2016, Trump Bump, 2017?

 

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At year end the Dow Jones Industrial Average was up 16.50%, the S&P 500 was up 11.96% and the MSCI ACWI ex USA was up 4.50%.  Value stocks outperformed growth stocks.  The Russell 2000 Value Index was up 31.74% versus the Russell 2000 Growth Index, which was up only 11.32%.  The Russell 1000 Value Index was up 17.34% versus the Russell 1000 Growth Index, up only 7.08%.  Energy stocks led the advance and were up 27.36%, followed by Telecom Services up 23.49% and Financials up 22.80%.  Healthcare was down 2.69%, Consumer Staples were up only 5.38% and Consumer Discretion up only 6.03%.  The bond indexes backed off some after the election as interest rates rose.  The Barclays US Aggregate Bond Index was up 2.65%.

Up until November 8, 2016 the stock market was up slightly and interest rates were still low and going sideways.  Then the unexpected happened and brought about widely anticipated changes in fiscal policy.  Donald Trump won and this changed the direction of investment markets triggering the “Trump Bump” up in the stock market and a rise in interest rates in anticipation of an improving economy in 2017.  The changes are: first, tax reductions for both the household and corporate sectors along with a major reform of the tax code in conjunction with a program of tax credits to the private sector to finance increased outlays for infrastructure; second, provisions to incentivize domestic corporations to repatriate $2.6 trillion of liquid assets held overseas; third, regulatory reform along with measures to increase domestic production of energy; and finally, various measures related to international trade in an effort to reduce the current account deficit.

Hoisington Investment Management Company

Hoisington Investment Management Company discussed all of these in its “Quarterly Review and Outlook Fourth Quarter 2016”.  Its comments are as follows:

Tax Cuts and Credits

Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented.  Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted.  Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.

Due to the extremely high level of federal debt, if the deleterious impact of higher debt on growth is to be avoided, then these tax cuts must be expenditure-balanced to the fullest extent possible along with reductions in federal spending (which has a negative multiplier).

Providing tax credits to the private sector to build infrastructure should be more efficient than the current system, but this new system has to first be put into operation and firms with profits must decide to enter this business.  Moreover, all the various rights of way, ownership and environmental requirements suggest that any economic growth impact from the infrastructure proposal is well into the future.

Tax Repatriation

One of the tax proposals with wide support gives U.S. corporations a window to repatriate approximately $2.6 trillion of foreign held profits under the favorable tax terms of 10% or 15%. There is a catch, however. To ensure that all funds are brought home, the tax is due on all of the un-repatriated funds even if only a portion is brought back to the United States.

Several considerations suggest there is no guarantee that these funds will actually be invested in plant and equipment in the United States.  First, the fact that they are currently liquid suggests that physical investment opportunities are already lacking.  Second, the bulk of the foreign assets are held by three already cash-rich sectors – high tech, pharmaceutical and energy.  The concentrated and liquid nature of these assets suggests that after an estimated $260 billion to $390 billion in taxes are paid, the repatriated funds will probably be shifted into share buybacks, mergers, dividends or debt repayments.  Putting funds into financial engineering will improve earnings per share, further raising equity valuations for individual firms; however, such transactions will not grow the economy.  Finally, the basic determinants of capital spending have been unfavorable, and they worsened in the fourth quarter.  Capacity utilization was only 75% in November 2016, well below the peak of just under 79% reached exactly two years earlier.  The U.S. Treasury’s corporate income tax collections for the twelve months ended November 2016 were 13.1% less than a year earlier, suggesting corporate profits eroded considerably last year.

Regulatory Reform

Regulatory reform could create increased energy production which would clearly boost real economic activity.  Regulatory reform is a strong proposal and will benefit the economy greatly, in time, by making the U.S. more efficient and better able to compete in world markets.  However, these benefits are likely to build slowly and accrue over time.  Without question, the regulatory reform is the most unambiguously positive aspect of the contemplated fiscal policy changes since it will produce faster growth and lower inflation.  Since bond yields are very sensitive to inflationary expectations, this program would actually contribute to lower interest costs as the disinflationary aspects of the program become apparent.

