December 31, 2016
The surprising election of Donald Trump as our 45th president capped a year of unexpected developments. The year began with a startlingly violent market swoon and V-shaped recovery. In late June investors were again caught off-guard by the unanticipated U.K. vote to leave the European Union, which confounded the betting parlors and sparked a sharp but brief market sell-off. The market quickly rebounded on expectations that central bankers would once again step in to provide additional liquidity to support financial assets following the uncertainty created by Brexit. In September, amid high levels of investor skepticism, OPEC agreed to cut oil production for the first time in over eight years, leading to an immediate positive response in crude prices. Finally, in November, American voters shocked the pollsters and the pundits, and perhaps themselves, by electing Trump.
Similar to the Brexit vote, the U.S. election served as a populist revolt against establishment politics and policies that had mired the U.S. in years of political gridlock and uninspiring growth. The market reaction was even swifter than Brexit, with financial markets plunging overnight only to recover by the next morning. From there the S&P 500 proceeded to rally nearly 5% through year-end on the hopes that pro-growth policies would be implemented by a united Republican administration and Congress.
Beneath the surface of the markets for most of the year, we witnessed a violent rotation that accelerated post-election as investors fled safe, defensive assets and secular growers for more cyclical stocks and beneficiaries of reflation. A good example of this phenomenon was the almost 24% rise in the S&P 500 energy sector for the year contrasted with the 4%+ decline in the S&P 500 health care sector for the same period. Another would be the fourth quarter decline of 2.7% in the S&P consumer staples sector versus the 20%+ gain in the financial sector for the period. For both the quarter and the year, all of the return from the Russell 1000 Growth Index could be attributed to the cyclical sectors. This return pattern mirrored that of 2015 when the less cyclical sectors led the markets and our clients’ out-performed both the Russell 1000 Growth and the broad market S&P 500 indices.
As Bank of America/Merrill Lynch stated on the front page of its January 3, 2017 US Performance Monitor report US stocks: MVP of both the year and the decade, the “Route to outperformance [in 2016]: Low quality, high beta, and Value.” While consistent with investors’ improving outlook for the economy and corporate profit growth, especially post-election, these characteristics are the antithesis of our portfolio, which tends to favor higher quality, lower beta, and above-average growth. Therefore, it shouldn’t be surprising, given this backdrop, that the portfolio lagged its benchmark for the year.
While the market’s post-election reaction is somewhat understandable, given the magnitude of the post-election rally, investors seem to be placing a lot of faith in the new administration’s ability to successfully push its agenda through Congress without giving much credence to possible adverse offsets. A combination of lower taxes, reduced regulatory burdens, and increased infrastructure spending, as proposed by Trump, indeed presents a powerful combination that would surely boost economic growth. However, this comes at a time when we are already eight years into an economic expansion, when most pent-up demand has been satisfied, and we are operating at near-full employment. Rising wages and commodity prices could be expected to spark greater inflationary pressures and, in turn, a more hawkish response from the Federal Reserve. The initial reaction in the currency and bond markets therefore has not been surprising, with both the U.S. dollar and bond yields rising sharply. A higher dollar and higher mortgage rates will likely serve as near-term headwinds to exports and housing, potentially dampening economic growth before the beneficial impacts of lower taxes, regulation, and increased infrastructure spending begin to be felt.
Additionally, there is no assurance that it will be smooth sailing for President-Elect Trump in getting his agenda through Congress. Republicans lack a veto-proof majority, Trump’s policies have sometimes been at odds with his own party and deficit hawks in Congress may balk at big deficit spending at this point in the economic cycle. In addition, investors seem to be giving little thought to how Trump’s trade policies and immigration restrictions may impact global growth.
All said, it is now up to policy makers to fulfill investors’ hopes for improved growth to justify the rally in share prices that we’ve seen post-election. With valuations full, bond yields rising, and investor sentiment overly bullish, any hiccups could lead to increased stock market volatility.
A pick-up in stock market volatility in 2017 would create both opportunity and risk for investors. Stock market sentiment data and high stock market valuations reflect a great amount of investor optimism. The median price-to-earnings ratio for the S&P 500 is higher than in 89% of historical periods and the median price-to-sales ratio is at the highest level in the data series. This suggests investors are not prepared for any disappointments that may occur with the timing and effectiveness of any fiscal stimulus; yet, at the same time, there is no discernable improvement in the economy. Any corrections in share prices will offer opportunities as recession risk still seems low, particularly with the likelihood of additional fiscal stimulus. Also, while the Federal Reserve is likely to raise interest rates two or three times in 2017, it will probably move in a cautious manner as long as inflation doesn’t accelerate above its 2% threshold. Lastly, President-Elect Trump’s pro-growth and market friendly policies, if successful, along with an improvement in corporate earnings will be favorable for the market.