2017 Outlook (December 21, 2016)

by Bill O’Grady & Mark Keller

Key Points:

  1. The economy will avoid a recession in 2017. GDP growth is expected to average 2.8% with core PCE inflation approaching the Federal Reserve’s target of 2.0%.
  2. Fixed income markets will be challenging:
    1. We expect three rate hikes of 25 bps each by the FOMC;
    2. Due to rising inflation expectations, 10-year yields will reach 3%;
    3. A swing toward equality and higher inflation would be expected to narrow credit spreads.
  3. Equity markets should be strong until Q4:
    1. Basis the S&P 500, our base case is for a 9.2% rise in earnings to $119.45;
    2. Our base P/E model is projecting a fair value of 18.4x;
    3. Our forecast for the S&P 500 is 2400 to be achieved sometime in 2017, most likely by Q3;
      1. Earnings should exceed our base forecast because:
        1. We will see a narrowing of the S&P/Thomson Reuters operating earnings spread;
        2. Corporate tax reform should increase earnings.
      2. Multiples should also expand due to:
        1. Improved investor sentiment over Trump’s victory, although this could wane by Q4;
        2. High levels of “sideline” cash.
    4. We continue to favor domestic over foreign stocks;
    5. We have a bias toward value;
    6. We are neutral on capitalization.
  4. Commodity prices will tend to struggle due to dollar strength. Oil prices will average around $55 per barrel due to OPEC’s actions to reduce supply.
  5. The dollar will remain strong. We would expect the EUR/USD rate to approach $1.00.

Note:  The structure of this report will be somewhat different from our previous forecasts in that we will present a framework for the economy and markets signaled by the election of Donald Trump. We will first offer a basic outline of what Trump represents and use this framework in our forecasts for next year. There are always risks and unknowns about any new president, but the potential for error is elevated as we believe this election clearly signals a change in direction for the economy and the country. Our 2017 Outlook will be affected by these changes, requiring us to discuss at least our initial estimates of the impact of President-elect Trump.

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