April 3, 2017
U.S. and European Political Environment: In our prior piece, “The Evolution of Trump’s Transition,” we highlighted three phases to the market’s response to Donald Trump’s unexpected win: 1) the Initial Reaction, 2) Speculation around the Administration’s initiatives and priorities, and 3) Emerging Clarity related to how investors should interpret new policies and proposals. With the first quarter of 2017 concluded, we are firmly in the transition between Phases Two and Three.
Under the new administration, few certainties have yet to emerge. However, the market interpreted positive economic data and policy developments as signaling an end to low inflation, low growth and a low interest rate environment. In March, this sentiment was backed by the Fed’s move to raise its benchmark interest rate for the second time in three months, to 0.75 percent.
Recent actions from the new administration seem to underscore President Trump’s intent to implement many of the promises made by candidate Trump. These included 23 executive orders that collectively advanced commitments to roll back the regulatory policies of the previous administration.1 Many of these early actions have targeted D.C. rulemaking in general and in particular, the areas of financial services, foreign trade, and the environment. Executive actions on immigration and the GOP’s legislative efforts to amend the Affordable Care Act (ACA) have yet to be fully resolved. As of this writing, analysts are still waiting for many more details on potential tax reform and an infrastructure package that could arrive in the second quarter. Given the failed ACA effort, there is more uncertainty regarding the success of these additional initiatives which in our mind are significant drivers of this “Trump rally.”
Globally, investors also gained some clarity from the Dutch elections during the first quarter. In essence, this was the first test in 2017 of European populism’s viability. The rising tide of populism was at least temporarily stalled when incumbent Prime Minister Mark Rutte emerged victorious over far-right and anti-Euro contender Geert Wilders. Over the next two quarters, analysts will focus on the upcoming elections in France and Germany, which will serve as a much broader bellwether to the political climate in Europe. Equally as important is the U.K.’s formal process of leaving the E.U. This complex, untested process presents an almost overwhelming array of decisions that must be made over the next two years by multiple parties. Prime Minister May formally initiated this process in late March.
Economic & Market Environment: Given this macro background, most asset classes performed well in the first quarter. Equities gained further momentum, building upon the strong finish in the fourth quarter. The Dow Jones Industrial Average passed the 21,000-point threshold in March, and then retreated slightly. The S&P 500 also increased 6.1% during Q1, posting its largest gains in February. As foreign economies showed signs of improvement, international developed market equities posted a 7.3% gain in the quarter as measured by the MSCI EAFE Index. Emerging market stocks also rebounded from a Q4 slump that was related to the dollar’s strength, as the MSCI Emerging Markets Index finished the first three months up 11.5 percent. Emboldened by Rutte’s March win in the Dutch elections, the MSCI European Monetary Union Index also finished the quarter up 8.6 percent. (Source: Bloomberg)
On the U.S. front, positive economic data supported equity gains. Among the headlines, the February jobs report showed a 10-basis point reduction in the unemployment rate, which fell to 4.7 percent. Nonfarm payrolls also came in far higher than expectations. The Institute of Supply Management (ISM) manufacturing index added further optimism as the February index logged an impressive gain to reach 57.7, its highest reading since August 2014, before dropping slightly in March. The manufacturing sector was bolstered by new orders and widespread strength across most sectors, with 17 of the 18 reporting industries showing growth. The ISM non-manufacturing index also surpassed expectations, registering a 57.6 percent reading in February. On March 30, the final real GDP figures for the fourth quarter showed 2.1% annualized growth, fueled by strong consumer spending.2
This positive economic data has translated into sustained corporate earnings growth. If projections for the first quarter are accurate, S&P 500 companies will have produced earnings per share expansion for three straight quarters, following a string of seven quarters of negative growth. As of March 31, 2017, the S&P 500 was trading at a 17.6 forward price-to-earnings ratio, which remains above both the five-year and 10-year averages of 15.1 and 14.0, respectively.3
The firming economic picture also supported the Fed’s decision to raise interest rates at the March FOMC meeting. The Fed raised the benchmark interest rate by a quarter point and signaled that future rate hikes would proceed at a “gradual” pace. Amid the rising rate environment, in which the committee anticipates raising rates two more times in 2017, fiscal policy is replacing monetary policy as the most influential market catalyst. As a result, the 10-year Treasury yield remained above its historic lows from last year and finished the quarter at 2.40 percent.4 Exhibit A highlights the returns for the quarter in the major asset classes:
Outlook: A Fact-Based Approach
Capital markets have always operated within a range of uncertainties. This year is proving to be no exception. Our three-phase template is intended to guide us through uncertain circumstances and to recognize facts from hypotheses. We will continue to employ this framework as more information unfolds regarding the new administration, Brexit and other global changes.
