Equities Sag as Political
Optimism Returns to Earth
March 27, 2017
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Republicans’ setback in passing health care reform could signal trouble for tax cuts and infrastructure spending plans.
Optimism over pro-growth legislation may fade, but the U.S. economy remains solid.
We think stocks may be poised for a correction, but we still support a pro-growth investment stance.
Stocks experienced their largest one-week decline since the election, as the S&P 500 Index fell 1.4%.1 Most losses occurred on Tuesday when it became clear that the Republican health care plan was facing trouble,1 signaling that President Trump’s pro-growth economic agenda could falter. Small cap stocks, financials and industrials fared the worst last week, with utilities and REITs gaining ground.1 Treasury prices rallied for a second straight week, while the U.S. dollar fell for the third week.1
Weekly Top Themes
- The GOP’s health care setback could signal additional political problems. From a political perspective, we think the key issue is whether the president will encounter similar problems with his tax reform agenda, which is likely to be as complicated as health care reform, if not more so. We think some sort of tax bill will be passed. If political turmoil is ongoing, higher risk, cyclical areas of the equity market would likely remain under pressure.
- Additionally, possible infrastructure spending may be less comprehensive than expected. While the president has talked a lot about additional spending, he has yet to put forward any specific plans. At the same time, most Republicans appear disinclined to support more infrastructure initiatives without spending offsets. We think investors are too optimistic about prospects for additional spending measures and may wind up being disappointed.
- Internal market dynamics suggest we may be at the forefront of a broader correction. Global risk assets, including equities, have remained quite resilient in recent months, but we have seen underlying changes. Higher-risk areas such as small caps, cyclical sectors and some fixed income credit sectors have been flagging,1 which could be a precursor to a broader risk asset selloff.
- Additionally, we may see a leadership transition from U.S. to non-U.S. equity markets. U.S. stocks have outperformed their international counterparts for years,1 but that trend may be changing. As non-U.S. economic and earnings growth improves, the leadership baton may be passing to other markets.
We May See a Correction, but This Bull Market Isn’t Over
U.S. stock prices rose significantly over the past year and experienced a strong bounce after the election. We have been saying for some time that economic and political optimism may be overdone. It appears investors are finally starting to question the extent to which President Trump can deliver on his wide range of pro-growth economic promises. Last week’s stunning setback for health care reform shows he will have difficulty pushing his agenda forward. Any
politically-oriented economic boost over the next 6 to 12 months may be less robust than expected.
Nevertheless, we remain relatively upbeat about the state of the U.S. economy. Growth trends and sentiment began improving last summer. We believe fundamentals remain solid, including the labor market, manufacturing, housing, consumer spending and business investment. Even if sentiment drops a notch or two due to fading political optimism, we expect economic growth will remain on track.
However, we think equity markets may have gotten ahead of themselves, and risk assets appear poised for a correction. The good news is that investor sentiment appears to have improved over the last year. Investors are unlikely to overreact to negative news as they did periodically throughout 2016.
We don’t believe the recent peak in equity prices marks the high point for this bull market, but more volatility is likely as the post-election euphoria continues to fade. As such, we suggest that investors ride out any near-term equity turbulence. At the same time, we think government bonds look expensive and do not believe the recent downturn in yields is likely to continue. We are maintaining our moderate pro-growth investment view and continue to believe equities will outperform bonds over the next year.
1 Source: Morningstar Direct and Bloomberg, as of 3/24/17
Last Week's Commentary
Equity Outlook: Long-Term
Looks Clearer Than Near-Term
March 20, 2017
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Equities and bond yields moved higher as the Fed raised rates without indicating it would quicken the pace of increases.
Investors remain optimistic about the political backdrop, but we think a lack of policy clarity presents risks.
A number of risks could spark a near-term equity correction, but we retain a constructive longer-term outlook.
The Federal Reserve’s decision to raise interest rates by 25 basis points, while keeping its dovish tone, was the big story last week. U.S. equities finished slightly higher, with the S&P 500 Index rising 0.3%.1 Treasury prices also advanced after falling the week before.1 Among stock sectors, income-oriented bond proxies outperformed, while health care and financials sagged.1
Investors Need Clarity on the Trump Economic Agenda
Political observers have been focusing on the GOP’s health care plan and President Trump’s proposed budget. Both face an uncertain political future, but the president and Congress are clearly looking to significantly reorient the federal government.
Both initiatives could shape economic growth and financial markets. But tax reform will likely have the greatest impact. Any tax reform plan is certain to address corporate tax repatriation. At present, U.S. companies are estimated to hold over $2 trillion in foreign income overseas.2 Enacting a plan that returns this money to the U.S would allow the government to tax these profits and produce revenue that could help pay for other tax cuts or infrastructure spending.
In our view, the chances of passing such tax reform are high and the markets have already priced in this change. This is one reason stock prices and bond yields have both risen since the election. Investors are anticipating an increase in tax revenues from repatriation that could fuel economic growth. If any such plan is smaller in scope than investors anticipate, it could present downside market risks.
Weekly Top Themes
- The Fed signaled that it will continue to raise interest rates slowly. The central bank’s relatively dovish statements seemed to signal that it intends to continue a slow and moderate pace of rate hikes.
- U.S. economic growth appears to be accelerating modestly. In our view, manufacturing is improving, home demand is on the upswing and consumer spending is stable. At the same time, inflation appears to be creeping higher.
- We expect Chinese growth to slow. We do not anticipate a hard economic landing, but slowing Chinese growth represents a risk to the global economy.
- Equities may be growing more expensive in absolute terms, but still look relatively attractive. Given the strong run-up in prices over the last year, equity valuations may be less attractive. But we still think they appear better valued than Treasuries or other government bonds.
Several Risks Could Cause a Setback or Correction
Equities and other risk assets have continued to be resilient over the last several weeks, but higher-risk areas of the market (small cap stocks, cyclical sectors and some fixed income credit sectors) have been flagging to various degrees.1 We have been suggesting for some time that the broader equity market may be slightly overextended and could be due for a setback or correction.
A number of catalysts could trigger such an event. Economic data has almost continuously surprised to the upside, and a string of disappointments could trigger a change in sentiment. Additionally, investors could become more impatient or less optimistic about the prospects for pro-growth legislation from Washington. Investors also seem complacent about Fed rate hikes, especially the possibility that the Fed could become more aggressive should economic and inflation data continue to move higher. Slowing Chinese growth could present risks, as could a flare-up in one of many geopolitical hot spots. Should any of these events happen in isolation, it probably wouldn’t surprise investors, but multiple simultaneous occurrences could trigger a risk-off phase.
We think it makes sense to approach equity markets cautiously in the near term, but at the same time, the 6- to 12-month outlook appears moderately constructive. Improving economic growth, rising corporate earnings and the likelihood of rising interest rates make stocks look more attractive than bonds. Investors may need to weather some additional near-term volatility, but we continue to believe that overweight positions in equities makes sense for the long term.
1 Source: Morningstar Direct and Bloomberg, as of 3/17/17
2 Source: Congressional Joint Committee on Taxatation