The first quarter picked up where the fourth quarter left off, with equity markets celebrating the surprise of a new U.S. administration that global investors perceived to be more business friendly than the previous one. During the quarter, stocks rallied around the world and along with a pullback in the U.S. dollar and signs that global growth was slowly reviving, many international stocks enjoyed gains in excess of the U.S. While the stock market roared, the bond and commodity markets were less enthused, as bonds bounced and commodities gave back some of the gains that accrued towards the end of the year. By the end of the quarter the equity markets were mostly calm, but with tensions that were beginning to build and signal that some of the election-driven luster was beginning to wear off.
Has the Hangover Arrived?
Last quarter we surmised that the results of the U.S. election provided a roadmap to help guide investments over the next few years, mostly based on potential future policy changes.The roadmap was based on three major forces that we believe will drive markets, sectors, and asset classes over a multi-year period: the likelihood for some degree of fiscal stimulus, deregulation, and protectionism. This thesis was constructed around the idea that these forces should act as a positive catalyst, but also included the caution that recent market euphoria might bring about a market hangover in 2017, as lofty expectations were primed to produce short-term disappointment as it became clearer that making major policy changes in the current political climate would be more challenging than advertised.
Admittedly, recent market strength held in a bit longer than anticipated during much of the first quarter, but recent activity suggests that a market hangover may now be unfolding. While the major U.S. indices have held firm, a variety of other markets have not been in sync with equities. Bond prices have drifted higher, defensive stocks have been outperforming their cyclical counterparts, and safe havens like gold and the Japanese yen have shown strength over the last few months. None of these market movements ensure that stocks will decline more meaningfully, but enough evidence is accumulating to suggest that an overdue correction may be approaching.
Game Plan for a Market Hangover
Market corrections never feel good as they are occurring, but they shouldn’t be viewed as a calamitous event, either. The truth is that after more than 200 days without even a 5% correction in U.S. stocks, the major indices might be ripe for a healthy cleansing of some of the momentum buyers who jumped on board over the last few quarters. It’s impossible to know how far a correction might carry once it starts, but considering that most of the broader evidence we follow is not signaling that a bear market is on the horizon, our current intent is to use any corrective activity to further align portfolio positioning with the areas of the market that should benefit from the catalysts previously mentioned.
Candidates to Build Into
The forces of fiscal stimulus, deregulation, and protectionism are leading the way in pointing to those areas that appear attractive to build into. Some of those areas are:
U.S. Financials, Regional Banks: The banking sector has enjoyed a marvelous run that started last summer, and the combination of tax cuts, deregulation, and protectionism should provide good catalysts to unlock the value that has built in a sector that may be finally awaking from a slumber it’s been in since the Great Recession. The entire sector clearly became overbought in the wake of initial election euphoria and a consolidation is now in progress, which should provide opportunities to add to positions there. Within Financials, smaller regional banks may benefit disproportionately from deregulation and tax cuts.
Homebuilders: Homebuilders represent another area that seems poised to outperform when the risk aversion phase runs its course. Deregulation could bode well for these companies, and fundamentals for the sector appear solid while relative value is attractive versus the overall Consumer Discretionary sector.
Smaller Capitalization Stocks: Smaller companies may disproportionately benefit from lower corporate tax rates in the years to come. These stocks have been reversing sharp election gains recently and will likely represent a good buying opportunity coming out of the correction. There are several ways to own smaller companies, both through sector and industry exposure as well as broader small or mid-cap indexes. It’s important to tread carefully with small caps, because they are typically more volatile and might fall quite a bit further than their larger cap counterparts in a decline.
Candidates to Reduce
Treasury Bonds: Government bonds sold off heavily following the election due to fears that faster growth and inflation would cause interest rates to rise. Like other post-election moves, bonds fell too far too fast, and they have recently been rallying back since March. We have already begun reducing some of our treasury holdings as bond prices have appreciated, and this will likely continue on further price strength.
Defensive/Income-Oriented stocks: Certain equity sectors are more defensive in nature and tend to demonstrate relative outperformance to the overall market when it’s falling. One example is Consumer Staples, which has a higher yield than the overall market and is known to benefit from the safety trade when investors are running for cover. Real estate is another high yield market that tends to do well as bonds rally, and poorly when bonds sell off. We are currently overweight both sectors and if they outperform on general market weakness (as they typically do), it may provide a great opportunity to sell into relative performance strength and reposition the proceeds into higher growth sectors that will be cheaper after a sell-off.
What Could Change Our View?
We realize that corrections are always scary events, and it’s a fairly safe bet that if the market correction intensifies there will be headline stories that tend to fray nerves and encourage investors to question whether the current market cycle is ending. Our job is to look beyond the noise of the day, and to make sure nothing major is cracking in the evidence. While our current plan is to take advantage of a potential buying opportunity, we must also be on guard for what could make the pullback worse than expected.
Below are some of the things that would likely be material enough to change our view:
The Business Cycle: One potential game changer in the evidence is the prospect of an economic contraction. Recessions are typically associated with the most meaningful drawdowns in the market, so if the outlook suddenly deteriorated and it became apparent that one was looming, it would lead to a defensive repositioning in portfolios. There are some risks to the current cycle given that it is late in age, inflation has picked up, and the lagged effects of higher interest rates and a rebound in oil from last year may still be filtering through the system. In addition, first quarter GDP has consistently been weak over the last few years due to ongoing seasonal anomalies in that data. On the bright side, global leading indicators are still rising and imply that any weakness is more likely due to short-term fluctuations within the ongoing cycle, rather than a major change from expansion towards recession. We’re not anticipating a recession anytime soon, but if that were to change, it would have clear implications for our overall view and positioning.
Technical Conditions: The technical environment will always show some minor cracks as markets consolidate prior gains, but most of the current softening implies a correction within a healthy ongoing primary uptrend. Complacent sentiment is starting to reverse and some shorter-term trends are breaking down, but most markets are still well above their long-term averages. As long as the primary trend remains intact, the pullback should be viewed as an opportunity to exploit. However, if the primary trend began to break down, that would also be a negative development.
Monetary Cycle: Extremely accommodative monetary policy has been a major driver of asset market inflation and has provided plenty of support to the global economy that has mostly sputtered post the Great Recession. If global central banks decide to collectively remove the punch bowl, this could weigh heavily on our market outlook. In the U.S., the fact that the Federal Reserve has raised interest rates three times does present a risk. However, the Fed has been insistent that additional rate hikes will occur at a very gradual pace, and if they stick to this approach, the economy can likely withstand rates that are slowly rising from very low levels. However, if they decide to increase the pace of rate hikes, then the risk of a monetary mistake would substantially increase.
Outside of the U.S., most of the other major global central banks are still providing plenty of monetary stimulus, which is helping to keep global liquidity flush. One notable exception is China, where authorities have recently been tightening financial conditions. Overall, our assessment of global monetary policy is that it is still supportive, but a bit less so than previously. If other central banks decide to follow the Fed’s lead and begin to reign in the accommodation, this would also elevate the monetary risk level.
Overall, the first quarter was a positive one for investors. However, as the second quarter gets underway, markets seem to be entering an overdue post-election hangover phase. For now, the overall weight of the evidence suggests the backdrop remains constructive, and thus any pullback should provide an opportunity to adjust portfolios to take advantage of anticipated policy changes that have so far been delayed, but are still likely to fall into place eventually. Of course, there are also risks to the outlook, so we’ll continue to look for signs of more deterioration that could create an unexpected detour on our roadmap.
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