Q&A with Managing Director of Portfolio Management of BBVA Compass Global Wealth Gwynne Shackelford and BWS Investment Strategist, Anne-Joëlle Viguier-Galley, CFA
In this edition of the BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley peer into their crystal ball for a glimpse of key drivers of the 2017 economy and financial markets.
In our opinion, it appears that many voters in developed countries are in search of personal economic change. Many economists believe this shift reflects a widening income inequality and a sense that the benefits from the lackluster economic recovery have not yet filtered down to the middle classes. The uneven distribution of wealth appears to be pushing voters to search for candidates who favor more nationalist, or populist, policies versus globalization. The trend of anti-globalization is exemplified across many regions: in the US, through the recent election of President-elect Trump and in the UK, through the vote to leave the European Union. France’s National Front, Germany’s Alternative for Germany, Italy’s Five Star Movement, and the Netherlands’ Freedom Party are all on the rise—each campaigning on an anti-globalization, euro-skeptic platform. The anti-immigration, anti-globalization policies appear to be a proxy for what is really a demand for a redistribution of wealth and a rejection of centrally planned policies.
U.S. equity markets appear dominated by two opposing trends. On the positive side, anticipation of tax reforms for corporations and individuals, fiscal stimulus and infrastructure spending, as well as improving investor confidence, are pushing stock prices higher.
Conversely, higher bond yields, the rising U.S. dollar, lower productivity, a tightening labor market, increased protectionism, and high debt levels versus GDP could easily slow the current recovery in the U.S. and abroad. This in turn could pressure earnings, resulting in disappointing stock returns. As we begin the new year, it seems to some extent that markets have already priced in all the positives and none of the negatives.
On a historically trailing 12-months basis, the P/E ratio of the equity market stands almost two standard deviations away from its median, as seen in Figure 12 below. Investors have effectively pulled forward some of 2017’s returns by driving P/E’s higher in anticipation of better growth prospects, increased U.S. fiscal stimulus, and a more business friendly Congress and White House. This potentially limits 2017 stock market gains as we discussed in the Equity Outlook section of the 1Q17 Market Outlook.
Over the last few weeks, the price portion of the P/E ratio has gone up – i.e. multiples have expanded –likely based on investors’ hopes that lower corporate taxes and a more “pro-business” atmosphere in the U.S. will drive adjusted earnings growth per share, or the E of the equation, faster than what the present consensus believes.
To drill down a little further, in this scenario, P/E’s expand based on the premise that earnings are the steady drivers of returns. Analysts currently project earnings’ growth to continue through 2017. According to Factset on January 6, 2017, the 12-months forward P/E ratio based on the forward 12-month EPS estimate of $132.92 stands at 17.1, which is above the 5-year average of 15.1, and above the 10-year average of 14.4.
Due to some recent wage pressure and better economic reports, interest rates began to rise prior to the election and have risen even more since that time. In July, 10-year Treasury rates bottomed around 1.3% following the flight to safety sparked by Brexit but had risen to 2.4% by the end of 2016.
The combination of some inflation and hopefulness that the economy will grow faster has made investors nervous about owning bonds, as long-term rates should continue to go higher and bond prices lower. Yet, the bond market may also be getting ahead of itself in predicting more inflation and much more growth. If these events do transpire, then rates should be higher, but they will only go as high as growth justifies over the long-term.
The U.S dollar had been strengthening against many currencies well before the elections, see Figure 13 below. Monetary policy divergences around the world continue, making $U.S.-denominated investments more attractive to foreigners. In the U.S., monetary policy is passing the baton to fiscal policy, but this is not necessarily the case in other countries which helps to drive the price of the greenback higher. A strong dollar is, generally speaking, not good for global trade, emerging markets and commodities in general, as most commodities including oil are priced in U.S. dollars.
Based on the anticipated continuing improving economic conditions, fiscal stimulus, and tax reform, we anticipate between two and three Fed rate hikes.
There is upside risk, predicated on the economy growing even faster than anticipated. The downside risk of only two rate increases may reflect lower economic growth, lower inflation, or maybe even stress coming from outside the U.S. Historically interest-rate moves have always trailed the actual pace of growth, forcing the Fed into a game of catch up. Should this be the case in 2017, then the Fed is more likely to initiate more, rather than fewer, interest rate hikes. Higher bond yields are an automatic brake to the equity market because investors can find attractive yields that compete with equity returns and the associated risk. Three or four rate hikes within the year could shock equity markets.
Part of the modest equity return we expect next year is due to this factor. Even with good earnings and GDP growth, investment dollars may flow into yields perceived to be more attractive and with less risk. That said, there is the expectation that any increase in long-term yields may be contained by the influx of flows from abroad because many countries have rates near zero.
Although monetary expansion may no longer be the primary stimulus of growth, it remains accommodative, not only in the U.S., but abroad as well. Given where the Fed rate fund stands and the continued quantitative easing by other countries, the entire global monetary system remains accommodative.
As always, but particularly now, it is important to try and balance the ebullient market sentiment with a healthy dose of caution. Whereas in the past investment professionals have not followed politics to a great extent because it tends over time to be a non-event, it appears that we are entering a period where politics move front and center. More than ever, it will be important to have an investment professional who follows a tried and tested investment discipline. Often it will be the investment professional’s role to be the contrarian. Prices do not go to the moon, and they seldom go to zero. It requires discipline in the face of short-term market reactions to adhere to a long- term investment strategy.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).