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Equity Outlook

Global populist political theme to continue

Although earnings turned positive in the third quarter, the post-presidential election rally was by no means earnings driven.

Against a backdrop of continued mild economic growth, buoyed by the prospect of fiscal stimulus and supported by an increase in sentiment, the U.S. stock market ended the fourth quarter with a full risk-on Trump rally. In the short period of heightened optimism – not totally devoid of speculation – the riskier the stock, the better. U.S. stocks outperformed international stocks, and the U.S. dollar remained atop world currencies. The S & P 500 Index snapped back from the worst 10-day start on record after an anemic return of 1.4% in 2015, to return north of 11%. Small caps, historically the beneficiary during periods of tax reform and less government regulation, outperformed at the expense of developed and emerging markets.

Although earnings turned positive in the third quarter, driven by easier comparisons and some abatement in the greenback’s earlier surge, the post- election rally was by no means earnings driven. The best performing sectors were financials and energy, clearly a bet on the future rather than the present. Prior to the fourth quarter, earnings growth was negative for six quarters in a row, largely due to the drag from energy companies. Waiting for the revenue side to kick in and grow earnings, corporations have supported profit margins with cost cutting. Citing a lack of business investment opportunities, companies also bought back their stock, effectively “micro-managing” earnings (when shares are reduced there is a lower amount to spread the earnings over).

Great rotation of yield investments begins

Going into the election, pundits had aligned a Trump victory with trade wars and other sanctions that would negatively impact the global economy, particularly large-cap multinationals. But within hours of the election, investors began to focus on the positives of a new administration, and the market rotated out of bonds and into stocks, pushing the domestic stock market to new highs. Improved sentiment, already on the upswing, also contributed to the rally. As rates rose, investors reacted to the global backup in yields, and the “great rotation” out of the bond market and dividend- paying stocks, including preferred, utilities, REITS, and consumer staples began. The weak growth and low inflation over the past few years benefited dividend-paying names and growth-oriented stocks. With economic growth expected to run above trend over the next few years, economically- sensitive cyclical businesses and companies classified as value stocks became the beneficiary of the rotation out of dividend-paying and growth- oriented names.

The rotation, combined with continued mild improvement in the U.S. economic backdrop, supported the Fed’s ability to raise interest rates. The combination of events was nigh a perfect storm for equity investors and those invested in very short, high quality bonds. Indeed, as the fourth quarter ended, it appeared that markets were focused on the positives, and none of the negatives, leaving many to consider that the market was now “priced for perfection”.

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Broad Market Returns 4Q16
P/E Ratios and EPS
Impact of Q4

Outlook

It is as though only positive outcomes have been baked into 2016 equity returns, but the actual reality will only be manifest as 2017 unfolds.

The global populist political theme that prevailed in 2016 is expected to continue in 2017 and may affect upcoming elections in Germany, France, Italy, and the Netherlands. If the anti-European-union populist candidates lose, signaling continued Eurozone viability, then European stocks could see a large bounce. But considering the strengthening U.S. dollar, stronger domestic economic growth, and the Trump tax cuts and fiscal policies, we continue to slightly favor the U.S.

Interestingly, from a consensus perspective, the presidential election was the second major populist-infused, geopolitical event of 2016 where the consensus was overwhelmingly one direction ahead of the event, only to pivot 180° afterwards. For example, with Brexit, consensus was 70% that Britain would remain a member of the Eurozone. The numbers were similar for Ms. Clinton to win the presidential election. Additionally, in both instances, the projected outcome from the non-consensus event also failed to play out. Both Britain’s exit from the European Union and the election of Mr. Trump were projected to generate major market selloff events. While the selloffs did materialize, both were extremely brief – the Brexit selloff lasted a few days and the Trump selloff only a few hours – and quickly reversed, as investor focus turned to the positive.

Under the new administration, we anticipate a shift from monetary to fiscal policy which may support the 8-year-old economic expansion and bull equity market. We are generally in agreement with the prevailing consensus that calls for 2017 earnings to be positive, although not off the charts, and certainly not enough to rationalize current valuations. Even before the election, 2017 year-over- year earnings were projected to be up 11% or so, according to Fact Set, largely due to easier comparisons relative to the previous six quarters. But if the new administration is successful in implementing fiscal policies that will stimulate growth, then there could be an upside to 2017 earnings forecast

Certainly, during the post-election rally, quite a bit of 2017 equity returns were pulled forward into the last quarter of 2016. Considering valuations and the mature market cycle, we anticipate 2017 U.S. equity returns in the neighborhood of 5%. P/E’s should be relatively stable if a modest improvement in earnings is coupled with an overall modestly increasing equity market. Productivity will be challenged as we are experiencing a tight employment market with very modest wage gains. The pressure building for wage gains will be more pronounced and hence a drag on productivity. Although increased business capital expenditures are expected in light of the perceived brighter future, it remains to be seen what will materialize.

