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Q4 Outlook: A look at key issues, sectors as 2018 approaches

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The stock market continued to hit new highs through the third quarter, confounding those who focused on the rapidly changing headlines in the U.S. and throughout the world. We believe there still are a number of key issues that investors should watch as we enter the final quarter of 2017. We also have updated our views on several key stock sectors. We believe there are opportunities in companies that continue to demonstrate strong fundamentals — despite the occasional distractions of the global news cycle.

stay alert to key issues
Tax reform leads the agenda

Since President Donald Trump’s election in 2016, there have been varying expectations for a change in U.S. tax policy. A broad tax framework with the goal to make American companies more competitive recently was released by the “Big Six”: Speaker of the House Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Chairman Kevin Brady, Senate Finance Committee Chairman Orrin Hatch, Treasury Secretary Steve Mnuchin and National Economic Council Director Gary Cohn. That group represents a wide swath of both the legislative and executive branches of the federal government.

Overall, we believe this plan is a positive move. It consists of a reduction in both individual and corporate tax rates and eliminates many deductions. Under the proposal, the corporate tax rate would be reduced to 20% versus the current federal rate of 35% and an average of 22.5% for other industrialized countries.

The proposed tax plan also calls for an incentive to increase capital spending. Republicans plan to pass this legislation under rules allowing a simple majority in the Senate, meaning no support from Democrats would be needed. We are cautiously optimistic that some version of tax reform will be signed into law.

Trump has continued to seek improvements in infrastructure across the U.S., as he did during his presidential campaign. We believe the focus of his administration will turn to infrastructure only after tax reform is completed. The discussion, however, is likely to focus on how to pay for infrastructure projects. We don’t think there will be broad support for large deficit-financed infrastructure spending. We think a more likely solution will come via a focus on public-private partnerships.

Trump also has been active since his election in pushing for deregulation as a way to support U.S. businesses. We believe this will continue to be a focus of the administration and think it will provide a positive impetus for business confidence and economic activity.

Changing tone of monetary policy

Global monetary policy continues to diverge. Even so, it is clear that more central banks are moving away from their crisis-induced policies that were prompted by the global financial crisis that began in 2008. We believe this divergence should be watched carefully as different parts of the world begin to exit extremely easy monetary policies.

The U.S. Federal Reserve (Fed) has hiked interest rates four times since late 2015. We think the Fed will raise rates again in December and two more times in 2018.

The Fed also has announced that it would begin to reduce its balance sheet starting Oct. 1 by allowing maturing Treasury and mortgage-backed securities to roll off. The drawdown will initially be capped at $10 billion per month and will increase by $10 billion each quarter until it reaches $50 billion per month. We think most financial markets already are pricing the drawdown into their projections and do not expect major volatility as a result of the Fed’s actions.

The European Central Bank (ECB) continues to purchase 60 billion euros per month in securities. We expect the purchase amount to wind down throughout 2018 until it reaches zero, with interest rates remaining at current levels.

We think the Bank of England probably will increase interest rates in November, but the pace of further rate hikes will be slow in 2018 because of a weaker economy in the U.K. and continued uncertainty in the Brexit negotiations between the U.K. and European Union (EU).

The Bank of Canada is likely to continue hiking rates slowly in 2018 and we think the Reserve Bank of Australia will begin increasing rates next year. However, the Bank of Japan still is likely to lag the rest of the world in removing its accommodative monetary policy and we expect little action on rates.

Geopolitics still deserve attention

The 19th National Congress of the Communist Party of China will be held in Beijing in late October. During this meeting, the leadership body of China — the Politburo Standing Committee — will be reshuffled and President Xi Jinping has the opportunity to reshape the committee with his own supporters. We will be closely watching China’s action following the party congress to see if it begins to address its structural issues. We believe that President Xi will continue to gradually push through reforms, slow the pace of debt accumulation and focus on improving the environment while working to prevent the economy from slowing much.

In Europe, the results of elections so far have not caused much concern. France and the Netherlands avoided anti-euro governments. Germany saw the ruling party win its lowest vote share in decades. Even so, it looks to form a coalition with two smaller parties. This coalition could cause issues with long-term integration in the EU, but we believe the short-term political outlook will be little changed.