The Uncertain Path of Trump’s Policies: Since last quarter, new facts have emerged around Trump’s policy proposals. The two thwarted travel ban attempts and one failed ACA modification are facts that drive those topics’ moving from Phase Two/Speculation to Phase Three/Emerging Clarity. These are important inputs to modelling the likelihood of tax policy reforms or infrastructure builds. Based on this new data, we have lowered expectations somewhat regarding the outlook for tax cuts. While it still appears more likely than not, Trump’s recent defeats have tempered expectations about future successes in that area.
We expect Washington’s process to have a major tactical impact on markets as officials debate the policies and many analysts have developed overly optimistic expectations. This should lead to greater volatility. However, the fundamental baseline of the U.S. economy appears to be improving, and will likely form a foundation for a slow, but steadily improving U.S. economic picture. As Trump proceeds with his administration’s other proposals and outcomes become clearer, such data will allow a more objective assessment of future equity returns. Although a major focus, the subject of President Trump is just one of several important factors that will determine the future state of the markets.
U.S. Corporate Earnings & Valuations: U.S. stocks appear to be priced for impressive earnings growth. Since the election, the S&P 500’s performance has boosted the Shiller P/E ratio (based on the average inflation adjusted earnings from the previous 10 years) to its highest level in many years.5 While most investors are optimistic that some form of 2017 tax cuts will contribute directly to earnings growth, we remain cautious. We think the U.S. economic picture has improved, but that U.S. equity valuations are somewhat vulnerable to negative surprises that are possible in the coming months. However, we view any selloff as an opportunity to rebalance exposure to U.S. equities to policy weights. It is likely that any overheating from the Trump stimulus effects will be well-managed by additional Fed rate increases undertaken to control inflation. Under these circumstances, U.S. equities still provide a solid foundation for growth in the core portion of a portfolio.
Interest Rates: Currently, three dominant factors are driving interest rates. The two traditional ones are the Federal Reserve and the observed health of the domestic economy. A novel third component is based on the Trump pro-growth agenda. This additional dimension complicates the interest rate picture. Referring to the traditional role of the Federal Reserve, rates will most likely continue to increase, but at a steady, accommodative pace. Given that chair Yellen has signaled a reasonable approach to balancing growth against inflationary pressures, we expect several more rate hikes this year. But we also think the Fed will adapt its stance, if necessary.
Regarding the economic baseline, we expect domestic earnings to continue their upward growth at a slow, consistent, pace. However, because of Trump’s policies, an early increase in the 10-year U.S. Treasury yield complicated the picture. Investors incorrectly assumed that pro-growth policies would quickly be approved. This increased inflation expectations. We now know that to date, this has not been the case, and most market participants are challenged to assess an equilibrium level for rates, given the additional uncertainties. As the second and third quarters evolve, such speculative positions will be tested and the future prospect of rate hikes should be easier to assess.
Brexit Execution: As the U.K. begins to implement Brexit, Europe may enter into a period of uncertainty not experienced since the fall of the Berlin Wall more than 25 years ago. We expect the U.K. and the European Union to experience two years of protracted, tense negotiations. E.U. members must agree upon details ranging from the eventful to the tedious. Unlike other material events that have impacted capital markets, there is no precedent for analysts to compare.
To formulate an outlook at this point in the Brexit process, it is useful to consider the multi-phased approach used in assessing the impact of President Trump. In the case of the U.K. though, the process is clearly in Phase Two/Speculation only, because there are no data points yet to analyze. We expect that more information will be released as the E.U. commences discussions on the steps both sides will take to complete the exit over the next two years. During Phase Two, we expect European stocks and bonds to experience increased volatility, even though the bloc is finally reporting measures of stronger baseline growth. As a result, we recommend being underweight developed international markets.
French Elections: While the recent Dutch election was the first test of populism within the E.U. this year, the bloc faces a greater, more impactful test with the elections in France on April 23. Among the candidates, Le Pen’s platform is the most aggressive, endorsing an exit from the E.U. as well as its currency, the euro. Analysts mostly agree that a Le Pen victory would shock the European markets, and possibly the U.S. markets by contagion. Although polls indicate that such a victory is unlikely, as demonstrated in the U.S. election and Brexit polls, they are less reliable for their predictive power. Although the results will not be known until the final round on May 7, we expect that incremental campaign details will evolve in the interim. Until the final results are known in May, it will be near impossible to discern campaign bluster from actual policies that will be executed by any of the leading candidates. This is another rationale for remaining underweight developed international markets through the next quarter. Exhibit B summarizes our perspective on developed markets as well as the other major asset classes.
Currently, there is more than the usual amount of uncertainty in the global markets. We focus on identifying the risks associated with the many potential outcomes of events, and how to position portfolios against such risks. As the many situations outlined above continue to evolve, we are prepared to make adjustments in order to achieve the optimal returns within a reasonable level of risk.
2 Bureau of Economic Analysis, March 30, 2017
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.