Awash in uncertainty, financial markets were choppy ahead of the election, but in a very short time quickly adjusted to the new direction. But this in itself leads to a whole new host of unknowns. It is as though all possible positive outcomes have been baked into 2016 equity returns, but the actual reality will only be manifest as 2017 unfolds. The anticipated changes must materialize promptly as financial markets are unlikely to grant Mr. Trump any extended time period to enact his proposed stimulus programs. All presidents have a pretty well-defined honeymoon period, and Mr. Trump’s has already begun. The market will soon see what and how much can be accomplished, and this in turn will increase business community confidence, or not, in turn affecting investor sentiment. 

Currency markets are always extremely volatile and difficult to forecast, but the expectation is that while the U.S. dollar will continue to strengthen in 2017, it will not do so at a brisk pace. Although we do not anticipate this, a surge in the greenback could have an impact on multinational earnings. 

China and Europe continue to be headwinds. Although China’s economy appears to be improving, the country faces a number of issues – shadow banking, economic uncertainty, capital controls, currency devaluation, and trade protection. A strong China benefits the world, and if new problems surface, there is always the risk of a “blame the Americans trade war” to divert attention. The rhetoric should fade if the country’s economic recovery continues. On the European side, should other countries follow Britain’s example, and vote to leave the Eurozone, it would be a headwind for the global economy. The populist politics platform is largely immigration based given the almost daily terrorist events in these countries. A continuation of, or acceleration in, such activity will only lend strength to the populist movement.

The risk of policy missteps is another concern. With a new president and Congress controlled by one party, expectations are high that much can be accomplished, but with the expectations come the risk of a misstep detrimental to the economy. The market hates uncertainty, and the second there is even a shadow of a doubt cast on the success of new policies currently on the table, the market is likely to experience heightened volatility. Also, Mr. Trump’s practice of calling out individual companies on Twitter argues against a free market and may not be necessarily good for business confidence. And there is the question of whether the new administration can change the attitudes of fiscal hawks in Congress sufficiently to enlist support for initiatives that will likely increase the deficit. These and a host of other factors have the opportunity to go awry as the new year begins.

In terms of tailwinds, one potentially significant event could be a tax repatriation holiday, or tax amnesty. Trump’s pre-election economic plans included a plan for tax amnesty that would allow U.S. firms to repatriate funds held overseas with only a 10% payment, versus the current 35% rate. Currently there is an estimated $1.2 trillion held overseas that cannot be brought back to the U.S. without being taxed at the corporate rate. While the amount is significant, some pundits argue that without meaningful corporate tax reform, the impact of such a holiday would be very short lived.

Positioning portfolios for uncertainty and opportunity

We have tilted portfolios to a slightly more value-oriented focus (including companies in the financial sector) which should benefit from the new environment. We maintain a slight overweight to the U.S. although we recognize that developed markets could see a big bounce should populist platforms fail. The fate of emerging market returns is strongly tied to the U.S. dollar. As long as the dollar remains in a stable appreciation range, these stocks should do well. But it is the U.S. that is positioned to benefit from fiscal change, and so we maintain a bias towards its stronger economy. We recognize the strength of small caps and the potential to run given beneficial fiscal policies, but high valuations lead us to remain neutral between small- and large-caps stocks.

In fixed income, we maintain a tilt towards relatively low duration and high quality bonds. A steepening yield curve will help banking. Rising interest rates help banks because margins start to improve and the companies are able to lend more, thus stimulating the economy.

A number of clients asked in advance of the presidential election, if they should become more defensive in their portfolios. Had they done so, they would have missed the post-election market rally. One cannot time the equity markets which is why broad diversification is so important. Certain sectors may be underweight in a portfolio, but they should not be void.

Going forward, because the market is such an effective discounting mechanism, there will be losers and winners from the proposed stimulus changes before any true results are actually realized. Such markets strengthen the argument for active management and the importance of stock picking.

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