After a rather tumultuous start to 2016 when the S&P 500 fell by 11.5% in six short weeks, it has been nothing but smooth sailing for the equities market. After the November 8 election in the U.S., many stocks rose to all-time highs and others continued to add to gains on the year.
The bond market continued to move higher throughout the first half of 2016, supported by central bank monetary policy. In Europe, rates remained in negative territory throughout the year and at the final meeting of the ECB in December, the QE program was extended by ECB President Mario Draghi. In the U.S., long-term bonds rose and reached highs in July but have fallen dramatically since. While the U.S. central bank waited until the 11th hour at its December meeting to hike the Fed Funds rate, further out on the yield curve rates increased throughout the second half of the year.
In 2017, the equity and debt markets will face a new set of challenges. This Friday is inauguration day for the new president of the United States and leader of the free world, and as he makes his mark on U.S. domestic and foreign policy, all eyes in the markets in the U.S. and around the world will watch and react. We are likely to see lots of volatility over the coming weeks and months because this U.S. president is likely to be like few before him.
Friday, January 20, 2017, a day that will live in infamy
No one knows quite what to expect from the next president of the United States who will likely continue to use Twitter as his bully pulpit. This Friday will mark the first time in our lifetimes where a president of the United States will not be a politician. The inauguration of Donald Trump will begin a new era for the nation and I expect him to live up to many of his promises and pledges on the campaign trail. With every new era things change, the status quo of yesterday in Washington D.C. is likely to never be the same.
The new era
The new administration comes to office with both houses of Congress from the same political party. Therefore, the days of gridlock that has ground government to a halt is likely coming to an end. While the legislature and the new president will not agree on all issues, the management style of the commander-in-chief should result in action. Policies that favor U.S. business and address trade imbalances between America and other nations will be front and center issues for the government over the coming weeks and months. Any regulations that inhibited the growth of U.S. business and GDP in the nation are likely to find themselves on the scrap heap of history. And, the rebuilding of the military and infrastructure means that the government will be spending a lot more than in past years. However, to recoup the outflows, income from renegotiated trade agreements and new structures when it comes to protection of allies around the globe can offset some, if not many of the new disbursements. An increase in economic growth will mean that inflation will quickly reach or exceed the central bank's 2% target level and the fiscal stimulus will result in more Fed Funds rate hikes in 2017 and beyond.
This new era will commence with many stock prices and indices within an earshot of all-time highs. Following the election, stocks took off to the upside. However, markets rarely move in a straight line and with the inauguration this week and the uncertainty of a new administration, stock rallies and bond selloffs have stalled, for now.
Following through means tough times ahead for bonds
The weekly chart of the long bond highlights the selloff that came to an end with lows during the week of December 19. The bond had recovered to 153-31 level over recent weeks during the period of transition before turning south once again and trading below 152 on Wednesday after the Fed stated that markets should expect "normalization" in rate policy meaning that the Fed Funds rate is likely to begin moving higher, sooner rather than later. New U.S. government policies leading to an increase in GDP growth will likely cause a continuation of the down trend that began last summer.
Higher interest rates will be good news for bank stocks as the margins on lending will increase. A relaxation of regulations in lending via alterations in the Dodd-Frank Act will cause profits from the banking sector to increase in the months and years ahead. The price to earnings ratios of major financial institutions remains much lower than the rest of the market. For example, JPMorgan Chase (NYSE:JPM) trading at around $83.94 per share equates to a P/E of 14.22. Goldman Sachs (NYSE:GS) at $234.29 per share has a P/E of 18.80 times earnings and Citigroup (NYSE:C) at $57.37 is trading at only 12.48 times earnings. These are just a few examples of financial institutions that will do very well if the promises of the incoming president translate into action. Recent earnings reports are only the tip of the iceberg when it comes to the potentials for these institutions in an environment where rates are rising and regulations are decreasing. A fulfillment of campaign pledges will likely lead bonds lower as rates reflect the new normal which will be higher economic growth.
Stocks are a sector-by-sector issue - The best prospects
When it comes to equities, I believe one must be very choosy when it comes to selecting companies for portfolios at this time. I think investors need to take the 45th president at his word. The CAPE ratio remains at a historically high level. (Source)
At 28.15 times earnings, the prices of many stocks in the S&P 500 and other major market indices are at very high levels with little room for growth. However, the incoming administration has already signaled where growth will come from when it points to more military and infrastructure spending. Those companies in that provide equipment and raw materials for military and civil projects are likely to have the most upside in the months ahead. U.S. companies will be the recipients of government spending under the new order. Additionally, fewer regulations in the energy industry will lower production costs and achieve another campaign promise, energy independence.
Stocks are a sector-by-sector issue when it comes to selecting the best prospects for the months ahead. I believe that raw material producers will continue to recover from multiyear lows established in early 2016 as infrastructure building require the basic ingredients, industrial commodities.
Economic growth is on the horizon - the dollar rally will eventually continue
This week, the president-elect complained that the dollar is too high, partially because of devaluations of the yuan by the Chinese government. The dollar moved lower in the wake of his comments but it was driven more by the news that came out of Europe on Tuesday.
When the British Prime Minister announced that there will be a hard exit from the European Union but the U.K. hopes to remain close to Europe economically, the market was not surprised. However, the disclosure that the details of the divorce will be subject to debate and approval by the British Parliament caused both the pound sterling and the euro to recover against the dollar. The dollar had been rising since the election, peaking at the highest level on the dollar index since 2002. Source: CQG
The monthly chart of the dollar index illustrates that the dollar broke above its technical resistance at 100.60 in November and it fell back below on Tuesday and Wednesday. 100.60 now stands as an important pivot point for the greenback but it will be interest rate differentials between the dollar and other major world currencies that keep the bid under the U.S. currency in the weeks, months and perhaps years ahead. The next level of technical resistance for the dollar index is at the 109.75 level and it is possible that we will see that level over the coming year. Increasing GDP in the U.S. and more rate hikes from the Fed are likely to lift the dollar against the euro and yen which continue to suffer from negative interest rates. I view past week's selloff in the dollar as a temporary phenomenon and a consolidation after the recent breakout to the upside. I am looking for the dollar to continue making higher lows and higher highs throughout the year with the euro going to parity and perhaps below.
A stronger dollar will make profits difficult for those U.S. multinational companies that do business overseas as the strong dollar will make their products less competitive. Additionally, the negotiation of new trade agreements or renegotiation of existing ones could cause a period of uncertainty and selling in the shares of companies that depend on foreign buying of their products. However, over the long run, I believe that the U.S. business will thrive from a new world structure for trade and the benefits will outweigh the costs for American enterprise.
The new president promised to Make America Great Again and with a leader like President-elect Trump, great translates to profitable. The dollar is likely to rally and interest rates will continue to move higher under the new order in the U.S. Fewer regulations and a concentration on America first after a long period of a trend towards globalism are likely to yield beneficial results for American business and individuals. In the post inauguration day market, I believe that the sectors with the most upside in the stock market are in banking, military, industrial building, energy, and raw material companies. It may be a rocky road for a while as the executive branch debates with the legislature. However, the new president who will emerge as the builder-in-chief will prevail, and spending, combined with fewer regulations and new trade agreements, will boost economic growth, and these sectors of the market will respond, in some cases, dramatically.
Inauguration day is a great reason to take a long and hard look at the equities in your portfolio. I am taking the new president at his word. I will be buying shares in companies that reflect President Trump's vision for the United States for the next four and possibly eight years.
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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.