POLITICAL RISKS AND MULTIPLE CONTRACTION
In early December, S&P Global, Inc., the credit agency stated that “the strength of institutions and quality of policy making can no longer be taken for granted”. The research firm was sounding the alarm on the rise of populism in Europe and the U.S. “We believe it may no longer be possible to separate advanced economies from emerging economies by describing their political systems as displaying superior levels of stability and predictability of policy making and political institutions”. Events used to demonstrate their concern were the Brexit decision, the election of Donald Trump, the recent Italian referendum and upcoming French elections. Conventional “wisdom” has proved too often to be wrong. The pundits are indeed fallible. Expert knowledge in some cases was not considered a positive – but rather to be “expert” meant to be distrusted. So as we turn to a New Year, voters decided in some important recent elections to be done with the “conventional” – sweep it aside –and to usher in something different. This is a consequential change affecting markets around the world. Historically, the “developed” markets (think Europe and the U.S.) have traded at superior multiples of earnings and cash flow to the “developing” markets (think China and India) partly because of their more stable governance institutions. If investors agree increasingly that the governance “distinctions” between developed and developing economies are no longer as marked as they once were, and we think this is happening, then we believe there will be multiple compression between the two. In short, the developing markets will trade at higher multiples of earnings and cash flow than they have and the developed markets will trade at lower multiples than they have.
FOCUS ON THE U.S…….
Daily “tweets” from the President-elect set the stage each morning for the news cycle. There have been a “parade” of cabinet candidates visiting Trump Tower this holiday season, disrupting New York traffic – but titillating political “junkies” and the media. Retired military generals seem to have taken any position connected with security or defense. Business people look to be the winners at Commerce, Labor, Treasury and State. Housing and Urban Development will get an ex-doctor, Education will get a big campaign contributor, an Oklahoma Attorney General will lead the EPA, and Energy will get an ex-Governor who ran for President with a goal of abolishing the very department he will head. The philosophy seemingly guiding the upcoming Trump Presidency is one of less regulation, lower taxes, greater infrastructural spending and a “transactional” foreign policy which will probably stress the conventional intercourse of current international relations. Certainly some aspects (like less regulation and lower taxes) of the aforementioned philosophy is attractive to investors. Some other characteristics (like an uncertain “transactional” foreign policy) will not be so welcome, because uncertainty begets increased risk – and markets do not like risk. There will be “bumps in the night”. Change is coming and change is rarely smooth. So far investors have chosen to see “the glass as half full” and have pushed up equity prices.
Importantly, the balance sheets of US households are stronger today than they have ever been with the collective net worth having recently reached a new high in nominal, real and per capita terms.
If the road ahead does get bumpy, Americans seem well positioned to withstand the “ride” – it seems to us.
OVERSEAS……
The emerging markets have been and continue to be “cheap” to the U.S. by at least one standard deviation. China is often in the news amid concerns regarding its economy and debt, especially at State owned enterprises. So far the Chinese have befuddled the “Bears” on Wall Street and we believe they will continue to do so. A wild card will be Mr. Trump’s “transactional” foreign policy style, as the Chinese seem to be in his “crosshairs”. This will bear watching. India is the fast ship at the moment. Prime Minister Modi, while not perfect, seems to be executing quite well in the eyes of many investors. The Indian economy is outperforming every other large economy in the world, the markets are up and the future appears bright with a large and young population. OPEC has reversed course after suffering mightily with low oil prices. Production will be restricted beginning in 2017 in accord with an agreement reached among the members of the cartel and also with the concurrence of other oil producers (think Russia). Skepticism about the “deal” is rampant. But compliance might be better this time vs. other instances because it was OPEC’s ox that was being gored and certainly the monarchy in Saudi Arabia, the prime player in OPEC, wants to avoid another Arab Spring. Already energy prices have risen and will probably stay at a higher level ($55/bbl – $65/bbl) throughout 2017 which should help the oil industry. In Europe, despite the fact that economies are doing better (i.e. in Spain, France, Germany and the UK), politics has “stolen” and will steal some of the “thunder”. Brexit unnerved investors. The upcoming French election has people guessing. Corporate Europe is moving forward. On that basis, markets should improve and are still cheap to the U.S. It’s just the politics that keep getting in the way.
THE BOND MARKET……
Bonds have been in a multi-decade “bull market”. That has ended. Yields have started to rise and will continue to do so as economies pick up speed. As employment levels increase, higher wages will be required to entice workers to fill open positions. Inflation, we think, is on the rise and as such the Federal Reserve will act to increase short term interest rates to make money more expensive. This all is fine and the natural way of things as an economy improves. Bonds will not for some time prove to be competition for stocks. Interest rates are still very low and even as they rise, rates will need to get to around a 5% yield (historically this has been the case), on the 10 year Treasury for bonds to compete and “crowd out” equities in investors’ eyes. But bond prices will not be going up in 2017.
PREDICTIONS – SO HOW DID WE DO IN 2016????
- U.S. economic growth will continue at a pace of around 2.5% – 3% Yes – Growth picked up nicely in the 2nd half of 2016
- U.S. inflation will remain quiescent Yes – Expect inflation to rise in 2017
- The dollar will stabilize, perhaps strengthen a bit more Yes – Uncertainty elsewhere has strengthened the dollar
- During 2016, oil’s price will find a bottom not far away from now and will rally into 2017 Yes – This is headline news
- Interest rates will rise – but the rate of increase will be slow Yes – Expect more in 2017
- Political reform will grow in South America Yes – Rousseff in Brazil impeached, Maduro in Venezuela “on the ropes”
- It will be another “Banner Year” for mergers and acquisitions Yes – Headline news
- Consumer spending will improve Yes/No – “Big Ticket” items bought, smaller purchases “patchy”
- Émigrés will continue to be a “hot potato” politically around the world Yes – Immigration is a political “lightning rod” for populists
- Amongst the popular investment alternatives, equities should do the best Yes – Slow start to year, but strong finish
PREDICTIONS FOR 2017
- S&P 500 corporate earnings +10% – 15%
- Inflation to range from 2.5% – 3%
- Business investment up due to cuts in corporate tax rates and overseas profits repatriation
- Government spending up due to infrastructure investment
- Personal consumption up due to tax cuts and wage gains
- Real GDP growth +3%
- The Federal Reserve will raise the Fed Funds rate by 0.75%
- Bond prices will drop, yields rise (10 year Treasury yield 3.5% – 4.25%)
- The Treasury will issue bonds with 40+ year maturities to take advantage of still historically low interest rates
- Equity prices will rise on the back of higher earnings and lower bond prices
A FEW FINAL THOUGHTS
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