2016 politics changes the investment landscape and investor sentiment
Democracy has spoken. People want change. From the shocking Brexit vote, to the unlikely emergence of Donald Trump, to the fall of the Renzi government in Italy, one thing is clear: populism is here, and it is likely here to stay. Historians have much to debate regarding the reasons for the abrupt political paradigm shift in Western democracy: from the wage effects of globalization, to the sterile entrenchment of a political elite. Here, I will address the financial implications of the Trump election opting to leave the political debate to the experts.
It seems so long ago--the beginning of 2016, that is. The year began following the first Fed rate hike in nearly a decade, and a dollar that had appreciated 25%. Manufacturing PMIs were well below 50, the level delineating between economic expansion and contraction. Oil had fallen out of bed, as had many hard commodities-a result of sluggish global growth. S&P 500 companies, especially those in the commodity industry, were entrenched in an earnings recession. Business investment was bad and getting worse. Germany, Japan, and a host of developed nations were experiencing negative interest rates, and many experts were predicting the United States would follow in their footsteps. The S&P 500 failed to breakout to new highs and by late January had already fallen more than 13%. Calls for a U.S. recession were the norm, notwithstanding the continued strength of the labor market. Headline inflation was struggling to breach 1%. On the surface, there was very little to cheer about.
Fast forward to today. The manufacturing sector is expanding. Retail sales have rebounded. The labor market continues its robust expansion. S&P 500 companies have emerged from a two-year earnings recession. GDP, near zero at the beginning of the year, registered 3.2% growth in the third quarter. And finally, a Republican political sweep has investors eagerly anticipating the prospects of tax-reform, infrastructure initiatives, and a repatriation holiday-which we expect to be passed in the first half of 2017. Political change has already had significant impact on markets, and for good reason--it will have a real impact on both growth and inflation in 2017.
From an economic standpoint, the first half of 2016 offered little to be excited about. But from an investor's standpoint, sentiment had become so rotten, that 2016 presented abundant opportunities. For the true contrarian--the investor that drowned out the apocalyptic calls for recession and a market crash-2016 was a profitable year. However, the 2017 landscape is much different from that of 2016. Investor sentiment has improved to the point where bleak expectations are no longer driving asset values. Treasury yields are no longer at all-time lows. The trailing earnings multiple on the S&P 500 is above 20. And sentiment indicators are considerably more bullish than they were just three months ago. As expectations for growth become stronger, asset appreciation is more dependent on underlying economic strength rather than pessimistic sentiment and broad underinvestment. This is the critical theme of 2017, and it is a marked change from 2016. We are now in a "show me" economy where bad news will be interpreted as such. Monetary policy will no longer provide a backstop to asset prices. Eventually it will morph into its enemy-although we don't expect that to be the case in 2017. So, what will the economic data show? Will weak earnings and economic growth materialize?
We don't think so, and here is why.
2017 Asset class projections
Sir John Templeton famously said, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." The U.S. markets, based on sentiment measures, are just now transitioning from skepticism to optimism. There is little evidence indicating we are in a euphoric blow-off top. Low risk-free yields, restrained business investment, and lousy investor sentiment have only recently started to improve. As such, the market moves over the last six months are likely to continue, and may accelerate. Holbrook's 2017 end-of-year targets are below.
Holbrook's target on the S&P 500 is 2,400, implying a 6.2% gain-higher if dividends are included. Currently, analysts expect 12% earnings growth in 2017--not overly optimistic for an economy emerging from a two-year earnings recession. However, analysts have yet to adjust for the corporate tax cuts that are likely to be enacted. Holbrook expects the effective tax rate for S&P 500 companies to fall from 28% to 20%. Each one percent fall equates to $1.75 increase in S&P 500 earnings so per share index earnings should increase from $119 to $133. With interest rates rising, we are likely to witness multiple contraction, so instead of the current 20x we forecast an end-of-year 18x trailing multiple. The result is a $2,400 target on the S&P. The remainder of our targets are predicated on the continuation of the reflation trade--which is currently reinforced by multiple indicators. Sentiment is improving. The labor market is robust. Inflation and wage growth are accelerating. And most importantly, the Federal Reserve has indicated a willingness to let the economy "run hot." Currently, the fixed income market expects one to two rate hikes in 2017. Given that core inflation is already increasing at 1.7% and core services are rising at 3.0%, we think that the Federal Reserve will be hard pressed not to raise Fed Funds three times in 2017. Remember, the service sector accounts for almost 70% of total consumption. With the commodity crash no longer putting deflationary pressure on both core and headline inflation, Holbrook expects core inflation to accelerate to 2.5% in 2017. Improving business sentiment, a direct result of pro-growth initiatives in Washington, will further support price increases. This is Trumpflation at work.
