Hawkish comments from the Federal Reserve and improved prospects for tax reform helped drive strong performance in reflation beneficiaries and smaller capitalization stocks in September. This is in stark contrast to the trends that have held for much of 2017 in which high growth technology stocks have lead the market. Interest rates rose across the yield curve in September, while interest rates ended the third quarter nearly where they started. We expect the unwinding of the Federal Reserve’s $4 trillion money printing experiment to have a major influence on financial markets for the next two years. We also expect the Fed balance sheet reduction to put upward pressure on yields, especially for bonds with two to ten year maturities.
We currently forecast that U.S. real GDP will grow at least +2.0% to +2.5% in both 2017 and 2018 with a potential upside from improved capital spending and Trump administration fiscal policies. Synchronized global growth, improving domestic demand, enhanced profitability, and modest regulatory relief have buoyed business confidence and, as a result, companies have displayed an increased willingness to make capital outlays and build inventory. We believe that a protracted balancing of accommodative monetary policy is unlikely to derail domestic economic growth in the intermediate term. However, the reduction of quantitative easing by global central banks will almost certainly shift the investment landscape. As equity markets shift from a monetary policy driven market (rising tide lifts all boats) to one driven by company fundamentals, stock picking (i.e., finding companies that can consistently deliver quality earning growth) will be the driver of investment performance. We anticipate that earnings growth, rather than PE multiple expansion, will continue to be the primary determinant of stock appreciation going forward. As the range of possible economic outcomes remains relatively wide given ongoing monetary/ fiscal policy uncertainty, we continue to employ a diversified “barbell” strategy across client portfolios that encompasses a combination of visible/conservative growth sectors and pro-cyclical, Trump policy beneficiaries. We have increased exposure to financials as the sector stands to benefit, in particular, from a rise in U.S. interest rates, deregulation, and tax reform. We have also added to capital goods stocks with the expectation for an improved environment for capital spending.