Weekly Markets Commentary — December 19, 2016

David Joy – Chief Market Strategist, Ameriprise Financial

Rates, Valuations and Earnings: What can we Expect in 2017?

As widely expected, the Federal Reserve raised the overnight rate by one-quarter of one percent last week. It was the second such increase in the Fed’s return to policy normalization, the first coming one year earlier. However, what surprised many market participants was the Fed’s new projection of three additional quarter-point rate hikes in 2017, up from its September projection of just two, despite raising its outlook for GDP growth next year by just 0.1 percent to 2.1.

Despite Fed Chair Janet Yellen’s best efforts to talk down the significance of the change, markets reacted sharply. Prior to the Fed’s decision, the ten-year Treasury note was trading at a yield of 2.44 percent. By the end of the day it was 2.57 percent, and ended the week at 2.59. The two-year note leapt from 1.16 to 1.27, before ending the week at 1.25 percent.

The dollar also firmed on the news. The DXY index rose from a level of 101.00 prior to the meeting to close out the week at 102.80. Since the U.S. election, the dollar has climbed more than five percent, while the yield on the ten-year is 76 basis points higher, and the two-year is higher by 42. The news also took some wind from the sails of the recent strength in stocks. The S&P 500 slipped by 0.6 percent over the final three days of the week, pushing the index to a weekly decline of 0.1 percent.

A Reminder to Investors: A Level of Risk Lurks Around the Corner

Last week’s economic data was on the softer side of recent experience. Retail sales, industrial production and housing starts were all weaker than anticipated. Consumer prices showed little change. There was some evidence of strength, however, as producer prices firmed considerably, and small business and home builder sentiment rose sharply.

Investors were also reminded last week of the presence of geopolitical risk, especially as we transition to a new administration, as China absconded with a U.S. undersea drone in the South China Sea.

Closing out 2016 and Looking Ahead to 2017

With just two weeks of trading remaining in the year, the S&P 500 is higher by 10.5 percent at 2258. If it closes there, it will have surpassed our beginning of year forecast of 2175 by almost four percent. While accuracy is great, more important is getting the market’s direction right. That way, portfolios are generally positioned correctly. And, if in a year when stocks are higher that means investors did better than we expected, so much the better.

But this time around, it also means that valuations are somewhat stretched. Fourth quarter earnings are now expected to grow by 3.2 percent, according to Factset. If companies deliver, it would mean the first consecutive quarters of earnings growth in a year and a half. But since the election, the move higher in stocks has outpaced the improvement in earnings. Bloomberg estimates the price/earnings (P/E) ratio of the S&P 500 to be 19X based on full year 2016 earnings. That compares to a five-year average trailing P/E of 17.2X, and a ten-year average of 16.9X. So, today’s valuation, while arguably not excessive, is elevated.

Certainly, earnings may catch up. For 2017 Factset now estimates that Wall Street is expecting earnings growth of 11.5 percent. That would put the forward P/E for 2017 expected earnings at 17X, more reasonable, perhaps, but still above the recent intermediate-term averages. And we suspect that stocks may have already discounted some of the anticipated improvement in the business climate under the new administration.

And so, as we look toward the New Year, we see the potential for somewhat better economic growth and improved earnings, offset to some extent by rising interest rates and tempered by elevated valuations. All of which equates, in our minds, to another year of modestly positive equity prices, with the S&P 500 rising to 2360 at year-end. That is just 4.5 percent above Friday’s close. If stocks perform better than that, as they have in 2016, so much the better, as long as we get the direction right.