September 30, 2017 –
The stock market’s favorable performance reflected rising profits and an improving economic environment which began in the second quarter of 2017. Real growth rose at a rate slightly above 3% in the second quarter, and initial indications are growth continued at a rate above 2% in the third quarter. If economic growth continues as expected, corporate profits should increase through the remainder of 2017 and in early 2018.
Future economic growth will be determined, in part, by economic policies the nature of which cannot be foreseen. The Fed has stated it will raise short-term interest rates going forward and it expects these rates to be over 2.5% by 2019. Further, the Fed has stated the increases are necessary to control the inflationary pressures which will develop as economic growth continues. This reasoning is inconsistent with the events of the last 70 years, and indicates the Fed may be repeating policy missteps observed in the stagflation era of the late 1960’s and all of the 1970’s.
In addition to managing monetary policy, the Fed plans to restructure its balance sheet in the coming months. It is likely the Fed will seek to reduce the amount of assets it holds by between two and three trillion dollars. No strategy for accomplishing this objective has been revealed. The transactions required to create the desired reduction in asset holdings are large enough to produce significant disruptions in the markets if they are not well managed.
There is an ongoing debate about the direction of fiscal policy. The Administration’s announced objective is to lower income tax rates for most individuals and reduce the number of tax brackets, while lowering rates on corporate profits. This debate is not unfamiliar in its tone or content. The Kennedy Administration sought similar changes as did the Reagan Administration. If an overall reduction in tax rates is put in place, forecasts for economic growth are likely to be revised upward.
While the stock market as whole is trading at a relatively high valuation, the foundation for rising corporate profits appears to be in place. We expect this trend to benefit a majority of stocks, but we expect those stocks of companies with reasonable valuations and visible earnings progress to produce more favorable relative returns.