Friday, December 30, 2016

Predictions for 2017

Making forecasts is of course foolish, but to a degree it's necessary. It's important to have a view on both the economy and on what the market expects of the economy in order to invest with confidence—confidence being a key ingredient for successful long-term investing. For example, taking on risk when the market is risk averse is potentially more rewarding than taking on risk when the market demands a high price for it. In a nutshell, markets move when the future turns out to be different than what was expected, so it pays to have a view on what is expected and what is likely.

So that readers may judge how successful (or unsuccessful) I've been in this regard, it has been my custom for a number of years to annually review the success or failure of prior predictions while at the same time offering up predictions for the future.

First, a look at how last year's predictions turned out:

I was generally optimistic, because I thought the market was still overly concerned about the economy's ability to grow, and because I thought the economy had lots of upside potential that could be unlocked with more growth-oriented policies. I thought the Fed would move very slowly to raise short-term interest rates. I wasn't at all convinced that Trump's policies would be good for the economy, since at the time he was emphasizing a populist, trade-bashing approach, but I didn't rule out an improvement. As it turned out, optimism beat pessimism this past year and I've been rewarded. The economy turned out to be a little better than the market expected.

I advocated holding risk assets, with an emphasis on yield. As it turned out, stocks with higher-than-average dividend yields handsomely outperformed the S&P 500, while almost anything beat the return on cash. I thought real estate would outperform but it didn't, mainly because of the market's concern that higher yields would be bad for the sector. I thought the outlook for gold and commodities was grim because the outlook for the dollar was positive; however, to just about everyone's surprise (including mine), gold and in particular industrial commodities did well this past year despite the dollar's strong performance. I thought emerging markets were due for a strong recovery, and that paid off in spades (e.g., Brazilian equities rose almost 70% in dollar terms this year).

I worried once again (as I have for many years) that the Fed might prove slow to react to the return of confidence, and that as a result they could end up falling behind the inflation curve. So far, however, that doesn't appear to be the case, since inflation expectations remain relatively docile. 

Here's what I see in my crystal ball for 2017:

In contrast to the situation a year ago, when I thought the market was insufficiently optimistic, the market today appears more optimistic about the future (e.g., the S&P 500 PE ratio was 18.8 a year ago, and today it's 21). This sets the bar for investing success higher than it was a year ago. The market is priced to good, growth-oriented policies coming out of the Trump administration, so any fumbles along the way are likely to be met with selloffs. (If there's anything we know about Trump, it's that he can confound expectations.) But by and large I expect he will pursue a pro-growth policy agenda, and this will contribute to a measurable and possibly a substantial improvement in the economy's growth. The going is likely to be bumpy at the outset, but over the long haul I expect to see an improving economy and further gains in equity prices and most other risk assets.

I don't necessarily disagree with the market's view that the Fed will raise short-term rates by 50 bps next year. But I worry, as I have for years, that there's a decent chance the market—and the Fed—could be underestimating the degree to which rates should rise as the economy strengthens. The market expects inflation to be well-behaved at somewhere close to 2% for the foreseeable future; I worry it could surprise to the upside. The main driver of higher-than-expected inflation would be a decline in the demand for money. As I pointed out before, if the market's demand for money should decline because of rising confidence and less risk-aversion, there is a virtual mountain of cash sitting on the sidelines that could fuel higher prices, especially if the Fed is slow to take steps to increase the demand for money by raising short-term interest rates. Over the long haul, I think there's a decent chance that interest rates will move up by more than the market currently expects, so risk-free Treasuries don't look very attractive at current levels. The yield spread on riskier bonds has come down a lot over the past year, so while they are still attractive relative to Treasuries, they certainly aren't a steal and should be approached with a degree of caution.

I think the market worries too much about the negative impact that higher interest rates could have on real estate and the economy. That's because the market sees higher rates as a "tightening" of monetary policy (which to be sure is eventually bad, since it's been the proximate cause of almost every recession), when in fact higher rates—for at least the next year—will simply be the natural result of a stronger economy. The time to worry about tight money is when real interest rates are 3% or more and the yield curve is flat or inverted, and we're a long way away from those conditions. Higher rates are not going to kill the real estate market, even though the market almost always reacts as if that's so. Real estate in general should benefit from stronger growth, and it should be a good hedge against rising inflation.

