years, but “perhaps the stars are finally aligning for a long-awaited reversal in this trend.”

9. Nationalist and protectionist trends rise as pro-domestic policies are pursued globally.

Doll notes that the 2016 global political environment was marked by a rejection of establishment policies and a rise in nationalism, protectionism and isolationism – a trend that the Brexit vote, the Trump election and the Italian referendum all symbolize, and point to a world in which many countries are withdrawing from the global economy. “In general, we believe more globalization and more trade are healthy for global GDP growth, so moves in the opposite direction are worrisome,” he cautions. “This issue won’t be decided in one calendar year, but should be monitored carefully.”

10. Initial optimism about the Trump agenda fades in light of slow legislative progress.

He nots that optimism surrounding the Trump agenda is high, as investors are expecting tax reform, increased infrastructure and military spending and a rollback of regulations. “While we believe fundamental change is on the way, it may not be as easy as it appears,” Doll says. “In particular, such comprehensive legislation is rarely simply crafted and passed without significant revision.” Secondly, Doll notes that most of the contemplated agenda is likely to be passed in 2017, but won’t take effect until 2018. “Additionally, the mood of the markets may sour if Donald Trump’s protectionist rhetoric (largely absent from post-election proceedings) resurfaces.”

Oh, as for Doll’s 2016 predictions:

1. U.S. real GDP remains below 3% and nominal GDP below 5% for an unprecedented tenth year in a row.
Correct

2. U.S. Treasury rates rise for a second year, but high yield spreads fall.
Correct

3. S&P 500 earnings make limited headway as consumer spending advances are partially offset by oil, the dollar and wage rates.
Correct

4. For the first time in almost 40 years, U.S. equities experience a single-digit percentage change for the second year in a row.
Correct

5. Stocks outperform bonds for the fifth consecutive year.
Correct

6. Non-U.S. equities outperform domestic equities, while non-U.S. fixed income outperforms domestic fixed income.
Half Correct

7. Information technology, financials and telecommunication services outperform energy, materials and utilities.
Wrong

8. Geopolitics, terrorism and cyberattacks continue to haunt investors but have little market impact.
Correct

9. The federal budget deficit rises in dollars and as a percentage of GDP for the first time in seven years.
Correct

10. Republicans retain the House and the Senate and capture the White House.
Correct

Total score: 8.5 out of 10.

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