SECOND QUARTER, 2017
THE ECONOMY: GROWING WITHOUT REGARD TO POLITICAL RHETORIC
The riff among Republicans exposed by the failure of the healthcare bill, point out the difficulties President Trump will have in achieving his campaign pledges of increased infrastructure spending, increased military spending, and lower tax rates. The proposed tax cuts could have the quickest influence on the economy, but probably won’t be in place until later this year or early in 2018. Harold Davidson & Associates is now forecasting United States Gross Domestic Product (GDP) growth of 2.4% in 2017, up from 1.6% growth in 2016. The rise in interest rates and the stronger value of the dollar since the election will act as a drag on growth. However, strong consumer spending driven by increasing wages, employment gains, and the strength of the stock market, should support the domestic economy for 2017.
The U.S. manufacturing sector is reaping benefits from stronger business investment and a long-awaited drawdown of excess inventories. Also, retail sales should add to growth in the domestic economy and are expected to accelerate to 4.2% growth, better than the 3.8% growth rate in 2016. In March, the consumer confidence index increased to the highest level in more than 16 years.
In this environment, the labor market will remain robust with job growth averaging 170,000 new jobs a month in 2017, although March recorded a low of 95,000 new jobs. While unemployment statistics currently are at 4.5%, we forecast the rate to decrease to 4.3% by the end of 2017. Gradually, we are seeing retirees surface for employment opportunities, which should slow the decrease in the rate of unemployment.
Inflation rates, as measured by the Consumer Price Index, are increasing at the Federal Reserve’s targeted rate of 2%. There is evidence from leading indicators that upward pressure may push inflation to 2.5% to 3.0%. Oil prices continue to rebound and the tight labor market will bring rising wages.
The administration’s open hostility to NAFTA, especially with respect to Mexico, risks a major disruption in economic activity. In 2015, U.S. exported goods and services to Mexico, our largest trading partner, totaled $236 billion, while imported goods and services totaled $309 billion. A significant reduction in U.S. – Mexico trade would have deleterious macroeconomic effects.
Military spending is expected to gradually build this year and next with the geopolitical threats coming from Russia, Iran, North Korea, and ISIS.
Automobile sales are expected to experience their first down year in the last seven years. While 2016’s 17.4 million annual rate exceeded 2015’s performance, Kelley Blue Book is now projecting a decline to 16.8 million to 17.3 million automobiles sold for 2017, a 1- 4% percent decrease from last year.
The Federal Reserve, after telecasting their move, finally raised the federal funds rate .25% in March. Based on forecast of a steadily increasing domestic economy, maximum employment and inflation at 2%, we now project two more interest rate increases of .25% this year, which would put the federal funds rate at 1.5% by year end. Mortgage rates will increase as well.
Globally, the Eurozone continues to experience solid economic recovery. GDP growth is expected to rebound to about 2.5% for all of 2017, up from the fourth quarter’s 1.7%. A stronger Euro, uncertainty about the Brexit, negotiations and important elections in France and Germany may cause Eurozone euphoria to be somewhat dampened. Apparently, the quantitative easing program has had a desired effect on the Eurozone. GDP projected growth percentages for 2017 for Spain and Italy, recently troubled economies, are rebounding to 2.2% and 1.0% respectively. China expects its growth engine to continue to cool off after decades of breakneck expansion. The government is targeting growth of 6.5% for 2017 which is down from the 6.7% growth that the world’s second-largest economy experienced last year.
THE STOCK MARKET: STOCKS REACH RECORD HIGHS DURING THE QUARTER BUT LOSE STEAM TOWARD THE END OF THE QUARTER
During the first quarter of 2017, the S&P 500 Index gained 5.53%. The stock market benefitted from earnings recovery both domestically and internationally, as well as a continuing stream of positive economic data. The market’s ascent, however, lost momentum toward the end of the quarter, after President Trump’s healthcare bill was pulled by House Republicans. The lack of support for Trump’s healthcare bill put a damper on the ascent of the stock market during the quarter and the failure of the bill called into question whether or not President Trump can get other legislation through Congress. President Trump quickly shifted his focus toward tax reform. Currently the U.S. has the highest corporate tax rate in the world and any relief will immediately trickle down positively in corporations’ bottom line. Reducing corporate tax rates will also likely cause money that is parked overseas to avoid excessive taxation, to flow back into the U.S. Corporations must currently pay taxes on repatriated funds, and rates can run as high as 35%. Tax cuts, deregulation and fiscal stimulus plans, such as the national infrastructure rebuild outlined by the President, should spur business investment and economic growth domestically, which should be positive for the stock market. Consensus earnings estimates for the S&P 500 Index are approximately $140 per share for next year. Using an 18x P/E multiple on the S&P estimate equates to a year-end value of 2,520, or 7% upside from current levels, which we think is attainable.
