Jan 09, 2017
Nobody saw this coming, but in the collective wisdom and unemotional ways of the market, it didn’t take long to comprehend that this was monumental. The combination of a highly improbable election outcome with such wide-ranging policy consequences was, and is still, startling. We’re sure there are parallels somewhere in modern history, but they elude us at the moment.
While nothing has actually changed just yet, the market’s favorable reaction to the likelihood of change is logical. A policy agenda that includes the prospects of lower corporate and individual tax rates, a rollback in business regulation, massive infrastructure spending, and repatriation of foreign corporate earnings back to the U.S. are all potential developments that would be enthusiastically embraced by the stock market.
In previous recent Investment Updates, we discussed what we and others believe to be a disconnect between what has been a good stock market and a not-so-good economy. As to how this disequilibrium would eventually become reconciled, we posited that it could come from a reacceleration of growth as opposed to a pullback in stocks. Until now, we admit it had not been easy to see where that growth was going to come from.
A Solid Year for Stocks
Stocks followed two very different but positive paths over the course of the year. The first six months were characterized by investors’ preference to play it safe and own defensive, higher quality investments, favoring Utilities, Telecom, and higher dividend paying companies. This period also included the recovery of Energy companies as the price of oil doubled from its February bottom.
The Brexit vote in late June caused a very temporary disruption, but the response by Central Banks drove the market to new highs. This was followed by a shift in preferences to more value-oriented and cyclical companies, prompted by modest signs of an improving economy. This refocus on economic growth was bolstered by the election results, driving stocks to newer highs.
For the full year, the S&P 500 ended 12% higher. The more cyclically weighted Dow Jones Industrial Average performed better; the more Tech weighted NASDAQ performed worse. In a reversal of what worked last year, Value indices outperformed Growth indices and small-cap stock returns exceeded large-cap stocks by a wide margin. In the context of 2015’s flat to down results for stocks, annualized returns over the past two years are still tracking in the 6% range.
This change in the economic outlook came at the expense of fixed income securities. Inflection points like these can be dramatic when the existing environment has been in place for a long time, as has been the case with “lower rates for longer.” With bond yields up meaningfully from the earlier lows of the year, future rate moves are likely to be more gradual.
Politics Not As Usual
With the recent strength in stocks, it is natural to expect a more circumspect view of how political rhetoric translates into actual policy. There are policy initiatives dealing with free trade and immigration that could likely run counter to a new pro-growth mindset. International relations also hold significant risks to the capital markets that will be hard for investors to ignore. The proposed border tax embedded in the Republican tax reform proposal has already pressured the stocks of import-dependent companies, like retailers.
The enormity of the Trump agenda suggests that priorities will need to be set and some items possibly set aside or abandoned in order to move forward in the most important areas. Expectations are high, obstacles are many, and the way this plays out in the various traditional and social media channels will likely generate its own angst.
Over the coming months, investors will have to adjust to a new style and method of governing. There’s no getting around the likely problems and opportunities in transitioning to a different way of doing things. The challenge of reconciling the conflict of a refreshing capitalistic spirit with the reality of a president who is not timid in suggesting how a business should run its operations creates an additional layer of uncertainty for investors.
Still, we can’t help but be fascinated by the oncoming collision of a freewheeling management style with the institutional bureaucracy of an entrenched political system. Something has to give and from the market’s point of view, politics not as usual should be a good thing.
One additional silver lining to this sea change – the markets may have finally moved beyond their fixation with the Fed and their addiction to extreme monetary stimulus as a primary driver of higher stock prices. This shift comes at a time when the effectiveness of monetary stimulus was already losing its edge, making this refocus on economic growth and profitability very timely. In the meantime, it would not surprise us to see stocks take a breather as we get through what promises to be an eventful and unprecedented transition of political power.