There isn’t a day that has passed since the November U.S. presidential election that Mr. Trump, now President Trump, has not dominated the headlines. Avid readers of this commentary over the years will acknowledge that I had grown weary of the omnipresence of the Federal Reserve and the vast shadow it has cast on the capital markets, compelling me to write about it far too often. Well, it appears the Fed is not nearly as relevant in this Twitter regime we find ourselves in and, unfortunately, I have already grown tired of referencing the machinations going on in Washington D.C. these days. Nevertheless, I intend to explore the relevance of both in this commentary. At the very least, Trump and Janet Yellen will share air time.
Reflections on Q1 2017
The ascent of risk assets upward since the election and continuing through the end of the first quarter has been breathtaking. Investors have been seemingly breathless in their desire to scoop them up across the entire spectrum of choices, leading to a first quarter experiencing little downside volatility and strong absolute returns.
In terms of volatility, the S&P 500 closed up or down 1% or more on just two occurrences during the first quarter, out of 62 trading days. That’s a remarkably sedate showing, and not what was expected.
Frankly, if we could close the books now on 2017, I would consider it a decent year. Volatility, not manifesting itself in markets, is embedded in the domestic and geopolitical backdrop. Headline grabbing and catalytic events have apparently not worked their way into investors’ assessment of risk. These include, but are certainly not limited to, the legislative machinations and uncertainty in D.C., the potential for a government shutdown in April, the imminent French presidential elections in April/May and later in the year, German elections, the U.K’s execution of Article 50, and ideas of a U.S. strike against North Korea being floated, just to name a few. It is silly to simply state the environment appears uncertain. The future and its effects on markets have always been uncertain in my 27-year investment career.
As mentioned in previous commentaries (see “Making Volatility Great Again-Augmenting the 4 D’s with the 4 P’s”), I do believe we are witnessing a transformative shift into an environment marked by socio-political events acting as the driving factors determining future growth. The extreme differences in paths markets could take have yet to manifest themselves in pricing. For now, markets have embraced an overly optimistic view despite the highly unpredictable U.S. administration, the secondary and tertiary derivative effects they may have on the global economy and markets, as well as stretched valuations to boot.
The one year returns look especially scintillating in many cases given where markets were in the first quarter of 2016—just coming off a bottoming out process that ended in mid-February, markets were at depressed levels. For the first time in a while, non-U.S. equities outpaced domestic equities. Notably, emerging equities put up big returns given a renewed sense of optimism regarding global growth. The big headlines have been China’s ability to rebound from disappointing GDP numbers, until recently, as well as the very surprising positive direction in the European economy. Projected GDP growth in Europe is expected to come in around 2.5% year over year for Q1 2017, a shoot-the-moon type of number given the anemic deflationary-like growth experienced by the region for years. As we review the past 12 months, we should be pleased with the absolute returns generated by well-diversified, balanced portfolios when considering the major shocks to the geopolitical infrastructure and the unknown effects those events may have on future economic growth.
And, of course, in March, the Federal Reserve raised interest rates for the third time in the past 15 months. The Fed’s stated objectives are stable inflation and low unemployment, but they continue to strive for market stability as well.
Policy (a non-partisan view!)
The 1986 tax reform legislation took Ronald Reagan five years to put in place and one should not underestimate the amount of dissension amongst factions within the Republican Party on this issue in 2017. It is complicated by the new administration’s inability to repeal the Affordable Care Act as spending cuts were included in the latter to offset lost tax revenues that were to help fuel a tax bill. Many other initiatives such as infrastructure, renegotiating free trade agreements, even approving the Keystone pipeline are complicated issues that involve many steps and, eventually, the alignment of multiple stakeholders. While the pomp and circumstance of executive orders grab headlines, practical execution is another matter. For example, the President’s “approval” of the Keystone pipeline would lead one to believe things would move forward quickly, however, state and local authorities need to review and approve the project and their approvals are not foregone conclusions.
Markets & Volatility
It appears markets are beginning to realize what we said in our January commentary--it is very difficult to get any agenda item through D.C. given the vitriolic environment between parties and the strife or lack of cohesion (at best) within the Republican Party. Markets had priced in all the good elements of the administration's platform as if they were somehow going to sail through Congress with alacrity. While an outsider like Trump can try to bring urgency to D.C., he lacks the savvy to figure out how to navigate and co-opt the well-entrenched factions who are now more emboldened to oppose the administration's agenda or try to change it to suit their interests. Next up: tax reform--good luck. Sounds easy but there is no alignment on it within the governing party. The bond market has been telling this story for some time--just look at the 10 year U.S. Treasury.
The U.S. Economy
Yet, from an economic perspective, the picture is flashing some mixed signals. In the U.S., we have continued to see strong employment numbers, and optimism amongst small businesses remains at 43 year highs while consumer optimism has reached 17 year highs. Also, as an indication of firming global growth that would be beneficial to our economy, U.S. export data has been strong lately. But, there are also signs of expansion fatigue. Consumer spending slowed in the first quarter and auto sales have continued their negative trend over the past year, which tends to have high predictive value for the broader economy.
