It appears that larger U.S. corporations are preparing to ramp up domestic investment and that animal spirits (emotion-driven confidence) are beginning to emerge, but this optimism has not yet translated into an equivalent outperformance in quantitative data in the first quarter of 2017. Indicators currently imply that potential weaknesses in first quarter GDP will be followed by a better second quarter, which has been a common trend in recent years. Given the uptick in global growth, the recovery in manufacturing and energy activity, lean inventories, and resilient consumer spending, we forecast U.S. real GPD growth in 2017 at +2.5% versus 1.6% in 2016.
Based on the timing and magnitude of President Trump’s policy initiatives, economic growth could get a considerable boost, notably in 2018 and 2019, if well implemented. Some derivative impacts of policy shifts – a stronger U.S. dollar, higher interest rates, and increased uncertainty – could, however, weigh negatively on GDP in the nearer term.
In Europe, growth remains low despite a weaker euro and an uptick in global growth, which have contributed to strong exports and improving business activity across the Euro Area. Although still experiencing economic expansion, growth in the U.K. has moderated in recent months as waning consumer confidence, subdued real wage growth, and higher inflation have weighed on retail sales. Despite solid economic momentum year-to-date, tailwinds from favorable currency exchange rates, Chinese government stimulus, and easier year-over-year comparisons will likely face in the second half of 2017. We currently forecast that 2017 real GDP growth will remain relatively steady at +1.7% in the Euro Area and decline to +1.5% in the U.K. as Brexit-related issues weigh on growth. We expect that monetary policy will remain accommodative through the end of 2017, but economic prospects remain somewhat constrained in the intermediate term by heightened political risk associated with upcoming elections in France, Germany, and Italy, as well as the U.K.’s formal initiation of Article 50 (i.e., two-year process to exit the EU) on March 29. However, we believe that a less-impactful political calendar heading into late 2017 and 2018 could set the stage for improved policy visibility and economic growth.
Improved growth overseas has lifted Japan’s economy in recent months due to an increase in exports and it’s capital spending has begun to stir, but Japan’s near-term growth remains tied to its trading partners’ prospects, as internal growth sources remain limited by severe structural challenges – particularly its rapidly aging work force, which is reflected in the country’s labor shortages and low unemployment rate). Japan’s consumption figures remain sluggish and consumer confidence is restrained. Prime Minister’s Abe’s reform efforts have yet to clear a path toward sustained, domestic-driven growth. We expect limited growth of +0.5% in both 2016 and 2017.
Thanks to government stimulus and an easy money policy, China’s economic upcycle has lasted longer than expected. However, structural issues remain and the monetary policy is shifting toward neutral. We think China’s growth is likely to peak in the near term and expect a gradual moderation in GDP growth. We believe the Chinese government’s goal of +6.5% real GDP growth in 2017 is achievable.
The Federal Reserve increased the target Fed Funds rate in March by 25 basis points to a new range of 75 – 100 basis points. Discussions at the Fed are now focusing on reducing its very large balance sheet, which would remove monetary stimulus and, in essence, raise interest rates. The market is currently anticipating 2 to 3 more rate hikes in 2017. We expect Treasury yields to continue to move higher over time as the new administration’s policies are implemented, but to do so in a range-bound fashion – with positive economic developments partially counteracted by contentious social and political headlines. The taxable bonds yield curve flattened during the first quarter of 2017 as yields rose in shorter maturities and fell in longer maturities.
The AAA tax-exempt municipal bond yield curve steepened slightly during the quarter due to modest yield declines at the short end of the curve and relatively small net yield movements 15 years out and longer. The yield was 4.25% at the end of March.
All duration indices had positive returns for the year, with performance relying modestly on positioning along the curve. The intermediate bond indices performed best, while longer duration bonds caught up in March – perhaps due to heightened political uncertainty. Infrastructure spending and tax reform is likely to impact performance in 2017. All investment-grade municipal bond index returns were positive at the start of the year. Lower credit quality outperformed. The housing sector, where we tend to have heavier weightings, has been the strongest performing investment grade municipal sector thus far in 2017, and we continue to find housing bonds offer strong relative and defensive value in rising interest rate environment for the near- to intermediate-term.
Total issuance in the first quarter of 2017 could be the lowest of the past decade, currently down 12% from 2016, and we expect supply for 2017 to lag the record pace of 2016.