The Post-Election Rally
May Be Losing Steam
December 5, 2016
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The equity rally faded as investors began focusing on rising bond yields and the climbing U.S. dollar.
The political backdrop still appears to promote economic growth, but investors are focusing more on specific policies.
Equity leadership has shifted noticeably as markets become more dynamic.
U.S. equities finished mostly lower last week, with the S&P 500 Index down 0.9%.1 Rising interest rates and the climbing U.S. dollar weighed on sentiment, and investors started turning from broad hopes of fiscal stimulus and tax reform to wondering about specifics. And oil prices rallied strongly due to OPEC’s agreement to enact production cuts.
Weekly Top Themes
- The November payrolls report confirmed that the job market is healing. The numbers were broadly in line with expectations. The unemployment rate fell more than expected to 4.6%, mainly due to a drop in the participation rate.2 Average hourly earnings fell for the first time since last December by 0.1% following a strong 0.4% gain in October.2
- The manufacturing sector is gaining momentum, as previous headwinds such as lower oil prices have faded. The Institute for Supply Management Manufacturing Survey came in ahead of expectations, while the Output Index reached its highest level in 20 months.3
- Consumer and business confidence have advanced since the election. This has boosted short-term U.S. economic activity. However, the potential downside includes an increase in mortgage rates and upward pressure on the dollar. Additionally, the political backdrop could cause a jolt to confidence levels if attention turns back to anti-globalization efforts.
- Treasury yields should experience ongoing upward pressure, but the pace is likely to slow. We expect yields will rise unevenly over the next few years as the economy continues to accelerate and as inflation moves higher, but market action should be more orderly than recent activity.
- Corporate earnings-per-share growth is accelerating. In November, 6 of the 11 S&P 500 sectors showed upward EPS revisions.4 The overall percentage of upward revisions was 60%, the highest level in several years.4
Market Rotation Is the Real Equity Story
U.S. equity markets appear dominated by two opposing trends. On the positive side, anticipation over possible tax reforms, fiscal stimulus and infrastructure spending, as well as improving investor confidence, are pushing prices higher. Conversely, higher bond yields and the rising dollar are causing concern since these developments could potentially slow economic growth before the positive factors kick in next year.
For most of November, the positive forces won, but concerns are rising that stock prices have run too far, too fast. Additionally, the post-election market environment is shifting as investors are focusing on specific policy questions. There remains a broad sense that President-elect Trump and the GOP Congress will focus on progrowth initiatives. Investors appear reassured by Trump’s mostly traditional political appointees, but the initial euphoria has faded. Investors are looking for specifics about tax reform policies, whether corporate and individual tax reform efforts will be combined and how spending priorities will be sequenced. At the same time, concerns appear to be growing that Donald Trump may be returning to the more combative anti-immigration and
anti-globalization rhetoric that dominated his campaign.
To us, the big story within equities is not the intense rally, but the significant rotation in market leadership. Financials (and banks in particular) have soared, while capital goods-related companies also experienced gains.1 Health care stocks rallied immediately after the election, but that rally stalled as investors await specific policy proposals.1 On the other hand, income-oriented and bond proxy sectors have lagged significantly.1 We also see intra-sector dispersions. In technology, undervalued, domestically-oriented segments have done quite well, while traditional growth and more globally-focused companies have lagged.1
In general, we think most of these trends will persist into early 2017, but market leadership is becoming more dynamic. This suggests that investment selectivity is growing in importance, an implicit argument for active management.
1 Source: Morningstar Direct, as of 12/2/16
2 Source: Bureau of Labor Statistics
3 Source: Institute of Supply Management and Markit
4 Source: Citi Research
Last Week's Commentary
Equities Continue to
Rally as Optimism Grows
November 28, 2016
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The post-election euphoria continued last week as investors bid equity prices to new highs.
Investors face a number of risks, including rising bond yields and a potential December rate hike, but we think equities should continue outperforming in 2017.
Equities continued to rally last week as all major U.S. indices hit new highs.1 Investor optimism rose as expectations for deregulation, corporate tax reform and fiscal stimulus under
President-elect Trump accelerated. These same factors put upward pressure on bond yields and the U.S. dollar. For the week, the S&P 500 Index gained 1.5%, as the consumer discretionary, energy and financials sectors pushed higher, while heath care, consumer staples and utilities lagged.1
Weekly Top Themes
- Consumer confidence is growing. The University of Michigan Consumer Sentiment Index jumped from 87 in October to nearly 94 this month.2 The post-election bounce shows consumers expect improvement in their financial situations in a Donald Trump administration.
- Improving economic data should lead the Federal Reserve to raise interest rates next month. U.S. durable goods orders surged 2.8% in October,3 putting further upward pressure on yields and the dollar. At this point, we would be surprised if the Fed did not raise rates in December and we expect central bankers to hint at a few more increases in 2017.
- Inflation expectations are increasing. We think commodity prices have likely bottomed. and we expect higher levels of federal spending next year. We don’t think inflation will rise sharply, but it appears to be accelerating, another reason to expect an upward move in bond yields.
- Increased fiscal stimulus could accelerate in-progress market leadership trends. In particular, we expect economically-sensitive cyclicals to outperform, while
income-generating sectors, defensive areas and low volatility segments could struggle.
- The Italian referendum vote scheduled for December 4 could cause headline risks and spark financial market volatility. The prospects for constitutional reforms could reshape the Italian political landscape and have unexpected financial results.
Markets Face Risks, but Equities Appear Well Positioned
In retrospect, it appears the economic and equity market backdrop was already improving before the election. Trump’s victory and the Republican sweep provided a catalyst for investors to ratchet up their optimism. Since the election, investors have rushed out of government bonds toward risk assets. While we think the economic and earnings environment remains favorable for stocks, investors should be aware of several risks.
The first, and most evident, is that the bond yield surge and U.S. dollar rally cannot be sustained without causing economic damage. We think upward pressure on bond yields and the dollar may continue long-term, but post-elections euphoria may be overdone and a near-term consolidation could occur. In any case, the pace of yield increases from the past few weeks will probably not continue.
On a related front, the likelihood of an imminent rate hike could cause market volatility. Today’s environment is somewhat similar to a year ago when the Fed last increased rates. The dollar is rising and some areas of the global equity market (Europe and some emerging markets) are underperforming. Last year, the Fed rate hike contributed to a souring of economic sentiment and a risk-off phase in markets. However, today we see some key differences: Equity markets are stronger, oil prices are more stable, inflationary expectations are rising and the global economy is healthier. As such, we do not expect one or even a few rate increases over the coming year to severely damage investor sentiment.
In addition to these risks, commodity prices could weaken and geopolitical turmoil may increase both home and abroad. Nevertheless, we think the recent equity rally has been driven by solid fundamental underpinnings of improving economic growth and better corporate earnings. Over the next year, we expect investors to become increasingly confident about the durability of the economic expansion. There will no doubt be periods of greater volatility, contractions and sell-offs, but we continue to maintain a pro-growth investment stance.
1 Source: Morningstar Direct, as of 11/25/16
2 Source: University of Michigan
3 Source: Commerce Department