Data Source: Bloomberg
Investors Hit the Risk-Off Button
What appeared to be investors taking a 'breather' on the cyclical, reflationary 'Trump' trade following January's reversal has now morphed into a risk-off posture. Much of the recent shift in risk postures is related to investors questioning the government's resolve to push through infrastructure spending and tax reform. Do investors now have buyer's remorse when it comes to expecting additional stimulus to extend the cycle? Or is this just a knee-jerk reaction to the latest machinations emanating out of D.C. overlooking the stronger underlying economic currents that are expected to produce 22% growth in S&P operating earnings for 2017.
Small caps had kept up with large caps through the first part of the month but then broke down towards the end of the month (Exhibit 1a). Interestingly, the shift to risk off did not negatively impact 'value' as much (Exhibit 1b), partly due to the continued strong performance of financials, perhaps over positive expectations for Dodd-Frank reform and rising net interest margins. Risk-off manifested itself in the form of high dividend/high quality stocks outperforming the rest of the market ( Exhibits 2 and 3).
Exhibit 1a and 1b: U.S. Small Caps Lag During Risk-Off but Value Holds Up
Exhibit 2: Growth and Defensive Sectors Led Cyclicals
Exhibit 3: High Dividend and High Quality Outperform Other Styles
The S&P 500 Low Volatility Index (SP5LVIT in Bloomberg) returned 4.5% versus 3.9% for the S&P as investors rediscovered their love for low volatility in the face of fiscal uncertainty. The sudden preference for low volatility has resulted in the index trading at a forward price/book multiple above its 2016 Brexit levels (Exhibit 4), suggesting that its run looks overextended in the near-term. However, we don't generally advocate factor-timing low volatility, particularly around valuation levels, but forward implied expected returns seem less appealing should cyclical reflation become in vogue again.
Exhibit 4 - Valuation of Low-Volatility Surpasses 2016 Brexit Levels
Fixed income credit markets brushed off 'risk-off' as credit spreads continue to narrow and are now within reach of the 2014 lows Exhibit 5). Despite the weakness in energy stocks, energy credit is now priced in line with the broader credit markets. Global supply/demand imbalances are narrowing but we are seeing a renewed pickup in North American production in response to higher oil prices (Exhibit 6).
Exhibit 5: No Risk Off Here - Credit Spreads Narrow
Exhibit 6: Energy Supply/Demand Imbalances Narrow Despite a Pickup in Production in Response to Higher Oil Prices
Large Fiscal Plans May Not Happen Until 2018
The markets seem to oscillate around the day-to-day Trump Administration statements concerning the outlook for infrastructure spending, tax reform, and healthcare reform. Yet, a bigger picture should encompass not only a short-term economic boost from fiscal initiatives but also the longer-term implications of how those initiatives would impact productivity. This Bloomberg Briefs article, " Trump Infrastructure Plan is Big, Bold (and Vague)," helps put the policy goals of infrastructure in proper perspective:
"The main priority is to boost the potential capacity for faster economic growth over the longer run. Eliminating transportation bottlenecks, expanding internet speed/capacity and taking measures to improve public health and education are just a few examples that can improve the overall efficiency of the economy, and thereby foster a rebound in productivity growth in the longer run."
Indeed, per the article , the broader point is to focus on the long-term productivity benefits infrastructure spending brings, and that we shouldn't be so short-sided as to focus only on what the near-term impact of (or lack of) infrastructure spending will have on the economy. The article posits that $1 trillion of proposed infrastructure spending only translates into 0.6% boost to GDP; however, given the decreasing influence debt expansion has on economic growth (see Stockpiling Income December 2016 Update), infrastructure spending would certainly have a meaningful impact from a New Normal perspective. Tax reform may not happen until 2018 as it appears to be contingent on whether Republicans choose to tackle the Affordability Care Act (ACA), yet, even without these fiscal initiatives, improving revenue growth should help boost earnings growth for this year, assuming margins can be maintained in the face of higher input costs (Exhibit 7).
Exhibit 7: Recovery in S&P Revenue Growth Should Translate into Higher Earnings
The U.S. economy is not necessarily dependent on all these grand fiscal measures as the cyclical reflationary forces that have been in place post-Brexit are giving rise to strong S&P earnings growth, narrow credit spreads, and higher inflation, even though long-dated Treasury yields have dropped in anticipation of a return to New Normal disinflation beyond the current credit cycle. The spread between short-term versus long-term Treasuries has narrowed and long-term inflation expectations have dipped below 2%, yet these levels are still above the pre-election levels (Exhibit 8).
Exhibit 8: Drop in U.S. Term Structure and Inflation Expectations - Coming Back to New Normal Reality?
Positioning for the Long-Term - The Futility in Trading Around Anticipated Events (or Statements that Speak to Those Events)
The market is a discounting mechanism, and the rapid reactions to every administrative or Fed statement seem to affirm the Efficient Market Hypothesis of how quickly information gets priced into the markets. This month saw the return to high dividend, high quality style of investing - a distinct shift away from pro-cyclical positioning that is supposed to benefit under this new administration. Next month may see the continuation of the defensive posture as Fed Funds futures now price in a high likelihood of three rate hikes, the first of which will happen in March. Regardless, long-term investors should focus on expected returns as priced into asset classes within the macro environment and decide whether they are being compensated for taking on those risks while remaining true to global diversification. At the margin, it would appear that more optimism is being priced into the credit markets while not enough optimism is being priced into cyclical equities, but the markets should sort themselves out as the macro environment unfolds itself under whatever fiscal policies get executed over the next year.
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