Welcome to the New Year! The current economic recovery turns nine this summer making it the third longest in U.S. history. However, this calendar-old recovery still appears young at heart. It has not yet sustained a real growth rate above 3%, has never been driven by excessive borrowing or lending nor produced a significant capital spending or housing cycle. Moreover, because it has only recently returned to some semblance of full employment, it has yet to seriously aggravate inflation. Yields about the globe remain near all-time records lows and the Federal Reserve is only now beginning to finally normalize monetary policy. Finally, despite an almost three-and-a-half fold increase in the U.S. stock market from its 2009 low, this bull market has never generated a broad-based public run into equities.

Perhaps for the first time in this recovery, we expect animal spirit behaviors; those originating from confidant businesses, consumers and investors, to increasingly characterize both the economy and the financial markets in 2017. Essentially, this furthers trends already evident during the last few months of 2016. After almost a two-year hiatus, economic growth recently accelerated and broadened about the globe. This rare synchronization in the economic recovery comes just as the U.S. has finally returned to full employment. Consequently, improved economic growth is also aggravating inflation and interest rate concerns.

Although broader economic growth, a restart of the earnings cycle and the election of a pro-business U.S. president have recently combined to boost confidence and awaken the animal spirit throughout the private sector, it also represents a quandary for the financial markets. The stock market begins the year surging to new highs as confidence in the durability of the economic recovery improves. However, the bond market is being battered by rising inflation expectations and recognition that the artificially low yield structure orchestrated about the globe during this recovery may finally be ending.

Here are some specific impressions for the economy and the financial markets in 2017.

Economic growth

The 2017 economic outlook is shaped by many important factors including a synchronization of economic policies about the globe, an economic recovery which is broadening both globally and within the U.S., a refresh and restart of the profits cycle, an end to the global manufacturing recession and collapse in commodity prices, the potential for awakening animal spirits and the increasing likelihood that a

recession is still multiple years away.

Synchronized global economic policies

Not only has global economic growth been persistently subpar, it has never been synchronized. Economic policies typically conflicted during this expansion and economic boats around the globe have seldom risen together. While the U.S. has persistently employed stimulus, other developed and emerging economic policies have often been restrictive. While Japanese policy officials were hesitant earlier in this recovery, today, similar to the U.S., they are implementing full-out central bank balance sheet stimulus. Likewise, the eurozone, which earlier adopted fiscal tightening, is now also fully embracing monetary stimulus. Moreover, the oil crisis has forced energy-based economies like Canada and Australia, which earlier felt sheltered from many ongoing global struggles, to also boost accommodation.

Consequently, as illustrated in Charts 1 and 2, in the last couple years, policy officials everywhere have simultaneously attempted to improve the economic

recovery. Already, signs of a synchronized global economic bounce are materializing and we suspect this will become more obvious as the year progresses.

David Fuller's view

There is a lot to like in this global report which I commend to subscribers.  After eight years of mostly negative comments, including a number of very bearish reports from so many analysts and strategists, this is the most bullish detailed report by far that I have seen since the 2008 crash. 

Market sentiment has steadily improved since Trump’s surprise presidential election.  This is despite many alarmist forecasts in anticipation of a Trump administration, albeit mostly from the left-leaning press.  Clearly the money men are delighted to see a President-elect who is interested in the US economy, and promises a number of stimulative policies.  This has led to a number of upside breakouts, often from multi-year trading ranges from trading ranges, and not just among US indices.     

In fact, James Paulsen mentioned “animal spirit”(s) 24 times in the report above.  Is that a record?  He also mentioned “synchronized” or “synchronization” of economic policies eight times. 

I agree with most of what Paulsen says but I am left asking myself, is he too bullish, at least initially?  On page 3 he mentions the “December jump in the Conference Board’s Consumer Confidence Index to its highest level in more than 15 years.”  On page 7 he mentions: “As [US] wage inflation surges above 3$, inflation expectations are likely to reach new recovery highs above 2.5% this year.”  I agree but they could easily rise faster, as we see with German rates in the lead article above. 

Paulsen mentions on page 8 that against general expectations he thinks the US dollar will move lower this year.  His reason for this: “… since 1970, the dollar has typically declined when the federal funds rate has been increased.  Often, what has moved the U.S. dollar is not interest rates per se but rather the “reason” interest rates were being lifted.”  My concern about this is that the US currency was commencing a  secular bear market around 1970, albeit dramatically interrupted by Paul Volcker’s record high interest rates several years earlier, which pushed Treasury bond yields to highs in 1981 and again a slightly lower peak in mid-1984.  I now believe the USD is in a secular bull market.  However, if Paulsen is right about the USD, I think that will be good for Wall Street because it will not be a headwind for US corporate earnings.

If the USD does weaken somewhat in 2017, as Paulsen forecasts, that would be bullish for commodity prices as he mentions on page 9 & 10.  Yes, but that would increase inflation pressures, ensuring further rate hikes by the Fed. 

I agree that US 10-Year Bond Yields could rise to 5% within the next three years, as discussed by Paulsen on pages 10 & 11, and I would not want to own any bonds at this time, except perhaps TIP bonds mentioned on page 12.

Paulsen also expects plenty of choppy action and tones down his bullishness somewhat in the latter portion of this interesting report.  Nevertheless he mentions on page 13 that the S&P could reach 2720 over the next five years. That is certainly possible but not in a straight line. 

Lastly, he is also looking a good correction in pages 15 & 16: “In a much less dramatic fashion, we suspect 2017 may rhyme a bit with 1987.”  I am expecting a sharp cyclical bear of 20% or so within the next three years but not another big secular bear unless something currently unexpected and quite alarming occurs – hopefully and probably only a minor possibility. 

The bubble of 1987, as veteran subscribers may recall, was a speculative overbought condition because US stock market futures contracts had been introduced for the first time. Consequently, institutional investors felt they did not need to worry about overvaluations because they could hedge very quickly if something went wrong.  It did, starting with central banks panicking and raising interest rates very rapidly in September and the first half of October 1987.  After several days of sharp selling, S&P 500 futures were swamped by hedge selling on Monday October 19^th, known forever after as “Black Monday” because everyone tried tied to hedge / sell at the same time.  Some people thought it was the end of the world but it was just a market panic, which caused little economic damage.  As with all crashes, it created a wonderful buying opportunity.

Here is the Federal Reserve’s far more detailed assessment.  

Here is a PDF of James Paulsen’s report.