Three Key Thoughts:

Markets Expecting Better Growth
ACA Fail, Taxes Next?
Fed on Target for a Change

Optimism about the potential positive impact of the Trump agenda continued through the first quarter. However, the impact was felt more broadly across the US stock market than it was in the two months immediately following the election.

The traditional growth sectors of the economy – technology, health care and consumer discretionary – led the stock market up in the first quarter. Stocks of financial, energy and industrial companies lagged the market. Small cap stocks also underperformed after a strong, quick run in late 2016.

Meanwhile, the bond market was positively subdued, compared to the fireworks than ensued immediately after the election. Even the dollar was a bit of surprise, giving back a good chunk of its post-election gains.

It would not be surprising to see volatility in the markets pick up from here. While the failure of the Republican effort to repeal and replace Obamacare didn’t set the markets back, a similar failure on tax reform could. We believe the markets’ current optimism is based partly on expected fiscal stimulus from lower tax rates.

In any negotiation of this magnitude there will be winners and losers. With Obamacare repeal and replace apparently off the table, keeping tax reform “revenue neutral” will be a much bigger task. And, if the so-called border adjustment tax proposal also falls off the table, then reducing tax rates in any meaningful way will become very difficult.

This assumes that some fiscal discipline is attached to the tax negotiations. The US fiscal deficit will begin growing in the next few years as entitlement obligations expand, particularly for retiring baby boomers. In our view, sharply higher deficit spending, either on tax cuts or infrastructure, could lead inflation and interest rates much higher, choking off the growth they were intended to create.

As we have been saying for some time, there are some sobering realities that serve to limit the potential growth of the US economy. First is the structural issue that an economy’s growth potential is the sum of the growth in the labor force and the productivity of that labor force. Labor force growth is pretty well set for the next 5-10 years at around 0.5%, which leaves productivity as the wild card. Except for the 1990s, recent productivity growth has averaged around 1%. Even if we doubled that, we still only get real growth of 2.5%.We may feel a bit better about that 2.5% real growth if inflation stays around the Federal Reserve’s 2% target.

Speaking of the Federal Reserve, we believe the other governor on growth will be tighter monetary policy. As we look at the Fed’s objectives, we see the table set for continued “normalization” of interest rates and the Fed’s balance sheet. The US economy is growing at or near its new potential rate, inflation is right around the 2% target and the employment picture is solid with unemployment under 5% and falling. As long as all three of these boxes stay checked, we believe the Fed will continue to raise rates gradually and will, with some advance notice, begin to reduce the size of its balance sheet. The Fed will be deliberate, however, erring to the side of more stimulus rather than less.

From the Middle East to East Asia, geopolitical events have grabbed the headlines. In particular, North Korea seems hell-bent on provoking confrontation with the US and its East Asian allies. It will be quite interesting to see if President Trump and his team can work with the Chinese to defuse this situation. Both sides have much to gain by working together.

There was very little reported immediately after the meeting between President Trump and President Xi but both North Korea and trade were on the agenda. It is certainly a positive sign that the two leaders met in person and have continued their discussions by phone. We also hope that the preparations for upcoming meetings will set the stage for a more nuanced set of trade policies from the Trump administration.

In Europe, the United Kingdom has kicked off the process of exiting from the European Union. It remains to be seen how much real impact Brexit will have on the economies of the UK and the European continent. Even while the European economy is showing signs of life, surprises in the upcoming elections in France and Germany this year could alter that course.

We have kept asset allocations relatively stable in client portfolios. While being cautious about deploying new cash, we have not reduced equity exposures meaningfully despite a strong first quarter. We continue to believe that non US stocks provide a more compelling value proposition than US stocks. Finally, we are re-evaluating fixed income investments as we believe that positive real returns will be hard to achieve in that space.