Accelerating inflation, in conjunction with a Federal Reserve reticent to aggressively raise rates, will steepen the yield curve and restrain dollar strength. We expect the dollar to be flat on the year, and given current bullish sentiment, there is risk to the downside. The Fed is the biggest wildcard here. If they allow the economy to "run hot" as they have insinuated, the dollar will be weaker than the market expects. If, alternatively, the Fed takes a more aggressive approach, the dollar will strengthen and the yield curve will flatten. This, however, is not our base scenario.
Economic growth in the United states will accelerate
Donald Trump has indicated that his goal is to stimulate real growth to above 4%. We think this is aggressive--perhaps impossible--given demographic limitations. Ultimately economic growth is a function of labor market growth and productivity growth. Policy has no impact on the former. With the working age population growing at half a percent annually, and productivity averaging 1.2% growth since the Great Recession, sustained 4% growth is likely out of reach. We think that productivity growth is poised to rebound above 2% in the intermediate term-so sustained 2.5-3.0% growth is more realistic. For 2017, our GDP growth projections are below.
If not for the consumer, the U.S. economy would have fallen into recession in 2016. Private investment, government spending, and net exports were detractors from Real GDP growth. 2017 will witness accelerating growth in business investment, government spending, and personal consumption. Net exports will likely continue to detract from GDP given recent dollar strength (which typically leads trade data). Based on initial estimates, Federal infrastructure initiatives should buoy government spending increases of 5%. Private Investment will accelerate 5% given improved business sentiment and the likely tax-repatriation holiday. Personal consumption, supported by tax cuts and wage gains, will return to 2014 levels, growing at 3.5% in real terms and 6% nominally. We expect real GDP growth to be just shy of 3% in 2017, about 80 bps higher than the current consensus estimate. This falls short of Trump's 4% stated goal, but is a welcomed acceleration from the post-recession 2% to which we have become accustomed.
The multi-decade bull market in treasuries is over
Longer-term yields bottomed-out in early July, well before the election. The Trump election has accelerated a trend that was already gaining momentum. While fixed income investors will certainly cringe upon receipt of their January statements, the move higher should be kept in context. Consider this: Since treasury yields bottomed on July 8th, the ten-year yield has increased by 103 bps. We can decompose that move into both growth and inflation expectations by analyzing the relationship between TIPS and nominal Treasury yields. The recent yield spike is due to increases in both growth and inflation expectations over the next ten years. In fact, the attribution is virtually equal (52 bps for inflation and 51 bps for growth).
Many fixed income investors view the recent rise in rates as a potential buying opportunity. We would exercise caution. The ten-year Treasury yield has historically tracked nominal GDP. If longer-term expectations for labor market growth and productivity (and Real GDP) are 2.5% and the Fed is willing to let the U.S. economy "run hot" (let's say 2.5% inflation), there is no reason why the ten-year yield can't move to 5% over the next couple of years. In fact, we contend that this is a probable outcome. Such a move will make the recent uptick in yields a drop in the bucket.
Yields have been artificially low since the Great Recession. Issuance has been subdued due to political gridlock and less government spending. This is likely to change with the new administration. Meanwhile, the Federal Reserve has bought up a significant amount of the outstanding float. This is changing as QE in the United States is already a relic of the past. And finally, investor sentiment and fear have been pervasive, increasing the demand for risk-free assets. There is evidence that this too is shifting. In 2013, Morgan Stanley called for a Great Rotation out of fixed income and into equities. I think they were three years early, but ultimately their call will be prescient. Fund flows over the last six months indicate that this process is already well underway.
We expect rate normalization to persist throughout 2017 and, as such, have a target on the ten-year yield of 3.5%--4.25% for the long bond. Treasury issuance will surge due to increased deficits as tax-receipts fall and spending spikes. We expect the Treasury to issue bonds with 40 year plus maturities as they seek to lock in rates that are still historically low. Term premiums will rise from historic lows throughout the year, especially if the Fed pauses in the face of higher inflation data.
The good news for investors is that not all fixed income is doomed. There are fixed income subsectors that can perform well in a rising interest rate environment: senior bank loans, high yield corporates, floating rate notes, ABS, and structured notes to name a few. Effective duration in the investment grade portion of portfolios should be tactically adjusted downward. TIPS will likely continue to outperform treasuries. High yield corporate bonds have historically outperformed other fixed income asset classes when inflation expectations increase-they are typically lower in duration and their high coupons can absorb rate increases.
Fixed income remains an important portion of a properly diversified strategic portfolio-even in a rising interest rate environment. However, within that allocation, it is prudent to tactically adjust exposure towards subsectors that will likely outperform in a Trumpflationary environment.
This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the author which are subject to change without notice. Forward looking statements, estimates, and other information contained herein are based upon proprietary and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.