Outlook 2016: Back to Normal for the Economy and Markets?

Presented by Andrea Stackland-Winterer

We ended 2015 approaching normalcy in the economy and markets. And after seven years of crisis and recovery, normal is something to celebrate.

Employment has returned to pre-crisis conditions—and even better in some respects. The housing market has recovered fully, with prices rising at sustainable rates. The consumer has become much stronger, and the government has actually started to contribute to growth, rather than detract from it. Unlike the unsustainable, debt-driven growth of the mid-2000s, however, growth in 2015 continued to run below its potential. Some think this is a bad thing, but I don’t. I prefer steady, if slower, growth to the stop-start of the preceding decades.

Expectations for continued sustainable growth As we look into 2016, I believe that we can expect the economy to finally approach normal levels, with normal employment conditions, normal interest rates, and normal markets. I expect growth to accelerate from 2015 levels to levels closer to what prevailed in the 1990s and 2000s—in other words, normal—and the following constituents will fuel it:

• Employment is likely to continue to grow, albeit at slower levels than in 2015, as we get closer to normal employment levels.

• Housing is expected to appreciate at a level driven by constrained supply and a healthy growth in demand, driven by household formation.

• Businesses may bring their investment back to normal as the energy sector stabilizes and the dollar steadies, albeit at a high level.

• Government spending patterns, now that there’s a two-year budget deal in place, look likely to revert to normal.

As we get back to normal, the economy is poised for continued sustainable growth. All things considered, I expect to see real economic growth of around 2.5 percent, with the possibility of stronger results. With wage income growing at around 4 percent on a nominal basis, business investment growing at around 6.5 percent, and government spending showing slow growth around 2 percent, this 2.5-percent figure appears both reasonable and achievable. Combined with inflation of around 1.5 percent for the year, nominal growth should approach 4 percent—even better than we saw in 2015.

What are the risks? For the economy, there are risks both ways here. On the upside, if wage growth increases, consumer spending power could increase more quickly. If consumer borrowing were to pick up—and there are signs that it is starting to—spending could grow even faster. Business investment could respond to improving demand and rise more than expected. Local and state governments could increase investment and hiring more than expected.

On the downside, risks are primarily external, with China as the biggest, followed closely by Europe. China is grappling with an economic transition from investment-led growth to consumer-driven growth, which may be slower and will certainly use less in the way of commodities—with consequent damage to the economies of other countries. Europe continues to wrestle with the interests of the continent as a whole versus those of the nation states, most recently with the Syrian refugee crisis, while the economic concerns have not gone away. As I write this, Italy may be moving into the headlines as the new Greece. Any of these could result in systemic damage, with consequent negative effects on the U.S. economy and financial markets.

The major domestic downside risk involves the effects of rising interest rates now that the Federal Reserve (Fed) has finally started to raise them. After the initial small rate increase, long awaited, in December 2015, many wonder how quickly the Fed will raise rates going forward. Should rates rise too far too fast, the economy could slow. The Fed is aware of this, however, and is determined to remain part of the solution rather than becoming part of the problem, so the most probable case remains very slow rate increases that support continued economic expansion.

For the stock market, 2016 could be quite challenging. I expect the U.S. equity markets to end the year with moderate appreciation from levels at the end of January—around 2,050 for the S&P 500 as a base case. On a relative basis, earnings growth should improve as the energy companies adapt to lower oil prices and U.S. companies adapt to a stronger dollar. With the potential for faster earnings growth, valuations may expand over the year, although that may be limited, as we start the year with pricing already high. Another headwind for potential multiple expansion is the expected rise in interest rates, making bonds more attractive as an investment and lowering the present value of the slowly growing earnings stream even more.

Unlike the economy, I believe the risks to the market are mostly on the downside. Valuations are high—higher than they were in 2007, for example. Profit margins are at historic highs, and the tailwinds that got them there are disappearing as wage growth picks up and stock buybacks stabilize or decline. Unlike in the real economy, market-related debt has increased back to 2007 levels and above. All of these factors will contribute to a more volatile market in 2016—which, however, is again a return to normal. Absent the Fed’s security blanket, the market should be more volatile, and I believe it will be.

That said, there is also the possibility that retail investors could continue to buy in to the market—which could drive prices higher. This “bubble effect” would drive valuations even farther above historic norms. Although this could certainly happen in 2016, it would only set the stage for a more severe adjustment later on.

A return to normal In considering the year ahead, I believe the economy’s return to normal should continue—and even accelerate. Low oil prices are likely to continue to support the global economy, allowing China and Europe to continue their recoveries over the year. This, in turn, will reduce the perceived risk level and potentially support global markets. As the economy normalizes, the Fed will continue to step back, which should lead to slowly rising interest rates.

Any interest rate increases will be constrained by the quantitative easing programs announced by both the European and Japanese central banks, as well as by ongoing political turmoil in Europe and potentially in Asia. Low rates abroad will support U.S. growth, however, and the strengthening dollar will make the U.S. even more attractive as an investment destination. The U.S. will remain the primary global growth engine and stable haven, which will add more support to U.S. markets.

Although U.S. financial markets are suffering from declines as valuations adjust downward, moderate appreciation from current levels, as of the end of January, remains quite possible, with earnings expected to return to growth in 2016 and valuations anticipated to increase, in general, with an improving economy. The outlook for foreign markets is more uncertain, however, as the effect of quantitative easing on those markets has been to increase valuations above historic norms.

Disclosures: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s. Emerging market investments involve higher risks than investments from developed countries and also involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation.

###

Andrea Stackland-Winterer is a financial advisor located at 175 Highland Ave Suite 304, Needham, MA 02494. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at (339) 225-4046 or at andrea@e-3-fp.com.

Authored by Brad McMillan, CFA®, CAIA, MAI, senior vice president, chief investment officer, at Commonwealth Financial Network.

© 2016 Commonwealth Financial Network®