It is sometimes said that history can travel nowhere for decades and then advance decades in a matter of months. Some will view 2016 as a year when time leapt forward while others think it took a major step backward. But nobody could say it stood still.
A universal revolt against globalization by everyone except the elites triggered a series of unexpected events reflecting a common sentiment coursing across the world. Yet those unthinkable events were expected to wreak havoc on financial markets and turned out to be only temporary blips.
Ever since the financial crisis, the U.S. equity market has emerged as the world’s strongest and global investors’ favorite default option. From that vantage point, the market reaction to an election outcome some claimed could presage the end of Western civilization shouldn’t have surprised so many—the market staged a typical fourth-quarter surge favoring old-economy industrial, financial and energy companies. Between January 1 and December 14, 2016, the Russell 1000 Value index outperformed its growth counterpart by 9.7%, reversing a multi-year trend.
Many, including President-elect Donald Trump himself, had predicted a stock market crash, pointing to any number of usual suspects—from central banking policies to over-regulation to sick European banks—as the cause. However, the alacrity with which those same seers bought into the concept of a Trump bull market left the few who had predicted the election result amused.
DoubleLine CEO Jeffrey Gundlach told clients in a November webcast that the same people who were predicting that a Trump victory would cause a global depression had no problem reversing themselves and calling for a “global boom.” Color him skeptical.
“The word ‘never’ means it’s about to happen,” the bond fund manager remarked. Never was that more true than in 2016.
In Gundlach’s view, the problem is obvious. He showed clients a chart of real U.S. incomes from 1973 through 2015. The top 5%, mostly technocrats and professionals, enjoyed a rise of 51.4% while everyone else was down 4.6%. If he had used the top 1%, it would “blow the scale” to absurd proportions. “Citizens are fed up,” Gundlach noted.
Citizens may indeed be mad as hell, but equities are frolicking among the buttercups as a powerful secular bull market approaches its eight-year anniversary. Little noticed in the October weeks leading up to the election was the fact that it coincided with the end of a two-year profits recession.
It’s noteworthy that the recent profits recession, like the one in 1985, failed to cause an economic recession or derail the current bull market. The president-elect is inheriting an economy nearing full employment, one that Harvard University’s Kenneth Rogoff thinks can grow at 3.0% on its own.
Combine Trump’s staunchly pro-business agenda with fiscal stimulus and there’s no telling where the economy and stocks could go, the bulls reason. T. Rowe Price chief economist Alan Levenson and others see virtually zero chance of a recession in 2017.
Brexit and the U.S. election may have garnered all the headlines in 2016, but other factors could prove more significant for investors. Northern Trust chief investment strategist Jim McDonald says that the markets were focused too much on the president-elect while downplaying the implications of the Republican sweep of Congress and the White House. The latter development is more important in his view because it breaks the gridlock of the last six years.
A consensus is building around the notion that both the bull market and economic expansion are entering new phases. In short, the New Normal could be dead. “It looks like we’ve turned a new leaf,” says Margie Patel, managing director at Wells Capital. “If there are lower taxes and reduced regulations, this could offset a rise in interest rates.”
Counterintuitive though it may seem, Patel believes that if yields on money market funds rise to the 2.5% or 3.0% area in the next few years, the relief for long-suffering savers could induce them to invest more in equities. Near-zero interest rates have created a “fear of the dark,” in her view. “It makes people think something is wrong or something is going to blow up,” she says.
Euphoria about lower corporate taxes may need to be tempered. President-elect Trump’s advisors have consistently touted a 15% rate, prompting many investors to assume corporations could now keep 85% of their profits, up from 65%.
Northern Trust’s McDonald notes that the effective tax rate for the S&P 500 companies is 27%, so the windfall may lack the magnitude some investors believe. But individual companies have different tax rates and some will be big beneficiaries.
Larry Puglia, who runs T. Rowe Price’s Blue Chip Growth Fund and its Large-Cap Equity Core Growth Strategy, points to those companies that have relatively high marginal tax rates and derive most of their profits from domestic operations as the winners. This group includes Fiserv, Ross Stores, Charles Schwab, United Healthcare and Alaska Airlines.
Then there is the pattern of the presidential cycle and stock market returns. The first year of a new president’s first term isn’t usually particularly propitious for equities. Nonetheless, McDonald expects U.S. equities to return 8% in 2017. This calculation includes 9% earnings growth plus 2% in dividends coupled with valuation compression as equities get more competition from bonds offering higher yields.
Brian Nick, the chief investment strategist at TIAA, agrees that expectations need to be tempered. “For the rest of this cycle, equity returns will track corporate profit growth,” he says, arguing the price-to-earnings multiples rarely expand very much in the middle and late stages of the business cycle.
