Quarterly Commentary

3Q 2016

The world seems to be at odds with itself. US stocks are near all-time highs, yet economic growth is soft and US corporate profits have stagnated. The Fed is poised to raise interest rates while central banks elsewhere take measures to support their economies. Investors see little upside in bonds, but their pursuit of quality dividend-paying stocks has led to stretched valuations for many popular stocks and funds. Then there are the elections – where for many, the preferred choice seems to be “none of the above.”

Equity markets floated above the dissonance through much of the third quarter. With the Brexit panic resolved in record time (US stocks sold off 6% over two days, then recovered in three), July and August passed without a single daily move of 1% in either direction. September saw minor turbulence as investors trimmed stock and bond holdings amid fears that central banks would pull back from easy-money policies sooner than expected. The S&P 500 posted a respectable 3.9% return in the third quarter. Key equity markets abroad fared better. Bonds returned next to nothing.

Elections – Bark or Bite?
Markets like the status quo. It’s sudden and game-changing events that shake them up. As August came to close a year ago, the S&P 500 tumbled 11% in five days in response to China’s move to devalue its currency. Go back another four years to August 2011, when Standard & Poor’s took the unprecedented step of downgrading US government debt from AAA to AA over concerns about deficit spending. The average daily move that month was over 2.5%.

A Clinton win in the upcoming presidential election is broadly viewed as the closest we’ll get to “more of the same.” A Trump victory comes with the potential for new policies that diverge significantly from today’s. The relative calm in the markets suggests most investors are comfortable with the polls that show a growing Clinton lead.

Might the pollsters and the markets be wrong? Those looking for parallels between this election and the Brexit vote note that populist discontent has been consistently underestimated by investors. However, several factors now point to diminishing odds for a market-rattling election upset. Fewer voters remain undecided, shrinking the ranks of possible Trump (or Clinton) converts. More mail-in votes translates to fewer last-minute decisions. Finally, the Trump campaign is relying on local Republican election workers to get out the vote, whereas the Clinton organization has over 450 offices up and running. It appears the advantage is Clinton’s.

Will markets react to the results? Research dating back over a century does not identify a strong association between presidential election outcomes and market returns. Certainly a Trump victory could prove to be an exception. Yet there have been momentous elections in years gone by, and even those with an upset winner had a limited impact on the markets. Perhaps this is due to our system of government with its checks and balances. More likely it is explained by the forward-looking nature of investors who assess the President-elect and conclude, “This too shall pass.”

Elections in other parts of the world also merit attention. Countries accounting for about 40% of the EU economy will be holding elections in 2017, including Germany where Angela Merkel is expected to run for a fourth term. European voters will be expressing their views on multiple challenges, including fallout from the UK’s projected 2019 exit from the EU, and the largest influx of refugees since World War II. These elections may prove to be more consequential than our own.

Lower for Longer, and Looking for Respect.
Some observers point to the Fed’s rate hike in December 2015 as a major reason for the stock market swoon in the early days of this year. A quarter-point change isn’t a big deal – it’s the Fed’s longer-term intentions that really matter. The surprise back then was the Fed’s announced intention to make four additional moves over the course of 2016. The markets only recovered when it became clear that this scenario was off the table.

The Fed seems anxious to reassert its independence and relevance (we recently came across a Gallup poll suggesting that Americans have less respect for the Fed than any other agency – even the IRS!). At the recent September meeting, the Fed signaled a desire to resume its tightening. Circumstances may change, but we think a December hike is probable. The September decision to hold was a close call, and we can envision consensus-seeking Fed members trading a hold vote in September for other members’ hike votes in December. The Fed now forecasts a slower course for raising rates (lower for longer…) – yet its projections still outpace current market expectations.

How do we proceed?
The events that stoke market volatility – debt ceilings, currency collapses, Brexit, even elections – ultimately find resolution and fade in importance. In the long run, economies and markets share a resilience that may be hard to appreciate in times of elevated uncertainty, but that reflects a shared understanding that life goes on. Beyond the headlines, humankind is making progress – finding medical breakthroughs, building safer cars and developing clean, renewable energy.

With so many fixated on the US elections, we are looking elsewhere for risks to avoid and opportunities to consider. The corporate earnings season is underway – we expect the recent run of lackluster results to continue. Against this backdrop, the strength of the stock market can be ascribed to multiple expansion. At some point, raised expectations must be met with higher earnings, or expectations and multiples will revert back to appropriate levels, implying lower share prices. We sense that complacency may have crept into a few market sectors, among them REITs and utilities. However, we do not view complacency or valuations as significant risks as we close out 2016.

Experience has taught us that previously-popular, crowded trades are more vulnerable in market corrections. Our response is to continue to seek attractively valued, out-of-favor investments with identifiable catalysts that should lead to reasonable returns. We are selectively utilizing preferred and convertible securities in place of stocks in our efforts to meet portfolio objectives. Patience will also be rewarded – now is a fine time to be holding some cash to take advantage of tomorrow’s opportunities.