International Trade Actions

Proposals to cut the trade deficit by tariffs or import restrictions would have the exact opposite effect of the regulatory reforms and increased energy production.  The more serious risk is that other countries retaliate.  From the mid-1920s until the start of WWII this process resulted in what is known as “a deflationary race to the bottom”.

Bond Yields

Our economic view for 2017 suggests lower long-term Treasury yields.  Considering the actions of the Federal Reserve to curtail the monetary base and excess reserves, M2 growth should moderate to 6% in 2017, down from 6.9% in 2016.  Velocity fell an estimated 4% in 2016 on a year ending basis.  We assume there will be a similar decline for 2017, although in view of the huge debt increase and other considerations, velocity could be even weaker.  On this basis, nominal GDP should rise 2% this year, which means inflation and real growth will both be very low.  A 2% nominal GDP gain for 2017 points to a similar yield on the 30-year in time, meaning that the secular downward trend in Treasury bond yields is still intact.

Barron’s Special Report

Each year Barron’s convenes a “Roundtable” of industry experts to discuss their opinions on what to expect in the coming year.  The lead this year is “The Big Shift – A year of momentous change could bring only single-digit gains for stocks, our experts say”. 

The article begins by saying, “This could be the year the movie runs backward: Inflation awakens.  Bond yields reboot.  Stocks stumble.  Active management rules.  And we haven’t even touched on the coming regime change in Washington, which will usher tax cutters and regulatory reformers back to power after an eight-year absence”.

This year’s event took place January 9 at the Howard Club of New York, and featured a dynamic discussion of myriad issues, from China’s currency to Europe’s bank woes to Donald J. Trump’s presidential agenda, all of which could reshape the global economy and investment landscape in 2017 and beyond.  What follows are some excerpts from the article:

The 2017 Roundtable Panelists

     

Typically, our market seers thrust and parry from breakfast till cocktails, but this year a remarkably cohesive consensus emerged (contrarians, pay attention). With the bond bull market seemingly ending after 35 years, geopolitical risks growing more pronounced, and the market richly valued, U.S. stocks could have a tough time generating more than mid-single-digit returns. The group generally expects stocks to perform well through the year’s first half, but sell off thereafter, posting full-year results that could range from down 5% to up 6% or 7%.

Our panelists have a dark view of developments in Europe, from the spread of populism to the persistence of negative interest rates, and some fear the euro’s days are numbered. In Japan, however, they say the sun is finally rising on equity investors, and opportunities could surface.

Bill Priest, CEO at New York’s Epoch Investment Partners, notes that rising price/earnings ratios did the heaviest lifting in recent years to catapult stocks to fresh peaks. That will change if bond yields head toward 3%, as expected. Now, he says, the burden will fall on earnings and dividend growth to propel stocks higher.

Barron’s: The world as we know it is changing, or so it seems, and not only because of Donald Trump’s presidential victory. Mario, enlighten us. What do you expect the new year to bring?

Mario Gabelli (Chief Investment Officer, Gabelli Funds, Rye, NY): Trump’s victory meant a rebirth of capitalism, with all its flaws, and a defeat for creeping socialism. It meant the U.S. would remain a place where capital would be honored, as opposed to impaled. Republican control of Congress means regulations will be reviewed and reformed, because the implementation wasn’t practical. Our tax policies could be reformed to make U.S. companies more competitive with the rest of the world. Monetary stimulus is ending; fiscal stimulus is coming, and could include spending on infrastructure and revitalizing the military.

The companies and people I’ve talked to see American innovation taking center stage. We are witnessing a wave of optimism sweeping the country. The question is: How much of the good news has the stock market already discounted? Financial companies will have good earnings this year. The oil ecosystem will improve. But currency translation will remain a problem for some companies, given the strength of the dollar. I continue to look for companies that have been ignored by the market, or unloved.

Felix Zulauf (President, Zulauf Asset Management, Baar, Switzerland): Will tax reform apply to 2017 income, or take effect only in 2018?

Brian Rogers (Chairman, T. Rowe Price, Baltimore): My guess is that a lot of the changes will be retroactive, impacting 2017. The backdrop, in general, will be positive for the first six months of the year. But with the stock market selling at around 17 times earnings, the jury is out on how much upside equities will have.