Skeptics Unconvinced
Not everyone believes in the Trump rally. On December 7, Gluskin Sheff’s chief investment strategist David Rosenberg noted that since the day after the election, the median stock has climbed a whopping 1%. Two sectors, energy and financials, benefit the most from deregulation ideas and represent just over 20% of the S&P 500. “The other 80% of the stock market is flat as a pancake,” Rosenberg wrote to clients.
Contrasting the post-election markets following the Trump and Ronald Reagan victories, equities performed far better after the Gipper won a huge victory of surprising magnitude, only to slide 25% in the next 21 months. A combination of “rising bond yields, Fed tightening and a stronger dollar took care of that honeymoon,” Rosenberg wrote.
Nearly a week after he sent that piece to clients, the Dow Jones Industrial Average stood within 100 points of 20,000, but Rosenberg wasn’t backing down. “It is incredible” what the market is pricing in because of one man, he declares. It took “the might Reagan” two full years to turn around the economy.
Trump, he argues, has the misfortune of entering the White House very late in the economic cycle. Analogies between the Trump and Reagan economies also struck others as misplaced. The current president-elect enters office in very different times and points in the business and market cycles.
Rosenberg isn’t alone. “Never once have I seen a presidential election check the course of the business cycle,” MFS chief investment strategist Jim Swanson says.
Reagan was inaugurated in the middle of a double-dip recession when equity price-to-earnings multiples were in single digits while interest rates were off the charts. Inflation was eroding consumer purchasing power.
But government debt and household debt were low and he had a demographic tailwind at his back. Trump faces a demographic time bomb, high levels of debt, older consumers who haven’t saved enough to retire and an aging economic expansion.
Timing aside, Trump is talking about the same type of multi-pronged fiscal stimulus of tax cuts and spending increases in defense and infrastructure that Reagan employed. Fiscal stimulus at this point in the business cycle is highly unusual, Nick says, but it would be more likely to extend the business cycle than shorten it.
Some of the infrastructure projects under consideration like airport extensions are long-fused, Swanson says. They require the use of eminent domain, and the necessary permits and approvals can get tied up in courts for years. “What we’re talking about is 20 basis points of GDP,” Swanson estimates.
Other reasons for his dour view include the fact that Trump’s proposed tax cuts, defense and infrastructure spending increases will only add to a “mountain of government debt” approaching 100% of GDP. That’s the tipping point at which experts like Rogoff and Carmen Reinhart believe economic growth starts to get hamstrung, Swanson notes. Stalled productivity gains and an exodus of baby boomers out of the work force and into entitlement programs won’t help, either.
Tax cuts for the affluent are unlikely to trigger much of a spending multiplier effect in Swanson’s view. As for cuts in corporate tax rates, the strong U.S. dollar may offset domestic profit gains for many S&P 500 multinationals. “Lots of companies have special deductions” and lobbyists will fight to preserve them,” Swanson maintains.
As consumer confidence climbed following the election, so did mortgage rates. “That can’t be positive for the psyche of the middle class,” Gundlach told clients. Rural voters who went overwhelmingly for Trump have high expectations that he thinks could make them vulnerable to disappointment.
Winners And Losers
Any change in American presidential administrations has its winners and losers, but the post-election rally favored old economy stocks in particular. The big losers, by most accounts, were the high-tech growth companies, while names from yesterday like U.S. Steel and Caterpillar staged powerful advances.
Growth has outperformed value for much of the bull market. “When growth is slow, money will pour into the few companies that are really growing,” TIAA’s Nick says. If “growth is going to be more widespread,” investors may not want to pay lofty premiums for it. “In terms of cyclical leadership, we’re willing to swim with the current,” Nick adds.
Technology. In his post-election webcast, DoubleLine’s Gundlach told clients to avoid the FANG (Facebook, Amazon, Netflix and Google) stocks in “a big way.” He found it ironic that the industry that “hates Trump the most” turned out to be the most responsible for his election. In his view, Trump could never have won without Twitter.
Technology’s future is closely linked to the S&P 500. Indeed, charts of the S&P almost mirror that of a large-cap, high-tech ETF, and that’s a major reason U.S. equity averages underperformed many others in the so-called lost decade between 2000 and 2010. Many of these companies face headwinds ranging from lofty valuations to the law of large numbers, which makes it difficult for a firm to increase revenue and attract more customers when it is already by far the biggest player in its market. Facebook, for instance, has warned that its growth rate will decelerate.
But many investors think values in Techland are reasonable. “Google trades at 15 times and Facebook trades at 17 times what we think they will earn in 2018,” Puglia of T. Rowe says. While many technology concerns have relatively low tax rates, they are likely to benefit from more robust economic growth.
