Quarterly Commentary

1Q 2017

With tongue firmly in cheek, we propose that our President’s greatest achievement so far is to lend his name to the stock market’s post-election advance. Trump Bump or Trump Rally – US stocks gained more than 11% from the election through the beginning of March – remarkably without a single daily decline of 1% or more, further evidence that political uncertainty does not necessarily trigger market turmoil.

Quarter In Review
US equity markets rallied after the election on expectations that Trump’s agenda of tax reform, regulatory relief and fiscal stimulus would bring about stronger growth and boost corporate profits. The primary beneficiaries were small cap stocks (that are less exposed to global trade friction, and would gain the most from lower taxes), financials (that would benefit from a softer regulatory touch and higher interest rates), and construction and materials companies (with more infrastructure projects to pursue at better margins). The surge in share prices was enhanced no doubt by the fact that small caps, banks and infrastructure stocks were just beginning a return to favor after lagging the market for an extended period.

By late February, investors began to reconsider just how much of Trump’s reform and spending agenda would become reality, and the share prices of the initial beneficiaries lost some steam. Attention shifted to improving economic data – in the US and elsewhere – and the realization that reflation, rather than deflation, might be the market’s new story line.

US wages are finally growing in real terms, and there are signs that the US economy may be closer to operating at full capacity. Negative interest rate policies in Europe and Japan have run their course – deflation concerns are receding. Consumers and businesses in the US and other developed markets (DM), having been through an extended period of balance sheet repair, began increasing their spending and investing during the third quarter of 2016. Many emerging market (EM) economies have been battling a different set of problems (high inflation, weak currencies), but after four years of belt tightening, they too appear to be in recovery mode.

Thus, what had been a domestic US story has broadened to an appreciation that the rest of the world is also on a positive growth trajectory. This creates a positive feedback loop between DMs and EMs, with global trade accelerating for the first time since 2010. The buzz term for this new market theme is synchronous global growth, or SGG for short. With all the talk of rates and growth remaining “lower for longer,” we seemed to have forgotten that such an economic expansion could happen.

It’s easy to see how the transition from Trump to SGG impacted markets. The Russell 2000 index of small-company shares jumped nearly 14% between the November election and year-end, compared with a 4.6% climb for the S&P 500. But, year-to-date, the Russell 2000 has edged just 2.1% higher compared with a 6.1% gain for the S&P 500. The technology sector, perceived to be a potential loser from changes to trade and immigration policies, had an anemic finish to 2016 but has led all other sectors in the first quarter of 2017, advancing over 10%. In a similar vein, growth stocks have outpaced value stocks in recent weeks. European and EM stock markets have rebounded in similar fashion.

Next Up
What are the risks to the current advance? What are we watching?

Risks to the global growth story probably start right here, considering that the US is in the most advanced stage of the business cycle, and that the US tends to have an outsized influence on the global economic cycle. While there is a relationship between declining unemployment and wage growth, we don’t believe that the economy is at risk of overheating. Yet the Federal Reserve could conceivably hike interest rates six more times by the end of 2018 (versus the three times currently priced in by the markets). Short-term rates would rise from 1% to 2.5%. With the 10-year bond yielding 2.37% at quarter-end, a flattening yield curve is not out of the question. Flattening – a convergence of short and long-term interest rates – occurs in anticipation of slower economic growth, and is a red flag for stock returns. To be clear, this is not our base case – it’s something worth monitoring.

Business cycles typically end with exuberance, forcing policy-makers to tighten monetary and/or fiscal policy aggressively. As both non-US DM and EM economies have only recently begun to return to normal, it is unlikely that threats to stability will resurface from those sources anytime soon.

Other risks may be revealed in the weeks to come. Every nuance associated with corporate earnings releases is scrutinized by analysts eager to find hidden meaning. Expectations (and stock prices) are much higher than they were a year ago. Cautious commentary from executives could lead to concerns that elevated share prices are not warranted.

The wrangling between the President and Congress has not dampened the optimism of business leaders or investors, and this may remain the case. However, we suspect it will be hard for markets to look past a failed effort to achieve corporate tax reform. There is also unfinished business related to the federal budget. Since the current spending year began last October, government agencies have been forced to operate within the previous year’s budget. An April 28 deadline looms.

Investors often seem to view markets through the lens of one big issue. The Reflation Trade that arrived on the heels of the Trump Rally may remain the dominant theme for months to come, or it could flame out as the next issue arises.

Current Strategy
We are managing portfolios in the context of a market that has exceeded expectations in the pace of its ascent. As we wrote three short months ago, “we can’t say with any certainty how 2017 will unfold and can’t predict when or how the current investing climate will shift. However, we can dedicate our efforts to assembling all-weather portfolios of securities that our research team has identified to be trading below their intrinsic value – portfolios created with the aim of meeting your needs and objectives.” That has not changed.

Buying what’s cheap requires going against the grain and seeing value where the rest of the world doesn’t. But the value approach comes with a drawback – it often needs time to work. If you think about it, this makes sense: value investing relies on the idea that prices for certain assets have deviated materially from their true worth. Why would that correct quickly? Value requires patience, which is not always available.

Creating portfolios that meet your objectives requires matching the investments with the time available until funds may be needed. For short-term horizons, it is necessary to complement value with other strategies to provide liquidity. Balancing portfolios of stocks with bonds and cash is the classic approach.