As we reach the midway point in the 2017 calendar year, I am preparing to write my semi-annual market themes. I find that the exercise of sitting down to articulate my current views on the market is a valuable tool in framing my asset allocation decisions. Before I author my themes for the back half of 2017, I decided to look back at my themes at the outset of the year. My themes, from an article published on New Year's Day, are listed in bold. After each theme, I discuss (in italics) how that theme has played out thus far this year.
U.S. Pro-Growth Policies or Empty Promises?
- Tax cuts, infrastructure spending, and selective deregulation would boost near-term U.S. growth. The extent of their long-term impacts on economic growth would be dependent on the fiscal multiplier and degree of deficit financing. The recent market rally has priced in an increasing probability that pro-growth policies are passed into law, but policy prescriptions and timing remain far from certain. We will see pro-growth policies, but I believe the market is too optimistic on their implementation at this point.
As I wrote this article in early January, we were a few weeks from the Trump inauguration. Fast forward nearly six months and the market hopes for tax reform, infrastructure spending, and pro-growth policies have dimmed. The Trump reflation trades that buoyed domestic-focused small caps (IJR), inflation-protected securities (TIP), and financials (XLF) have unwound a bit. Rates have rallied as inflationary pressures from accelerating growth have been re-priced lower by the bond market.
I was right to believe that the market was being too optimistic on their implementation, but with U.S. stocks still bouncing around all-time highs and a solid 10% year-to-date total return for the S&P 500 (SPY), market participants underwhelmed by the Trump White House can still smile at their gains. It does not appear that this Administration will be able to pass a comprehensive tax reform. The path of least resistance - corporate and individual tax cuts - would still seem more than likely to me as a countdown to 2018 mid-terms begins.
A Turning Point for Europe?
- A weaker Euro, a potential for a growth pickup in the key U.S. export market, and still easy monetary policy could support European businesses. As has been the case for nearly the past decade in Europe, uncertainty remains elevated. Externally, U.S. trade policy and its commitment to NATO in the face of a flexing Russia are emerging issues. Internally, the EU must contend with a looming Brexit and the prospect of more political disruption given looming elections. Europe remains at an inflection point - there is a path towards the growth needed to grease structural reforms and heal the banking system, and a dark path towards further fracturing of the European experiment and weakness in the periphery.
Europe has surprised to the upside in 2017 with gains for risky assets across the continent. The Vanguard FTSE Europe ETF (VGK) has returned 17%+ year-to-date, including reinvested dividends. Russia has been more topical stateside than in Europe. Elections in France yielded market-friendly results, while recent U.K. elections and the failed Italian referendum disappointed markets.
The removal of tail risks from the existential crisis threatening the Eurozone has limited the downside for European assets. With cheaper valuations than their U.S. counterparts and rebounding global growth, European assets appear likely to continue their recent outperformance.
Little Trouble in Big China?
- To continue to rebalance its economy from an export-led economy dependent on state investment spending to one tied more directly to the domestic consumer, China will need firm global economic growth… and a weaker currency. The latter directly contradicts the campaign goals of President-Elect Trump, and could potentially increase tensions between the world's two largest economies, which could lead to a pickup in market volatility. Chinese capital outflows and the pace of debt growth will also bear monitoring.
The Middle Kingdom has found a middle ground with the yuan, maintaining a monetary policy that is neither too tight nor too loose. Resultantly, the dollar exchange rate has been relatively stable, muting potential criticism from the White House. A re-escalation of North Korean tensions has offered the potential for a more cooperative U.S.-China dialogue.
In a bit of a surprise amidst a presidency full of headlines, Trump and Xi Jinping appear to have developed at least a cordial relationship that could serve to temper potential tensions between the world's foremost superpower and its most quickly developing one.
Debt growth that is fueling the continued economic expansion appears unsustainable, but the state-influenced banking system differs markedly from the Western systems that have come under stress after rapid debt growth reversed.
The Emerging Market Phoenix
- Relatively low valuations compared to U.S. assets, depressed currencies, and the prospect of a positive feedback loop from an uptick in developed market growth could combine to be constructive for emerging market assets. Counterbalancing these positive tailwinds is the slowing path of globalization and the potential for trade conflicts borne out of a more isolationist America.