As I mentioned earlier, markets are immune to the aging process and so is the economy. With that said, the current expansion’s duration is moving quickly into record territory. According to Ed Easterling of Crestmont Research, “The current expansion, which started in June 2009, is now the third longest in recorded history since the 1850s. If it lasts until May 2018, the current expansion will become the second longest and then in July 2019, it will become number one. But most of all, if the current expansion endures to January 2020, then it will mark the first decade (the 2010s) without a recession.”
While the Federal Reserve raised interest rates at its March meeting on the heels of the December 2016 rate increase, there were many “dovish” signs in the narrative—signs the Fed will be tentative regarding the pace of rate increases to ensure the recovery is not stunted. The Fed has been waiting to hand the baton to fiscal policy but, in their recent statement, their projections for the possible effects of fiscal stimulus efforts were moved further out in time as the new administration’s initiatives seemed to have stalled. Additionally, and surprisingly, the Fed commented on the equity markets—something they are loathe to do—by expressing concerns regarding equity valuations. Could this be another “irrational exuberance” moment? I don’t know, but it appears this Fed is concerned about risks to the economy and may be raising rates in the face of these risks in order to replenish ammunition to deal with the next recession -- whenever it occurs.
While the Fed also discussed allowing their multi-trillion-dollar bond portfolio to start rolling off (i.e. not reinvesting maturing bonds), they also mentioned bringing back the reinvestment program when the economy moves into recession. I do think it is good news that the Fed is trying to right-size its balance sheet (gradually and prudently) while attempting to normalize interest rates—this bodes well not only for their efficacy to combat the next recession but for the dutiful savers and the retirees who would benefit from a rise in interest rates.
Despite being faced with the United Kingdom triggering Article 50 to exit the European Union, populist candidates competing in French and German elections as well as the often forgotten about massive Italian debt problem, Europe is showing signs of life as inflation picks up, credit expansion accelerates and real GDP has experienced a recent “surge” to 1.7% as of year-end 2016.  While a weaker Yen has helped Japan’s exports, the economy continues its generational slog absent the structural changes required to give it the necessary boost. Despite its growing debt burden and Chinese officials targeting a lower annual real GDP growth than in recent years, the Chinese economy appears stable but the central government continues to struggle with the need to move from a production-based economy to a consumer-based one. Finally, the emerging markets, with their young demographics and relatively lower debt levels, have reappeared on the global economic scene showing renewed strength despite the concerns related to the potential for U.S. trade protectionism. Strangely enough, emerging market countries are in the process of emerging from the constraints imposed by populist leaders and policies as the developed world wrestles with the early stages of that movement.
The unwinding of the Trump rally may have begun. We have seen declines in small cap and bank stocks as well as other expected beneficiaries from the administration’s policies. At the same time, we are also seeing high yield credit spreads start to widen—all signs that the end of this rally may be near. One area of concern for us is the record low level of equity market volatility, as a contrarian indicator (too much investor complacency and bullishness), which has been bouncing around in the lower 4% of all quarterly periods since 1950.
Keep in mind, volatility has been bouncing at the lows for years now. Are we overdue for a correction? It seems that way, but markets do not decide to correct because they are long-in-the-tooth. They respond to a change in sentiment (requiring an economic, political or market catalyst to go from optimism to pessimism), change in fundamentals indicating slowing/declining growth, the inversion of the yield curve (a typical harbinger of an imminent recession), and/or a liquidity squeeze. We have been in the camp that too much optimism is priced into markets, especially the U.S. markets, and our conservative position should serve us well when the downturn occurs, but trading this market based on measures like the smoothed CAPE (the Cyclically-Adjusted Price-Earnings) and VIX (a measure of stock market volatility) levels is a low probability endeavor.
As I write this commentary, the U.S. has initiated air strikes against the al-Assad regime in Syria in response to the horrific use of chemical weapons on their civilian population. I will not comment on the human tragedy that persists in Syria as that goes beyond the scope of this market commentary. However, I am compelled to interpret the action’s potential implications from a market perspective. Is it possible this decisive move against a diabolical dictator guilty of unspeakable atrocities could be a unifying factor for this administration—one that creates some form of bipartisan support? If that thesis comes true, could it be the Drano for the clogged D.C. system to unleash positive economic stimulus such as tax reform and infrastructure spending? The next few weeks and months will be telling.
View as PDF: The Fed Has Finally Been Trumped Q1 2017 Commentary
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 “Breakfast with Dave,” David A. Rosenberg, Gluskin Sheff, April 5, 2017
 “Quarterly Commentary by Ed Easterling of Crestmont Research”, Advisor Perspectives, April 6, 2017
 “Quarterly Commentary by Ed Easterling of Crestmont Research”, Advisor Perspectives, April 6, 2017
 Data Sourced From Yahoo Finance