Oscar Schafer (Chairman, Rivulet Capital, New York): From the time Ronald Reagan was elected in November 1980 until he was inaugurated in January 1981, the market was up 9%. It then fell about 30% through August 1982. I’m not predicting that, but we have had a lot of euphoria.

Priest: There are only three components of equity returns: dividends, earnings, and price/earnings ratios. In the past five years, the MSCI World Index was up 87%. Of that 87%, 74 percentage points came from P/E-multiple expansion. Earnings were down two percentage points, and dividends were up roughly 15 percentage points. The market was up because quantitative easing [central banks’ asset-buying programs] effectively lowered the discount rate applied to earnings and cash flow. It had a profound impact. The election was an inflection point, as we can see from the postelection rise in bond yields. P/E ratios now face a serious head wind. It can be overcome with accelerated earnings growth, and tax reform will be a part of that, if it happens. Also, dividends are going to grow, probably faster than people think.

The danger now is that pressure on P/E multiples will be negative. Unless we get tax reform and more growth in the real economy, the chances of a down stock market aren’t insignificant this year.

Barron’s: Won’t significant spending on infrastructure help to boost the economy?

Abby Joseph Cohen (Senior Investment Strategist and President, Global Markets Institute, Goldman Sachs, New York):On the infrastructure front, the easy stuff is most likely to get approved in the short term, as part of a corporate tax-reform package. Projects could be funded in part through tax credits or public/private partnerships. Congress is unlikely to approve massive spending on infrastructure, which has been discussed, in the next year or so.

Jeffrey Gundlach (CEO and Chief Investment Officer, Doubleline Capital, Los Angeles): Negative rates are toxic to banking systems. Also, they don’t motivate consumption. They necessitate savings. A 60-year-old who hopes to retire in 10 years and have a 20-year life expectancy beyond that has to save twice as much when interest rates are at zero than when they’re at an old-school 5%.

Nominal GDP is the single best indicator of the secular trend in interest rates. Nominal GDP rose for a couple of decades into the 1980s. Interest rates, as we know, rose in the early ’80s. GDP has been falling annually, with few exceptions, since around 1982. Last year, real [inflation-adjusted] GDP probably grew 2.1%. If fiscal stimulus lifts the growth rate this year to 2.5% to 3%, and you throw an inflation rate of 2% to 3% atop that, conservatively you’re talking about nominal GDP around 5%. How can bond yields stay at 2.4% in that environment?

Cohen: As a country, we have underinvested in capital and labor. On the capital side, we haven’t invested in public infrastructure, and capital spending has been insufficient in many industries. On the labor side, we haven’t done what is needed in terms of education. Normally, economic growth is related to labor-force growth. Many people believe that one reason economic growth has slowed is because the labor-force participation rate has fallen. Also, there hasn’t been enough investment in innovation. In the golden period of the 1950s and ’60s, the U.S. spent approximately 4.5% of GDP on basic research and corporate research and development. Now, we spend 2.5%. Much of the decline owes to government defunding at the National Institutes of Health, the National Science Foundation, NASA, and other agencies. Companies have picked up some of the slack, but investments aren’t where they need to be.

Barron’s:  What is happening in China?

Zulauf:  China did everything right until 2008. It had a wonderful period of 10% growth for 25 years. Since 2008, policy makers have gone wild, making one mistake after another to keep the economy growing. The growth rate has broken down; it is now between 6% and 7%, or whatever the government publishes. It will continue to slow, because once an economy reaches the size of China’s, it can’t grow at the same rate as before.

The Chinese are trapped in a debt bubble. Next fall, the Chinese Communist Party will hold its 19th National Congress.  President Xi Jinping needs to stabilize the currency and economy before then. China has only two options: Stabilize the currency by tightening monetary policy, which would lead to a recession, or shut off capital outflows, which, with credit expansion at 40% of GDP annually, could lead to rapid inflation.

Barron’s:  Which course will China choose?

Zulauf:  They will try a little of both. But the pain for the economy will be too great, so eventually they will let the renminbi go. It could slide to eight or nine to the dollar from about 6.90 now.

The other problem is Europe.  As I have argued for many years, the European Union made a mistake by implementing the euro.  It strangulated many economies and killed a few million jobs. The centralization of Europe’s economy is inefficient, but the European political leadership won’t change it. They are married to their idea, as it was designed on a piece of paper. The failure of the common currency has led to the rise of populist movements throughout Europe.