The dollar is fairly strong at current levels, because of several well-known factors: the Fed is the only major central bank that is in rate-hiking mode, and the U.S. economy has a lot more upside potential than almost every other major economy. But the dollar is not yet "too strong," nor is it likely to be a problem for the economy. The dollar is relatively strong because the U.S. economy looks more attractive than most others; if you want exposure to this relatively attractive economy, you're going to have to pay up to get involved. That's reasonable. This is not a situation in which the dollar is strong because there's a shortage of dollars in the world, and that is probably a good explanation for why commodities can continue to rise even as the dollar rises: it's about optimism and growth, not tight money.

A year ago I noted the impressive victory of Argentina's Macri, who, like Trump today, was set to move policies in a more pro-growth direction. Since then we've seen pro-growth surprises in Brazil and the UK (Brexit), and there's likely more to come (e.g., Italy and France). The political winds are in fact shifting in a more pro-growth direction in many countries (a new and better government in Venezuela is almost a certainty), and that is a nice tailwind for most risk assets. Emerging markets still look good, despite the strong dollar, because, again, it's about the return of optimism and growth.

I don't have strong feelings about gold, but I do believe it is still expensive relative to its long-term average real price which I figure is somewhere around $500-600/oz., so I'm not keen on adding it to my portfolio. Oil seems reasonably priced at current levels, and it's unlikely to become too cheap or too expensive for the foreseeable future, thanks to plenty of fracking capacity that is currently on the sidelines and upside economic growth potential.

The important thing about Trump is that he is a businessman with experience in how things work in the real world; he's not an ideologue. He understands and appreciates the power of incentives, and he is distrustful of the power of government to accomplish good things. It's very encouraging that he understands the growth-damaging effects of regulations. He won't always do things "correctly," but he's likely to get good results.

My main concern with Trump is that he fails to understand the benefits of free trade, and his trade advisor, Peter Navarro, is exceptionally clueless in that regard. Whether the two of them can persuade a more trade-savvy Congress to impose punitive tariffs on imports is not clear, however. I'm hoping that their bark ends up being worse than their bite, and practical considerations trump rhetoric in the end. We don't need balanced trade (e.g., no trade deficits), but what we do need is freer trade. For that matter, the economy desperately needs less regulation, not more.

I'm not worried that a much-needed reduction in tax rates will balloon the deficit, because lower tax and regulatory burdens, plus fewer deductions and subsidies, should add significantly to the tax base. I seriously doubt that we'll see a major and foolish rush to spend money on infrastructure; what we need instead is for government to create incentives for more infrastructure spending at the private and local levels, where the risk/reward tradeoffs are best understood. 

18 comments:

The Cliff Claven of Finance said...

Have you ever predicted a recession before one started?

Please provide real-time evidence that you have correctly predicted any recession before it started.

I say this not to be mean, and perhaps get banned from your blog comments.

I say this because you are obviously not a young man, and have lived through many recessions.

When I hear a prediction from anyone about the future economy, the first thing I want to know is how well that person has predicted the future economy in prior decades.

If there was no long track record of accurate predictions, they why should anyone listen to the current prediction, or even rely on it for their investments?

Almost all economists predict economic growth every year.

As a group, economists have NEVER predicted a recession.

Its far more important to predict a recession, and be correct, than to predict continued economic growth every year like a stopped clock.

But that's just what most economists do -- especially those affiliated with Wall Street (selling financial products).

I don't believe economists should make public predictions.

They should focus on teaching economics so that people can judge what proposed government policies are likely to do to most people in the long run.

We have a president elect whose primary policy position was opposing balance of trade deficits ...

... and almost no one in the mainstream media talked about the balance of payments ... and the dollars from overseas that were loaned to the US government to finance its massive deficit spending (massive considering where we are in the business cycle).

I assume the mainstream media don't talk about economic issues in detail because they don't know anything.

That's where economists could significantly benefit the nation (and you have by talking about proposed trade policies on this blog).

When someone promotes free college, or a $15 federal minimum wage, we need journalists with enough knowledge to at least have a high level discussion on the pros and cons of those proposals.

