Over the eight months since the U.S. presidential election, we have been monitoring the initial surprise, subsequent policy speculation, and rolling disclosures of economic and political policies coming out of Washington, D.C. This approach has provided a forward-looking view of President Trump’s potential impact on the markets. Eight months of observations are now available to check against our original beliefs and expectations, and the results are surprising.
As it relates to the U.S. economy, we would have anticipated more fact-based data on policy matters such as healthcare reform, tax cuts, infrastructure spending, and other topics by now. We anticipated analyzing the facts, refining our template, and tightening our outlook on Trump’s likely market impact. Somewhat unexpectedly, political gridlock has delayed executing these steps. Zero momentum—neither acceleration nor deceleration—means we cannot track a policy’s trajectory. Therefore, we must accept this phenomenon in which the absence of data becomes the data, and proceed accordingly. Indeed, the impact of political gridlock is meaningful. If the current state continues for some time, it could signal a “new normal” within which the U.S. will operate. Thus we must include an additional scenario of no new policy approvals as a constraint when formulating our U.S. capital market outlook.
This revelation is important, but hardly without precedent. Neither is it catastrophic. History shows that political dynamics are not the solitary drivers of market performance. While politics certainly influence markets, it is an over-simplification to link market movements solely to events in Washington. Reviews of periods following political scandals such as Watergate reveal that markets traditionally have moved according to economic forces, not in response to the scandals themselves. Most important is the state of the U.S. and global baseline economy, not the state of the president’s proposals. In many ways, policy gridlock is actually better than policy volatility, since the latter is more difficult to model. On the positive side, this scenario of gridlock allows us to decouple market fundamentals from political uncertainty and “follow the facts” rather than speculate about the potential geopolitical drivers and risks that exist today.
This renewed focus on fundamentals has so far proven to be constructive for investors. Continued earnings strength, in which approximately 75% of S&P 500 companies beat first-quarter estimates, paired with mostly positive economic news, fueled domestic stocks in the second quarter. And while we consider international markets independently, improving hard economic data in France and Germany had the same effect, even in the face of a potential Brexit overhang.
U.S. EQUITY MARKETS
The S&P 500 finished the quarter 3.1% higher, maintaining a steady upward trajectory, except for a momentary setback in May, with the largest gains coming in late April on the back of solid earnings news (see Exhibit A).
We remain optimistic about the U.S. equity markets. Disaggregating stock returns to their basic building blocks, the U.S. markets are driven by earnings expectations plus dividends, and adjustments to market valuation ratios such as the Price/Earnings (P/E) ratio. Expectations of Trump dynamics are embedded in these calculations. Assuming that the “Trump factor” remains in gridlock, we are optimistic about the fundamentals for earnings, as the current consensus estimates for S&P 500 earnings per share growth is about 15% for 2017 and 12% for 2018, according to Bloomberg. Dividends also appear sustainable at current levels. Regarding P/E levels, the major U.S. large-cap indexes are valued at roughly 17 to 18 times forward earnings versus historic averages closer to 15. These levels leave little room for P/E multiple expansion. The index has already returned nearly 10% year-to-date, but if the consensus is accurate, it appears some room still exists for increased returns through the remainder of the year.
The caveat, however, is that an underlying sensitivity can be detected among investors in U.S. stock markets. While volatility remains muted, we have seen flashes that convey a waning confidence in the absence of positive policy developments. In late May, for instance, the S&P 500 fell a sharp 1.8% on news related to the president’s dismissal of FBI Director James Comey. Even though equities quickly rebounded, the sudden shock underscored how quickly volatility can return to the market.
U.S. ECONOMY AND INTEREST RATES
From a high level, the U.S. economic news was largely positive in the second quarter. The Institute of Supply Management (ISM) Manufacturing Index remained healthy in the latest May reading, helped by stability in new orders, employment, and inventories of raw materials. Meanwhile, the May ISM Non-Manufacturing Index was slightly down from April, but signaled continued strength in business activity, new orders, and backlogs. If there was an area of concern, however, May’s retail sales figures surprised the market with a 0.3% month-over-month decline, as autos, department stores, and restaurants all showed weakness.
The U.S. economy is experiencing a near ideal balance of strong job growth and moderate inflation. When the unemployment rate fell to 4.3% in May, it represented a new 16-year low, which almost certainly played into the Federal Reserve’s decision to raise interest rates by a quarter point at its June meeting.
Most economists project slight jobless rate declines in 2018, and moderate U.S. GDP growth of around 2% over the medium term. If these conditions persist, it is possible the Fed will continue raising short-term rates in several increments over the next few quarters. We also anticipate the Fed will start to reduce its massive balance sheet debt by simply not reinvesting proceeds from maturing bonds. We think this action represents a low risk to the markets.
There is a slight conflict of data that complicates Fed decision making. Eight years into the U.S. economic expansion, the unemployment rate is so low that it should normally pressure inflation, yet inflation remains well below target. This disconnect has persisted, culminating in a third consecutive “disappointment” in inflation. Despite weak inflation, we expect the Fed to stay the course on policy normalization. Thus, short-term rates should continue to increase at a measured pace, setting a firm foundation for controlled growth.
INTERNATIONAL DEVELOPED MARKETS
The U.S. markets aren’t alone when it comes to an unsettled geopolitical picture. In the U.K., the decision by Prime Minister Theresa May to call a snap general election backfired when the ruling Conservative party lost its majority in Parliament. The results left markets unsure about the nature of Britain’s departure from the European Union. The biggest question facing investors now is whether new leadership will pursue a “hard Brexit,” necessitating new trade deals, or a “soft Brexit,” in which the U.K. maintains access to the European single market.
