An improving economic setting coupled with rising interest rates drove significant gains in bank stocks, a subsector emphasized in the portfolio. M&A activity for select stocks also added to relative performance. Internet-based growth stocks dragged on performance; somewhat the reciprocal of the financial sector’s gains.
The S&P 500 has rallied close to 9% since its pre-election low despite an outcome that defied most pundits. What happened? First, investors dislike uncertainty so resolution helps. Secondly, economic activity strengthened. For example, the domestic ISM Manufacturing Index improved from below 50 (contraction) to 54.7 (expansion). Oil rallied from $43 per barrel to its current $53 after OPEC reached a production cut agreement in the eleventh hour. Last, the new President with the likely support of majorities in both houses of Congress offers the promise of lower tax rates, stimulative deficit spending and pro-business policy. All else equal, lowering the US corporate tax rate from its current 35% to 20% (Speaker Ryan’s proposal; Trump is at 15%) would lift after tax profits by over 20% on a theoretical basis. All else will not be equal but that is “HUGE” potential for corporate earnings.
These changes in fiscal policy are still on the come. Most political observers anticipate that a financial budget deal will not be reached until July and may not be retroactive. Deficit hawks are not yet an extinct species in the Beltway. Although both proposals lower corporate and individual tax rates, Trump and Ryan’s plans differ greatly in detail, with the Speaker introducing complications like a Destination-Based Cash Flow Tax (don’t ask). It is likely that volatility will be created as the political process kicks into gear so keep your Twitter feed open. View it as the storm after the storm. That said, lower taxes are a priority for all the controlling players so we anticipate a deal will be reached.
We should also be cognizant of the risks arising from an unorthodox and therefore unpredictable Presidency. With 60% of worldwide GDP created by international trade, the possibility of protectionism triggering retaliation is a significant threat. Only time will tell whether we get the bully pulpit or sharp-toothed regulations. Continued dollar strength is also a risk. Besides hampering US exports, emerging market debt is often denominated in our currency so this could become an issue.
Beyond parsing through a new administration, we believe that 2016 marked a significant inflection in the world-wide interest rate environment. That is a big statement so we will elaborate. Going back to 2010, the yield on the 10 Year U.S. Treasury bond was close to 4%. Fast forwarding six years, it dropped to 1.35% this past summer. The aftermath of the financial crisis and aggressive responses by central banks (quantitative easing, negative interest rate policy) drove a series of lower highs and lower lows. The resulting liquidity created profound implications for financial assets. Within the stock market the quest for yield became a dominant force (a relative headwind for a manager focused on earnings acceleration).
Our view is that this trend has been exhausted. Although the pace was frustratingly slow, the domestic economy has recovered and then some. Nominal consumer spending is now over twenty percent higher than its previous peak and the unemployment rate approximates 2006 levels. Remember that the 10 Year Treasury yield was about 5% then and currently runs at less than half that level. We are now seeing a pick-up in inflation from both wages and energy. Central bank policy also seems to be running its course. The Federal Reserve Board ended quantitative easing and is now signaling a series of increases in Fed Fund Rates. The Bank of Japan shifted to targeting the yield curve rather than rates. Finally, although they won’t call it tapering, the European Central Bank has slowed its bond buying. This is not to suggest we expect interest rates to shoot up in a straight line from here. Rather, all this points to an end in the trend of declining rates. Call it normalization, and we like that.
Our commitment to equities approaches maximum level. We retain overweightings in interest rate sensitive financials on the basis of improving net interest margins and healthy loan growth. Energy stocks are also overweighted. Even with 50% compliance on OPEC cuts, oil inventories can be worked down in the first half of 2017. Our emphasis is on low cost properties with rising production. Within Industrials, we own two railroads in the early stages of operational turnarounds. Cable operators represent significant holdings. Defensive sectors remain underweighted.
We anticipate some bumps in the road but our outlook for 2017 is constructive. Multiples can hold despite higher rates and corporate earnings are pegged to rise mid-single digits. Throw in a modest dividend yield for equities and we will take it.