Wayne Gretzky, a National Hockey League Hall of Fame inductee, is probably the greatest hockey player of all time. He had a storied career even though he lacked overwhelming size or strength; in fact he was a good 30 pounds lighter than the average player of his time. On the ice, he showed great stamina and a fast and accurate shot, but the guy also had remarkable instincts. He was unrivaled in his ability to handle the puck and has a great line about his anticipation on the ice: “I skate to where the puck is going to be, not to where it has been.” Investors have played the markets just like Gretzky, rallying higher in anticipation of pro-business, pro-growth policies touted by the Trump Administration and a Republican congress.
Committed and Decisive
The first few weeks of the Trump administration have been busy, very much like all newly-elected presidents embarking on a first term in the Oval Office. There’s plenty to do: the hiring of staff, Congressional hearings for cabinet-level nominees, and the debriefings of current operations, but markets aren’t really responding to any of the “new Administration” minutiae. Market participants, like Wayne Gretzky, are getting positioned for where they believe policy is going to be, focusing mainly on the likelihood of more favorable tax policy and of less regulation. Let’s look at a few of the executive orders signed by President Trump so far.
- An Obama-era regulation on coal has been put to bed.
- An order to reduce regulatory burdens on small businesses was signed into law.
- An order was signed to build a wall to protect our southern border.
- An order was signed to advance construction of the Keystone XL and Dakota Access pipelines.
- An order was signed to roll back some of the banking and financial regulations in The Dodd-Frank Act.
- An order was signed regarding our nation’s healthcare system, essentially beginning the process of repealing and replacing the Affordable Care Act, or “Obamacare”.
- An order was signed to withdraw the United States from the Trans-Pacific Partnership (TPP).
President Trump has made it clear that his administration will do its best to make good on key campaign policies, and that was clarified on the final day of February when President Trump made his first address to a joint-session of Congress. In the address, Trump discussed key policy issues including protecting our borders, immigration reform, renegotiating international trade deals, easing business regulation, and reforming healthcare, education, and the tax code. He didn’t discuss many details, but the emphasis on protecting the American people and our economy was the real focus. Trump reiterated plans to stimulate job creation throughout his speech, and he stressed that our problems can be solved if the parties of government commit to working on them together.
There was a lot to digest, but investors have largely made their opinion clear since the election: “We think business will do well.” Tax policy alone could do a lot to boost earnings. Some early research on the impact of proposed tax cuts suggest that a cut in the corporate tax rate from the present rate of 35% down to 25% could add as much as 9% to bottom line earnings. Deregulation will take many different forms, but various sectors are expected to benefit greatly as is evidenced in the recent rally. Financial, Healthcare, and Energy sector stocks have performed especially well although the Energy trade has backed up a bit since the beginning of the year.
Trump’s presidency will also greatly influence the global economic landscape. Trump’s campaign was filled with negative rhetoric on trade deals like the North American Free Trade Agreement (NAFTA) and the TPP. There are many facets to these shifts in policy, and they are largely interrelated. Obamacare contains rules regarding taxes, and trade deals will eventually work out measures regarding tariffs or a border adjustment tax. There is much to be seen regarding international trade deals, and currency manipulation has also been criticized (China, Trump has his eyes on you).
It’s not just the prospects of a Trump agenda that’s lifting stocks, it’s also earnings. Most S&P 500 companies have reported Q4 2016 earnings at this point, and the blended earnings growth rate is 4.9%. It’s been awhile since we’ve seen back-to-back quarters showing year-over-year earnings growth, but that’s where we are.
The S&P finished up 4.0% for the month of February and is up 5.9% for the year so far. Month-to-date and year-to-date small cap and mid cap stock returns are trailing the S&P by about a couple percentage points, as are international developed stocks, but one of the real winners so far is emerging markets which are up 3.8% for the month and 9.4% for the year.
Bonds and Interest Rates
High quality, plain vanilla bonds (as measured by the Barclay’s Capital Aggregate Bond Index) are up about 1% for the year. Last month we highlighted how bond returns got pinched in the final quarter of 2016. Interest rate expectations have changed quite a bit since the election, and bond market investors are looking for higher yields. Inflation came in at 2.3% in January, and during her most recent congressional hearing, Fed Chair Janet Yellen’s tone was noticeably more hawkish. After Yellen’s testimony to Congress Fed Funds Futures – which show the market’s view on the likelihood of interest rate hikes– saw the March rate hike probability move from 20% up to 33%. After President Trump’s address to Congress, that probability jumped again from 33% to 66%. Remember, we only saw one interest rate hike of 0.25% in all of 2015, and only one more of the same size in 2016. This could be the year where we see multiple rate hikes (the consensus view is 2-3), putting the Fed Funds rate above 1% for the first time since the back half of 2008.
February started off with positive jobs data. January saw 227,000 jobs added, and inflation has officially reached the Fed’s stated target. Low unemployment and healthy inflation readings are the Fed’s primary policy goals, and Yellen’s recent testimony to Congress suggests that the Fed thinks the economy is doing just fine. Also, the University of Michigan Consumer Sentiment Index raced up to a 13-year high in January, posting a final reading of 98.5.
When a hockey team gets behind and time is running out, the coach will often pull the goalie out of the game and substitute in another offensive player in order to create more scoring opportunities. Usually a lone defensive player is left to protect his team’s goal as best he can, but the strategy is all about creating the best situation possible to score. There’s risk in the strategy, but when your team is after a playoff spot or, better yet, a championship, you’ll resort to any means necessary. That’s not too unlike President Trump’s policies: Pull the negative forces of high tax rates and burdensome regulation from the equation and shift the strategy to one of offense, and good things may come of it.
Right now, we’re transitioning to this “pull the goalie” strategy, but we’re watching it all play out in super slow motion because the wheels of government turn slowly. It’s like the goalie is ever so slowly skating to the sideline (executive orders setting this in motion), and the replacing defensive player (the favorable taxes, new trade deals, and deregulation) has yet to hit the ice. It’s a real nail-biter right now.
In foreign markets, slow growth has also been a big theme. The European economy shows signs of growth as the Eurozone economy kept pace with the U.S. for the first time since 2008. Meanwhile, two of the world’s largest emerging market players – China and India – are experiencing a larger disparity of outcomes. China recently reported a slowdown in trade, with exports falling nearly 7.7% in 2016. The drop was the second annual decline in exports in a row, and the worst since 2009. In contrast, India has become more of a bright spot. India’s Finance Ministry forecasts that growth could dip to around 6.5% in the current fiscal year, before picking up to as much as 7.5% in the next fiscal year.