Investors did gain clarity elsewhere, however, as Emmanuel Macron became the president of France in the first week of May. Combined with the Netherlands’ election of Mark Rutte in March, this news helped avert the market unrest that might have occurred if Marine Le Pen, the French populist candidate, had won the vote. Investors now have their eyes trained on the German election in September.
The French election powered international developed markets higher in late April before finishing the quarter with a 6.1% gain, as measured by the MSCI EAFE Index. The MSCI European Monetary Union Index, benefitting from the same tailwind, gained 8.0% in Q2.
Developed market growth expectations are best understood by separating the U.K. from the rest of the European Union, given the potential impact of Brexit. We generally view Brexit as a U.K.-specific matter, and are cautious regarding the two-year path to negotiating an exit. As such we continue to underweight the country, and expect volatility to fluctuate as weekly developments are disclosed. On the other hand, profits in core activity among the other major members of the E.U. are improving. Upward revisions in Eurozone earnings have broken the trend set since 2012, and we expect profit growth to build momentum from here. Resolution of France’s elections and clarity on the upcoming German elections bode well for these countries. Unlike France’s election, Germany’s appears more predictable. This increases confidence in making investment decisions for the remainder of the year. If favorable incremental economic data develops, we will increase exposure to the Eurozone markets, but still with a balanced concern regarding how Brexit may impact the overall bloc.
Developed-market stocks in Asia have also performed well during the quarter. A stable yen has set the stage for stronger earnings in Japan, while the broader continent has benefitted from a firming economic picture. The Australian market, however, was an exception, thanks to a dimming outlook for commodities. The MSCI Pacific Index advanced 3.9% in the second quarter. Generally, we believe that these markets will continue to show growth, but Brexit and the possibility of increasing inflation could impact investors’ enthusiasm. Watching how the European Central Bank responds to increasing inflation is extremely important at this stage.
Emerging market stocks weren’t immune to geopolitical turmoil, as Brazil’s president was charged with bribery and obstruction of justice related to JBS SA’s unfolding political-kickback scandal. Yet the MSCI Emerging Markets Index continued its strong run, ending the quarter up 6.3%, thanks to strength in Chinese, Indian, Argentinian, and South Korean equity markets.
Starting in June 2018, the global index provider MSCI will include Chinese stocks in its emerging markets index for the first time. This signals an improved confidence in the Chinese market. (In the past, there has been considerable skepticism concerning the integrity of their financial reporting, for instance.) This addition will most likely draw billions of dollars into the Chinese equity markets from passive indexers alone. We see possible increased investment opportunities in China, subject to very careful, detailed analysis.
In general, we believe emerging markets are inexpensive compared to the developed markets, but also see them as priced appropriately for their risk and consistent with historical valuation levels. For example, the recent political events in Brazil have chipped away at investor confidence there. Even though there seems to be relatively little risk of a broader contagion effect in the future, we remain extremely cautious and underweight the asset class. We take this stand despite the observation of recent upward revisions to forecasted earnings growth over the next 18 months.
Three simple factors will combine in a complicated way to drive the direction of the U.S. dollar, which saw strength earlier in the year and began to deteriorate in the second quarter as the yield curve flattened and the 10-year U.S. Treasury ended the quarter at 2.31%:
- Trump’s Policies: There is the possibility of Trump’s policies driving the dollar, but the direction depends on the success rate of his policies being approved. Adoption of pro-business policies are likely to strengthen the dollar. We saw this initial data point immediately post-election, as investors drove the 10-year U.S. Treasury to higher rates in anticipation of rapid growth that has so far not materialized. Since then the dollar has steadily weakened.
- The Fed: If the Fed continues to raise rates, higher yields would make the dollar more attractive versus other currency alternatives, thus driving the dollar higher.
- U.S. Consumer Health: Steadily improving U.S. consumer health should bolster the general thesis that higher rates will be expected.
Presently, these factors are set against a consistently weaker trending dollar, though. This suggests that investors are still working through the gridlock of the Trump administration.
Pulling together our insights across geographies and markets, we’ve summarized our forward-looking perspectives by asset class in the table below:
LOOKING AHEAD: A TWO-DIMENSIONAL MARKET
In order to gauge the health of the investment markets through the rest of the year, what signs do we look for in the coming months? We can cast them in two dimensions, as illustrated in Exhibit C: a baseline economy derived from economic and market measures, and another describing exogenous uncertainties derived from Trump policies and other geopolitical matters (e.g.,Trump, Brexit, German elections, etc.). Currently, in the U.S. we are positioned in a Trump gridlock, but with quite strong baseline economic measures. For developed international markets, the baseline is not as strong, but it is improving as negative Eurozone uncertainties are diminishing.
For the U.S. markets, only time will tell if this current state is stable, but clearly three of the four possible scenarios favor an optimistic tendency. For example, the best path would lead to the upper right, resulting from continued strong economics and a break of gridlock to improving political policies, such as tax reform or infrastructure spending (“Improving”). A less desirable, but still acceptable path could lead to the diagonal states (top left and bottom right), marked by either a still-firming economic picture paired with an uninspiring geopolitical outlook or a deteriorating economy offset by positive developments in Washington and globally. We will carefully monitor conditions for evidence of trajectories away from the current state toward the weak baseline and negative exogenous uncertainties. As we enter the last half of a truly memorable year, we believe that an analytical approach like this will continue to play a most critical role in discerning value for our clients.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.