Going forward, it will be important to watch elections in Italy, which must be held by May 21, 2018. The anti-establishment 5-Star Movement now is neck-and-neck with the ruling Democratic Party. If 5-Star candidates win the elections, they wouldn’t have enough seats to form a government but could form a coalition with other parties. Such a government led by 5-Star would likely be unwelcome by the markets.

Recent turmoil in Spain in response to the Catalonia region’s push for independence also is cause for concern. Spanish Prime Minister Mariano Rajoy’s response to the crisis has brought into question the viability of his government and the possibility of snap elections. At the very least, the outlook is unclear. Catalonia’s action is a reminder, too, of other regional independence movements across Europe, including in Venice, the Basque Country, Scotland and Wallonia. While we do not anticipate that the vote in Catalonia will spur other areas to act, they do remain a potentially troubling undercurrent in what otherwise is a unified Europe.

In the U.K., Prime Minister Theresa May had hoped to strengthen her position with a speech at the Conservative Party conference in early October. Instead, her speech was disrupted by a prankster, she struggled with a cough and ultimately she was panned by critics. Even her supporters were underwhelmed. Several large publications in the U.K. are calling for her to step down. While we see no signs that she will do so, a change in prime minister could affect the negotiations and timing of the U.K.’s exit from the EU. May repeatedly has said she firmly plans to have the U.K. entirely out in early 2019.

What direction for inflation and wages?

Up to this point, inflation has been below the central bank targets in most countries. Wage growth has been sluggish. We would highlight that labor markets are fairly tight in the U.S., U.K., Germany and Japan, to name just a few. While no one knows the precise level of unemployment at which wage growth will accelerate, we do believe the bias for wage growth is to the upside.

Even so, we don’t think this will push inflation significantly higher. Instead, we think the move higher in inflation is likely to be gradual. However, in an environment where markets are accustomed to very low inflation rates, any surprise move toward higher inflation would be disruptive.

Key sectors to watch now

Technology retained its place as the stock market’s best performing sector through the third quarter, with the S&P Information Technology Index returning 8.3% for the year to date. While technology remains a top performer, the Ivy Investments team sees a number of opportunities, and risks, as we look ahead. Here are our thoughts on key sectors to watch as we head toward 2018.

Technology

The sector has been the driver of upward market activity this year, led by large-cap names – namely the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google-parent Alphabet). Unlike the dot-com bubble era, these companies are highly profitable with a lot of cash on hand. Growing confidence in the economy and optimism within many companies’ management teams is likely to drive further corporate investment and may lead to renewed revenue growth.

Health care

We have seen secular growth across the sector, and we think it remains attractive as a defensive investment amid uncertainty. Stocks across the sector have performed relatively well despite concerns about pricing pressure and policy questions arising from ongoing debate in Washington. Even with the concerns around drug pricing, we believe biotechnology and pharmaceutical companies that bring economic value to the market (fewer hospitalizations, better patient productivity, etc.) have the opportunity for appreciating stock prices.

Energy

These stocks generally rose toward the end of the third quarter as oil prices stabilized around $50 per barrel, though the sector overall has been disappointing over the course of 2017. But we believe low valuations mean there is opportunity for active stock pickers. The Ivy team still believes that shortfalls in oil supply are likely within two years. Among global producers, the U.S. is the only area where oil production is growing and that growth is not likely to compensate for increasing global demand and declining rates from existing wells.

Financials

We believe a healthy global economy, within a rising rate environment, is positive for this sector. Several financial company stocks turned higher in September. The lingering perception of a less-intense regulatory environment also has boosted prospects of financial stocks, though specifics remain mired in political debate. We see opportunity as bank profits stand to improve if the Fed follows through on the plan to gradually increase interest rates over the next 12 months.

More broadly, growth stocks, especially technology and health care, have outperformed value stocks, such as financials and energy, so far this year. We believe this trend has been supported by the prolonged low-growth, low-interest-rate environment that has pervaded since the financial crisis. Essentially, any growth has looked attractive, so investors have been willing to pay for it.

However, as the economy continues to show steady improvement, with interest rates likely to rise gradually, that dynamic could change. It’s an area we’re watching closely, one that we believe could provide opportunity for active managers over the next several quarters.

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The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through October 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

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