There will be an election in the Netherlands in March; the populist party is leading so far. The more important election is in France; the first round will take place at the end of April, and the two winners will move to the second round. There are four candidates who matter: Marine Le Pen represents the far-right Nationalist Front party. She has a socialist economic agenda. François Fillon, the conservative, has a terrific, almost Thatcher-like reform program. He wants to get rid of half a million government jobs and increase the workweek. He won’t be elected in France on that platform. The third candidate, Emmanuel Macron, is pro-EU and wants to further economic integration. That doesn’t ring a bell with most people in France. The fourth candidate, not yet chosen, will represent the Socialist party. I predict the Socialists will drop out in the first round.

Barron’s:  And the winner is?

Zulauf:  Le Pen has a much better chance of winning than most people think. If she is elected, she has said she will launch a referendum on membership in the EU and the euro zone both. Le Pen would tear down the institutional architecture of Europe, and chaos would ensue. In the first half of the year, the market will focus on Trump and celebrate his moves. But there are many risks outside the U.S.

Cohen:  The creation of the euro hasn’t been an impediment to Germany. It has benefited in terms of trade. Given that backdrop, are you surprised by the political tension within Germany?

Zulauf:  Germany superficially is a big beneficiary of the current structure. It has doubled its exports to 50% of GDP since the introduction of the euro. But it will lose out on Target2 [a European payment system enabling the settlement of transactions with central bank money]. Germany has claims on 750 billion euros [$797 billion] against other EU countries, with Spain and Italy each accounting for more than €300 billion of those liabilities. If the currency union breaks apart, do you really believe they will pay Germany?

Priest:  Italy is the Achilles heel on the European economic front. It is the eighth-largest economy in the world, and it has the fifth-largest amount of sovereign debt outstanding. Its Target2 balances are astonishing. Money has flooded out of Italy, and the banking system is sitting on a crisis.

Zulauf:  Germany looks like the big winner. But when you look more closely, and include Target2, things won’t actually work out as they seem.

Gundlach:  And the German population doesn’t quite understand this. According to ,a poll by Pew Research Center, 38% of Germans disapprove of the EU’s handling of economic issues. In France and Italy, two-thirds-plus of the population are dissatisfied with the EU. In polling terms, that is enormous. Those countries have almost maxed out on dissatisfaction.

Gabelli:  Then there is Europe’s immigration issue, and the fact that these countries always bailed themselves out by devaluing their currencies, which they are currently unable to do.

Zulauf:  The immigration problem is just the tip of the iceberg. It isn’t the key problem. Protests against the establishment are growing throughout Europe, but the establishment has no rules on how to break up the European Union purposefully. When it happens, chaos is guaranteed.

Barron’s:  How smoothly will Britain be able to exit the EU, now that it has voted to do so?

Zulauf:  Discussions will start in the spring, and they will be nasty. The EU will be tough and seek to demonstrate to all members that exiting is not an option. It is very costly. The process will create a lot of turmoil, which isn’t good for global economic growth. Global trade will continue to decline.

Barron’s:  The U.S. stock market sold off momentarily after the Brexit vote and then recovered and went to new highs. How will U.S. stocks respond if anti-euro parties gain more power in Europe?

Zulauf: As soon as there is a greater-than-50% risk of the euro’s failure, the markets will sell off, and not just for a day. Capital doesn’t want to get involved in chaotic situations.

Barron’s:  Meryl, what excites you about 2017—and what worries you?

Meryl Witmer (General Partner, Eagle Capital Partners, NY): For corporations, lower taxes, and less regulation are absolute heaven. If the corporate tax rate falls to 15%, as President-elect Trump has proposed, why would you do business anyplace else? And if business ramps up as I expect, companies will need to hire more people. There are a lot of underemployed people in the U.S. who would like to work. Also, we might see an increase in allowed immigration.

On the other hand, equity valuations are stretched somewhat, although there are pockets of value in the market. I don’t see the market taking off this year, but things could look good if Congress doesn’t screw them up. I have been impressed by Trump’s cabinet picks. Hopefully he will do well, and if so, longer-term, the markets will do well. It is fascinating that Trump can be so effective simply by tweeting.