Dividend-Paying Consumer Staples. During the income-parched environment of the post-crisis era, these companies became favorites of many bond investors who need income. The investment management industry responded by introducing a smorgasbord of low-volatility mutual funds and ETFs.
The upshot was that many companies like PepsiCo, Coca-Cola, Clorox and Kimberly-Clark saw their shares soar. Even though many of these mature businesses struggled to achieve single-digit unit volume growth rates, they started sporting price-to-earnings multiples in the mid-20s, frequently exceeding those of companies with more exciting businesses. “Investors may favor companies with great economic sensitivity and leverage to this higher growth,” Puglia says.
Indeed, consumer staple stocks were among the biggest losers in the wake of Trump’s victory, with some falling as much as 9% or 10%. When investors get excited about equities as they did after the election, many flock to high-beta names. “A little volatility will [cause] investors to return to high-quality, low-volatility stocks,” says Northern Trust’s McDonald. “It’s too early now.”
Financials. After a decade when it often seemed financial companies could do nothing right, a confluence of factors is conspiring in their favor. “It’s not just deregulation—they’ve underperformed for so long,” Nick says.
Banks typically perform well late in the business cycle and it’s certainly not early. “They were disfavored and hamstrung by [Dodd-Frank] and now the yield curve is in their favor,” says Swanson.
Parnassus Funds founder Jerry Dodson has invested in banking’s bad boy du jour, Wells Fargo, because he likes its high percentage of recurring revenue. Despite its problems with fake accounts, its shares rebounded quickly after the election.
Industrials. This sector is perceived as a primary beneficiary of a potential boom in infrastructure. But the reality is U.S. manufacturers are already doing quite well—they are just doing it with fewer workers.
In the days after the election, Trump’s chief strategist Steve Bannon spoke about building giant shipyards and ironworks complexes, an idea that struck many as anachronistic. “We won’t be investing in shipyards and ironworks,” says Jerry Dodson, adding these investments nearly brought down the Japanese and South Korean economies in the 1970s and 1980s.
A pioneer in ESG (environmental, social and governance) investing, Dodson is open to playing the sector selectively. Several of his funds own Praxair, a manufacturer of specialized industrial gases.
Patel of Wells Capital believes that in the early stages of the post-election rally, a lot of money managers moved from technology into industrials. She worries some industrial stocks have climbed too far, too fast, though she still likes defense stocks.
“All the money that wanted to be in cyclicals was in tech and a lot went into industrials,” Patel says. “Some industrials could be overvalued.” Indeed, Caterpillar has warned investors that 2017 could be its fourth year in a row of lower revenue for the first time in its history and the market ignored its warning as the stock, a Dow component, was a standout in 2016.
Pharmaceuticals. Drug pricing was a favorite target of Democratic nominee Hillary Clinton, and their stocks jumped in the weeks after the election. But then President-elect Trump fired his own salvo at them in early December and many drug and biotech concerns gave back some of their gains.
Pricing and politics are only two of the problems facing this defensive sector. Many biotech companies have enjoyed outsized returns over the last five years as the industry saw a wave of new chemical compounds receive FDA approvals.
But as they’ve come to market, more than a few have posted disappointing sales results. If economic growth accelerates in the next year, investors may seek out less defensive ways to play the cycle.
Potential Dark Clouds
This analysis assumes that the economy and equity market don’t suffer a serious setback. The president-elect stunned both parties and the entire political establishment, but he has no government experience and will learn on the job. Ditto for several of his top advisors.
As Swanson sees it, the odds of “disappointment risk” are high. “What if the new administration makes a major mistake?” he asks. “You don’t have a conservative president.”
Trump may be pro-business but his behavior is erratic and he appears addicted to tweeting out barbs—many singling out business leaders and individual companies—on a daily basis. Given his stance on trade, Swanson thinks the odds of an international dispute could become elevated.
In contrast to Rogoff, Swanson also thinks the economy may be weaker and may be later in the cycle than conventional wisdom holds. “It’s not a recession but you are fighting a declining cycle,” he says.
McDonald isn’t as worried that the new administration could become embroiled in a damaging trade war. But he does think it’s possible the Federal Reserve could tighten more than markets expect.
Concerns about growing budget deficits over the next five years are on point, McDonald thinks. They are currently running at $600 billion a year, and an economic slowdown could exacerbate them.
Gundlach has warned repeatedly about the 10-year anniversary of the Great Recession in 2018. That’s when the big bulge of baby boomers start turning 65 and going on Medicare. This will happen at exactly the same time that 10-year debt, issued when the government was running trillion-dollar deficits, will need to be refinanced.
But for now, the markets are euphoric and the economy, in the midst of the third longest expansion in history, is humming. If there is no recession before 2020, Donald Trump could be able to run for re-election on the longest recovery on record.