Will the Trump stock market rally continue into 2017?

The U.S. stock market rallied to new highs in the weeks following Donald Trump’s election as president of the United States. The “Trump rally” was strongest in segments of the market projected to benefit the most from policy changes under his administration. Small company, financial services and energy stocks were among the winners, while healthcare stocks, bonds and bond proxies were among the losers.

Expectations for 2017 are generally positive for the stock market, anticipating that the “pragmatic” economic version of Trump wins out over the “anti-growth” version of Trump who often appears in late night Twitter rants.

Key economic assumptions for the new year are for moderate growth in corporate earnings, rising employment and wages, and interest rates that rise at a moderate pace. Policy assumptions are for increased government spending, corporate and personal tax reform, and for an easing of regulation.  

The expectation of corporate tax reform provided a significant boost to small company stocks, which often pay effective tax rates that are close to the statutory maximum. If corporate taxes are lowered, the small company stock rally is likely to continue.

{mosads}The hope for a less-burdensome regulatory reform is providing an additional boost in sentiment for small company stocks, while contributing to the rally in bank stocks. Low interest rates and a flat yield curve have hurt bank stocks for many years, so the reversal in interest rates and inflation expectations triggered a rally in bank stocks. Strong economic momentum and increasing interest rates make financial services an attractive investment segment for 2017.  

Trump’s selection of fossil-fuel friendly advisors and the recent OPEC agreement to limit oil production has boosted energy stocks, though energy prices may not have much more room to run given shale supply that will come back into production as prices rise and the increasing cost-competitiveness of renewable energy sources such as solar and wind. Although Trump may want to help the coal industry and fossil fuel producers, economic reality may get in the way of his plans.

“Lower for longer” Federal Reserve policies are being supplanted by a more balanced outlook in which inflation is considered an emerging risk. Consequently, investors have adjusted their expectations for rate hikes, with longer-term government bonds, municipal bonds and emerging markets debt losing ground. Bond proxies that benefited from the quest for yield earlier in 2016, such as utilities and real estate investment trusts, also lost ground after the election. A rising rate environment into 2017 will extend the pressure on bonds and bond proxies.

Healthcare and defense stocks are controversial segments of the market. Both were expected to be winners in a Trump administration. Healthcare was expected to benefit from lower pricing pressures and repeal or restructuring of the Affordable Care Act.  However, Trump has become more vocal about high drug prices, so the sigh of relief from pharmaceutical executives after his election may have been premature. Defense stocks were also expected to winners under Trump, but recent criticisms of Boeing and Lockheed Martin indicate that Trump may strike a hard bargain with government contractors.

European stocks face challenges in the aftermath of the Brexit vote, populist unrest and a weakened banking system. Japan faces daunting debt levels and demographic challenges, though Japanese stocks have rebounded in recent weeks with help from a falling yen and government equity purchases. Emerging markets have a mixed outlook, as rebalancing toward consumer-oriented economies will help some emerging markets, but the strong dollar and American protectionism will hurt others.

The euphoria of the recent rally may fade as Trump faces the limitations of presidential power. Uncertainty is building about the specifics of his governing priorities and ability to implement policy. Changes to the market outlook are likely to be driven by a few key economic and geopolitical considerations, including tax and spending initiatives, trade policy, immigration changes and global geopolitical developments.

The bottom line is that investors can count on 2017 to be a year of continued volatility.

Daniel Kern, CFA, is chief investment strategist for TFC Financial Management, a financial advisory firm based in Boston. He earned an MBA from the University of California, Berkeley and is a former president of the CFA Society of San Francisco.

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