During the quarter ending March 31, 2017, Harold Davidson & Associates added to many existing positions. These include substantial positions in the defense, shipbuilding, and aerospace industries. Additional purchases included two companies in the banking sector, a large domestic money center bank, and an international bank which has 75% of its revenues derived from the United States. Additionally, we purchased more of a credit card processing firm which recently consolidated their European operations into the parent company, which should provide a catalyst for accelerated growth. Also, additional purchases were made of an established computer company that is rapidly expanding from legacy hardware to supporting client shifts to the cloud. Sales during the quarter included eliminating positions in a large supermarket chain; a mid-priced department store chain; an international utility; and a commercial property real estate investment trust. Positions were trimmed in two international pharmaceutical companies and an international beverage company.
The composition of the assets currently managed by Harold Davidson & Associates is as follows: Cash and cash equivalents – 4%; municipal bonds – 4%; corporate bonds – 1%; bond mutual funds – 14%; equity mutual funds – 16%; common stocks – 52%; and real estate equities – 14%.
THE BOND MARKET: FEDERAL RESERVE RAISES RATES AGAIN
The Federal Reserve’s Federal Open Market Committee (FOMC) voted at its March 15 meeting to raise its target for the federal funds rate by .25% to a range of .75 to 1%. The move was the second time in three months that the FOMC raised rates. The committee based its decision on a combination of factors including conclusive evidence that the economy is showing signs of robust growth. Inventories for both high quality corporate and municipal fixed income securities remain tight. The yield on 10-year Treasuries has steadily fallen in 2017, to 2.396% from 2.446% at the end of 2016. We continue to substitute purchases of individual bonds with institutional quality bond mutual funds offering favorable yields.
THE REAL ESTATE MARKET: CURRENTLY PROVIDES NO CLEAR INDICATIONS - IT IS GOING UP, DOWN, OR NOT MOVING AT ALL?
Both the residential and commercial markets seem to be somewhat in a lull, and we are waiting to see how the current administration’s policies affect the market.
During the past quarter, residential development was up significantly but prices remained stable. There was a rush to lock-in low interest rates before the recent interest rate increase, and many people successfully refinanced their homes. However, for new purchasers, there was a drop in the number of housing sales and there remains very little housing product available for purchase. While the statistics may show prices increasing modestly, the empirical evidence seems to indicate prices have stabilized. Sellers have few options where to move, and buyers have found very little inventory available. It seems that the overall market has taken a bit of a pause as we digest the current administration’s economic and home ownership policies.
Commercially, there is very little inventory of quality real estate investments for sale. There continues to be an abundance of institutional and 1031 capital chasing very few quality properties. However, even with few properties on the market, we are starting to see buyers require increased yields in order to compensate for raising interest rates, and sellers are slowly following suit. As interest rates continue to rise, we expect commercial real estate values to continue to decline. However, we project interest rates will increase gradually and any decline in values will be minimal.
SUMMARY & CONCLUSIONS:
Harold Davidson & Associates is now forecasting United States GDP growth of 2.4% for 2017. The Eurozone is expected to rebound to GDP growth rate of 2.5% for 2017 as well. Based on the tight labor market and inflation rates at close to 2%, our forecast is for the Federal Reserve to raise interest rates two more times this year, bringing the federal funds rate to 1.5% by year end. We are optimistic that while the stock market had an outstanding quarter, with the S&P 500 Index gaining 5.53%, that the continuing stream of positive economic news will propel the market by at least another 7% by year end. While real estate is challenged by higher interest rates, we are confident that there will be opportunities to purchase good quality properties for our clients’ portfolios.
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"'Economic Outlook & Investment Perspective' is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved."
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