Instead, journalists (and the president elect too) don't know much about economics .... and economists are busy giving us their predictable bullish annual forecasts:
'We expect the economy to grow 1.5% / 2%. / 2.5% / 3% (pick one) next year.'

Scott Grannis said...

I haven't predicted any recessions in my career, which started in the early 1980s. Back then I was part of a team that predicted a huge decline in inflation and a very strong economy, and that proved correct. But there have been only three recessions in the past 35 years; recessions are the exception, not the rule. Over the years I have been quite successful as an investor, however, perhaps because I don't try to time the markets; I try to buy things that look undervalued and I am very patient. If Trump starts a trade war, I would predict bad things for the economy, possibly a recession. I've been clear that Trump is very wrong when it comes to trade. I don't think he will make a big mistake, but that's just my guess. I have absolutely no connection to Wall Street firms. I'm just an independent observer who spends time looking out over the Pacific Ocean. I don't mind criticisms, as long as they are well articulated. You make good points. But I don't think anyone has the proven ability to forecast recessions.

If I have an inherent bias, it is that I think it is difficult to overestimate the US economy's inherent dynamism. Over time it pays to be an optimist rather than a pessimist.

Scott Grannis said...

I did correctly predict the 2009 recovery (4-5 months in advance of its occurrence), and I did correctly predict that the recovery would be "sub-par" and disappointing, mainly because of all the faux fiscal stimulus, rising tax rates, and increased regulatory burdens. Yet despite predicting a disappointing recovery every year since early 2009, I remained steadfastly bullish on the outlook for the equity market, mainly because I thought the market was being too pessimistic.

anonymous said...
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Benjamin Cole said...

Wonderful post by Scott Grannis.

BTW-- worry not too much about free trade. Forgotten today is that President Reagan was a aggressive protectionist, yet it was a great time to be an investor.

My bad scenario outlier: real estate values fall a little in 2017, and that cramps the endogenous creation of money. This leads to a recession. The very strong US dollar is cramping exports too.

Michael Meyers said...

Scott,

Thanks again for your ongoing effort in publishing your blog. It is always very insightful.

As for "free trade", sure, when we trade our corn for their bananas then both parties are better off. The problem is that some world players make trade as an economic, I win - you lose, proposition.

As an example, when China sells us steel made in state owned factories at below true costs, then "free trade" is maybe not so great for us. Of course you could argue that we are getting the cheap steel, but putting our steel industry out of business is not good for us long term.

Rob said...

Many thanks Scott for another year of valuable blogging insights.

As a Californian do you worry about the state going bankrupt ?

Scott Grannis said...

Re: trade with China. I recommend you spend some time reading some of the hundreds of posts on the subject of trade at Cafe Hayek. Don Boudreaux is an eloquent and prolific defender of free trade, and it makes no sense for me to do other than refer to his work:

http://cafehayek.com/?s=trade

xr-3609 said...

Scott, thank you for another year of your really informative, educational, interesting, valuable for investing, and eminently readable; economic opinions!

Regarding the Cliff Claven of Finance's comment:
1. "I don't believe economists should make public predictions": Cliff try North Korea
2. "As a group, economists have NEVER predicted a recession": an impossible criticism, and if it were possible, in what time frame, and how would the market discount the predicted recession? You could have a parallel universe in which the market fully discounts and then fully values the recovery, before the recession actually begins!
3. We assume Cliff is talking about an NBER recession? Wherein not all recessions are even defined by "two or more quarters of declining real GDP," most are "but not all of them." http://www.nber.org/cycles/recessions_faq.html
4. An NBER recession is defined and timed by the NBER, "The committee's determination of the peak date in December 2007 occurred 11 months after that date and the committee's action in determining the trough date of June 2009 occurred 15 months after that date. Earlier determinations took between 6 and 21 months. There is no fixed timing rule. The committee waits long enough so that the existence of a peak or trough is not in doubt, and until it can assign an accurate peak or trough date." http://www.nber.org/cycles/recessions_faq.html
5. Cliff said, "They should focus on teaching economics so that people can judge what proposed government policies are likely to do to most people in the long run." Cliff, you found the right economist in Scott Grannis. If you know any comparable sites, please share!



