JPMorgan's David Kelly.

David Kelly, chief global strategist for J.P. Morgan Asset Management, cautions investors to “curb” their enthusiasm about prospects for the U.S. economy and financial markets in 2017.

In a recent Guide to the Markets conference call, Kelly noted that optimistic expectations about the new Republican-led federal government, including plans to reduce regulations and personal and corporate income taxes while increasing spending on and infrastructure, may be overdone.

The ratio of U.S. debt to GDP, which has been rising steadily rising to 77% currently, for example, “limits what the new administration will be able to do,” said Kelly, explaining that some  House and Senate members could “balk at the idea of ballooning the deficit. 

A cut in personal income tax rates may be delayed and smaller than expected while postponement of the DOL fiduciary rule and easing of the Dodd-Frank Act “will not result in enormous change,” said Kelly.  The energy sector, however, could benefit from changes in regulation, he said.

In addition, he noted that a Republican House bill that restructures foreign earnings of corporate taxes so that companies are taxed on domestic sales but not sales of exports is complicated. The legislation could reduce the trade deficit and help companies that rely on exports but it could also hurt those companies that rely on imports, said Kelly.

Prices for imported goods would rise, leading to higher inflation and more-than-expected Fed rate hikes, which would “blunt economic efforts to grow the economy faster.”

 “Don’t expect a tortoise to suddenly turn into a hare,” said Kelly, discussing the U.S. economy.

He referred to the U.S. economy as a “healthy tortoise,” whose inflation-adjusted growth is likely to slow to 1.5% in the fourth quarter, down from 3.5% in the third, then strengthen to 2.5% in 2017 and 2018, which is on the higher end of economists’ forecasts.

Kelly is also more optimistic than other economists on his outlook for U.S. unemployment, forecasting a decline to 4% by year-end 2017 and 3.5% by the end of 2018 (the jobless rate in December was 4.7%).

As for the stock market, Kelly said corporate profits have already rebounded – up 231% for the S&P 500 since the market bottomed in March 2009 – but he still expects another 5% gain in 2017, and even more if corporate taxes are cut.

The current P/E of 16.9 times forward earnings is “not that high,” said Kelly.

He favors emerging market stocks and said investors who refrain from investing internationally now, perhaps because emerging markets have underperformed developed markets for four years running are “making a mistake.”

The valuation of emerging markets is 1.4 times earnings versus 16.4 times for developed markets.

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