With the Vanguard FTSE Emerging Markets ETF (VWO) up around 16%, emerging markets have seen strong year-to-date performance. There has been more smoke than fire around an increasingly isolationist U.S. economy. Mexico, the poster child for a less trade-friendly United States, has seen a leading ETF that targets its stocks (EWW) rise nearly one-quarter.
As is typical, "emerging markets" is a broad term for developing nations that often misses the idiosyncratic differences between each country. Tensions on the Korean peninsula, the Qatari-Saudi row, new corruption allegations in Brazil, political turmoil and a downgrade to junk for South Africa have all highlighted the potential for geopolitics to trump economics. Attractive valuations and rebounding global growth have more than offset these concerns.
The Monetary to Fiscal Handoff
- The post-crisis period in global capital markets has been dominated by extraordinary monetary accommodation. With the United States normalizing the Fed Funds rates, and questions about the efficacy of further easing in Europe and Japan, the era of supportive monetary policy is coming to an end. Global central bankers have long hoped for austere fiscal policies to be rescinded in favor of fiscal stimulus and structural reforms. The path is visible in the U.S., but will it be tread in 2017?
The Fed has boosted the Fed Funds rate twice in 2017, and the market is pricing in a third hike for later in the year. The European Central Bank appears to be ready to taper, but rate hikes are likely still off on the horizon. The Bank of Japan has indicated that it would keep the 10-yr JGB at 0%, which amazingly in this market environment is actually a relaxation of monetary stimulus.
While monetary accommodation appears to have peaked globally, rates still remain extraordinarily low. While many market participants banked on the "Fed put" during the cyclical recovery, the Fed is striving to move rates away from the zero bound. With monetary support waning, what does that mean for markets? Monetary policy does not operate in a vacuum.
It needs to work in concert with fiscal policy in the context of a structurally sound economic system. With fiscal, tax, and structural reforms waylaid by a bumpy start for the Administration, the handoff of the baton from monetary policy to its fiscal counterpart appears to be at risk of being dropped.
Do High Multiples Portend Low Returns?
- While markets appear optimistic at the prospect of a pick-up in economic growth from increased fiscal stimulus, elevated equity multiples and still historically low interest rates suggest forward returns for stocks and bonds will be weaker than in the early phase of this prolonged cyclical recovery. Some of the gains from economic expansion have already been pulled forward by financial markets.
Academic research has shown that current multiples are an effective predictor of long-run returns. Mathematically, lower yields on Treasury securities dictate lower realized returns to maturity. Despite the view that market multiples are relatively stretched, the equity and bond markets have still registered impressive gains in the early year. While markets can stay buoyant for extended periods of time, we could be experiencing that pull forward of market gains absent a sustained pickup in earnings growth.
Known Unknowns and Other Surprises
- While the largest questions remain around the trade and geopolitical policies of the incoming U.S. administration, other known uncertainties remain - both domestically and globally. The smoothness of the path of Chinese growth, the pace of Fed normalization, the impacts of Brexit, and European elections are all risks the market is dynamically pricing. Volatility tends to cluster, and we are likely to see some volatility events in 2017 that are less readily anticipated by financial markets, much as we experienced in 2016.
While there have been no shortages of surprises in 2017, volatility has remained extraordinarily low, and it has had a meaningful impact on asset prices. Think of this low volatility in the context of the famed Merton model used to assess the creditworthiness of a company's debt. Low volatility makes the probability of financial distress further away. In that environment, we have seen a rally in credit spreads across sectors.
Low volatility favors securities with embedded optionality (e.g. the homeowner prepayment option in mortgage-backed securities and mortgage REITs), which have recorded robust gains. Despite the many surprises of the Trump administration and the geopolitical machinations of governments positioning for a shift in American foreign policy, perhaps the largest surprise in 2017 has been financial markets bereft of volatility.
Asset allocation decisions are the predominant drivers of portfolio performance. Risk tolerance and investment horizons vary for each investor. Hopefully, the periodic publication and discussion of my personal themes can help investors frame their own market thesis. Global assets prices have surprised to the upside in 2017 amidst reduced market volatility. Over the next few weeks, I will sharpen my thoughts about financial markets with a revised outlook for the back half of the year.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY, IJR, VGK, VWO.
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.