Barron’s:  Oscar, where do you stand on these issues?

Schafer: Ray Dalio [the founder of Bridgewater Associates] might have put it best when he asked: Will the Trump administration be aggressive and thoughtful or aggressive and reckless? There are so many uncertainties this year. Higher earnings and higher interest rates are yin and yang. It could be a tough year for the market, but a good year for stockpickers.

Barron’s:  We’ve heard that one before.

Cohen: But this year, it will be correct. I’m with Oscar on the importance of stock selection.

Scott Black (Founder and President, Delphi Management, Boston): I like to go by the numbers. At this time last year, the consensus forecast for 2016 S&P 500 earnings was $126. The consensus is predicting that actual results will come in at $108.84. The consensus for 2017 is $130.84, which would imply a 20% increase. There is no way, with 4% nominal GDP and a strong dollar, that earnings will get there, even with energy-company profits improving. My forecast is closer to $123.

The market currently trades for 18.5 my expected earnings for this year. The historical average is closer to 16.5. The small-cap Russell 2000 index and the mid-cap Russell 2500 finished the year, respectively, at 28 times and 24 times 2016 estimates, and 23 and 21 times forward earnings estimates. Small- and mid-cap valuations are in nosebleed territory. That said, there is the potential for more gains because of bullishness about the Trump administration.

I agree that it will be a stockpickers’ year.

Zulauf: Stocks could easily rise another 10% into the middle of the year. But after a soft period, bond yields will rise again, with the 10-year Treasury yield hitting 3% or going a little above it. That will trigger a big correction in equities, just when everyone is fully invested after buying into the Trump rally. I expect the S&P 500 to be slightly negative for the full year.

Rogers: It is tough to argue for a gain of much more than 6% or 7%, especially in a rising-interest-rate environment.

Priest: I’m in the 5% to 6% category regarding the market’s potential gain.

Gabelli: I see zero to 5% growth for the stock market.

Cohen: We have a good sense that the economy will grow by 2% to 2.5%. We’re pretty sure that corporate earnings will be up about 10%. My forecast for stocks assumes the first half of the year will look pretty good because economic forecasts are baked in the cake. This year, the risks are skewed to the downside.

Gundlach: We are going to break out of the land of stability this year, and certainly by 2018, and there will be an inflation surprise. That isn’t going to be helpful for equity valuations.  I see a single-digit decline for the full year.

Cohen: The underlying theme of a portfolio has to be reflation. Fixed- income markets are a dangerous place to be.  If you believe that GDP will grow by at least 2% in the next year or two, and that S&P profits will rise, the stock market doesn’t look overpriced. There are bigger pockets of opportunity within the stock market.

One big change in our industry in the past 20 years has been the move to passive investing. According to Zacks, there have been four new exchange-traded funds launched every day since the end of 2014. According to The Wall Street Journal, Vanguard passive funds held a 5% ownership stake in only three S&P 500 companies in 2005. That number is now 468.

The chance is high that we will see some sort of reversal this year. We are breaking a lot of trends this year. We are breaking trends about a multidecade bull market in bonds, and trends about equities. The easy work on P/E multiple expansion has been done, as Bill noted. There could be a real advantage to good active management this year.

Priest:  The index-fund trend has been turbo-charged in the past five years.  When most of the market’s return owes to multiple expansion, indexing is an ideal way to win. If we have entered a new regime, with earnings and dividends starting to drive total return, the opportunities for active management are only going to get better. Lower correlations are good for active management.

Gundlach:  People say bonds are in a bubble, that they are over-owned. I agree with that. But anything that is momentum-driven is in a bubble. This passive stuff is in a bubble.

Conclusion

At Monroe Vos we agree with the view from Hoisington and the Barron’s panel.  We believe that interest rates may back down in the first half of the year and that the stock market can continue to rise.  In the second half of the year interest rates may rise and the stock market will reach such an overvalued position that a correction will be likely.  The wild cards are the elections in Europe, what happens in China, and what the Trump administration and Congress gets done.  All of these can have a dramatic effect on global markets.

 

Jamison Monroe
Chairman & CEO
Director of Consulting