Unknown said...

Thanks for your predictions Scott. Would you be able to elaborate the pros and cons on the Border Tax Proposal that I've read articles from both Donold Trump and Paul Ryan? Thanks in advance.

Andrew Ross said...

Scott;

You've stated that the time to worry about the economy is when real interest rates are 3% or more and the yield curve is inverted. However, you did not explain at what duration.

Short term TIPs are currently negative.
5 years 0.1%
10 years 0.6%
15 years 0.7%
25 years 1.0%

I'm thinking that you must be referring to long term real interest rates. Is that correct?

Also, liquidity is also abundant as you've explained before and normal tightening is accompanied by a reduction in liquidity.

Would rising real rates go hand in hand with a reduction in liquidity? Or, could rising real rates with abundant liquidity be a totally new phenomenon or maybe just impossible?

Thanks again for such an astute evaluation of the economy.

Wishing you the best 2017!

Scott Grannis said...

Andrew, re yield curve: I'm referring to both the nominal and real yield curves, both of which are still "normal," or positively-sloped. Starting from short-term rates (which are very low historically), moving out the yield curve results in a steady increase in rates. The current real Fed funds rate is about -1%, while 5-yr real yields are about zero.

In a typical "tightening" of monetary policy, the Fed pushes the funds rate higher and higher. As the real funds rate approaches and exceeds 3% or so, this is approximately the point at which liquidity becomes scarce. As liquidity becomes scarce, long-term real interest rates begin to decline relative to short-term real rates, as the market begins to price in a weakening of the economy in the future.

In any event, at the Fed's current pace, real short-term rates are not going to reach 2 or even 3% for a very long time, I suspect.

Unknown said...

RE: Cliff Haven's comments - We all need to be thinkers who seek quality input from a variety of sources to formulate our own convictions. Scott's excellent blog is such a source - a well articulated, well educated point of view. Nothing more. None of us should be looking to him or anyone else to correctly predict 12 out of 3 recessions.

Thinking Hard said...
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The Cliff Claven of Finance said...

Thinking Hard:
I think I like "Cliff Haven" even better than Cliff Claven.

I come to this website because I think Mr. Grannis presents a good summary, with very good charts, of establishment economist view ()at least the ones who favor capitalism).

Establishment economists are almost always optimistic and bullish -- their employers, or former employers, usually required that.

If one is always optimistic and bullish, one will be right 8 or 9 years out of 10 = a very good batting average, but the thing people need to know most of all is if a recession is coming -- because if a recession is coming, a decline in the stock market is not going to be the usual "Buying opportunity", it will be the worst possible time to invest.

If one is always optimistic and bullish, one should not make annual forecasts because they will always be bullish and will miss the one or two recessions / bear markets in each decade.

A forecast that misses all recessions is not worth anything, and could be especially dangerous for readers who have great trust in that economist (after all, he will be right every year there is no recession, so will seem the smartest just before a recession, that he didn't predict, starts).

Mr Grannis wrote in his comment here:
"I don't think anyone has the proven ability to forecast recessions."

And that is exactly my point.

If no one can forecast recessions, then what is the point of presenting a bullish forecast every January?

At best, readers will think your guess is as good as mine.

At worst, readers will use the forecast for a decision to move their cash into the markets ... at just the wrong time, if a recession is ahead.

(1) It's been a long time since the last recession started.

(2) Stock valuations (market cap weighted) are near the highest ever -- and for the median stock, valuations are at all-time records.

I think knowing those two facts is more useful than a 2017 forecast that says GDP growth will be 1.5% / 2% / 2.5% / 3%
(you pick one), and there will be no recession, which pretty much describes every annual forecast of every establishment economist in the world ... and on Mars too.







John said...

Echoing others' thanks for continuing the high-quality, data driven blog. Continue to watch for details regarding proposed policies for relief from regulatory burdens.

Will Dodd-Frank restrictions on prop trading go away?

William McKibbin said...

Maybe it's my age, but I have been steadily divesting since last summer, including income stocks, precious metals, and non-producing real estate. I just can't sink my teeth into the current market conditions. But again, perhaps it's just me. I would be very interested in acquiring treasuries once rates rise above 8-9 percent. But for now, I like cash.

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