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March Madness: LPL’s ‘Sweet 16’ Bracket for the Market

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Source: LPL

Just like the markets, the NCAA college basketball tournament is full of surprises.

LPL Financial Chief Investment Officer Burt White, though, says that such developments — namely the second-round exit of Duke and Villanova — make things exciting.

As for the markets, White and colleagues have put together their “Sweet 16” bracket for stocks, identifying keys factors affecting them.

“While the path for several policy-related areas is uncertain, we still expect a solid year for stocks in 2017 — potentially even slightly above our year-end S&P 500 target of mid-single-digit gains, depending on that policy path,” he explained in a report released Tuesday.

Here is a quick rundown of what White and the investment research team at LPL anticipate for the rest of the year. (They didn’t share their NCAA basketball predictions, unfortunately.)

1. Economic growth, positive: Near 2.5% growth in U.S. gross domestic product in 2017, roughly in line with long-term averages, supported by improving business investment, steady consumer spending gains and pro-growth fiscal policy; leading indicators and the yield curve suggest a low probability of recession over the next 12 to 18 months; economic data have broadly surprised to the upside in the U.S. in recent months and are improving overseas.

2. Fed policy & interest rates, mixed: The Federal Reserve should hike interest rates twice more in 2017; its acknowledgement of the improved economic outlook and plan to hike rates gradually are encouraging, but there is still a possibility that the Fed spooks markets by speeding up its timetable.

3. Inflation, mixed: The Consumer Price Index posted a 2.7% year-over-year increase in February, accelerating from January’s 2.5% reading amid increases in energy prices; further acceleration in inflation presents some risk to stocks, though we expect it to be contained.

4. Geopolitics, uncertain: In Europe, the anti-EU party failed to wrestle power from the current Dutch prime minister, but French elections in April may spark another wave of structural concerns; China’s debt problem remains a risk; and military conflicts overseas could disrupt markets at any time.

5. Earnings, positive: The latest reading, near 58, for the ISM Manufacturing Index suggests continued earnings growth; fourth-quarter earnings season was generally good, with high-single-digit S&P 500 earnings gains and supportive guidance; better economic growth and supportive fiscal policy later in the year offer potential upside.

6. Valuations, long-term negative: Rich valuations are a concern, though valuations are not good predictors of near-term stock market performance; moderate inflation and low interest rates are supportive of above average valuations in the short term.

7. Sentiment, mixed: Analysis of investor sentiment reveals signs of increasing worry, but from a contrarian perspective, this could be a positive sign; there are signs of optimism, though, and LPL is not seeing the type of exuberance observed at previous stock market peaks.

8. Technicals, positive: The technical indicators for U.S. equities continue to exhibit bullish momentum above shorter and longer-term moving averages; if the S&P 500 remains above its 200-day moving average, the long-term price trend remains bullish for stocks.

9. Corporate tax rate, very positive: Bringing the rate down, potentially to 25%, would help keep U.S. companies from moving offshore and boost corporate profits and U.S. economic growth; some estimates suggest S&P 500 earnings could rise 10% or more in 2018, although offsets to keep the budget deficit in check will be needed.

10. Capital expensing, positive: To incentivize capital investment, tax reform may include a provision to allow immediate depreciation of capital expenditures; this measure could stimulate capital spending and lift U.S. manufacturing, but would have to be paired with the elimination of the deductibility of interest expense.

11. Interest deductibility, negative: Proposed by House Republicans, this step would help pay for lower corporate tax rates and offset the lost tax revenue from full capital expensing; although politically messy and likely to hurt big borrowers, LPL believes this provision has a fair chance of being enacted as a revenue raiser paired with full capital expensing.

12. Trade policy/border tax, possible negative: The House plan includes a provision that essentially taxes imports, which could be a big source of tax revenue to help pay for the corporate tax cuts; LPL does not expect this plan to make it through Congress due to the outsize impact on some industries and concern that an import tax could lead to escalating trade tensions with China and Mexico; a watered-down version or targeted and temporary tariffs are possible.

13. Repatriation, positive: A policy with bipartisan support, a lower tax rate for companies to bring cash back from overseas would generate additional tax revenue (the cash is otherwise trapped) and likely drive additional capital investment, as well as shareholder-friendly dividends and share repurchases. Repatriation is very likely given the tax revenues that must be raised to offset lost revenue from a lower corporate tax rate or fund infrastructure projects.

14. Infrastructure, possible modest positive: President Donald Trump has proposed $100 billion per year in infrastructure spending, but we are skeptical that this level of spending will be achieved given the limited number of attractive revenue-generating projects and constraints from the deficit hawks in Congress; also, the impact of the spending may be a couple of years away.

15. Health care reform, possible negative: The importance of the Affordable Care Act (ACA) lies in its tie to corporate tax reform, because tax reform cannot happen until the first phase of the health care overhaul is completed; the replacement is uncertain, though the basic principles are coming into view.

16. Financial services reform, positive: Changes will take time, but the end result is likely to be more lending and less friction in capital markets; the downside is the risk that we are sowing the seeds of the next crisis.

White says that market watchers can expect “a deeper dive” into some of these factors in LPL’s “Final Four” report next week.

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