2016 began with a thud and ended with a bang. After one of the worst-ever starts to a year, U.S. stocks managed to rebound and ultimately finish the year with solid gains. Much of the rise came in the final few weeks of the year, following the surprising results of the U.S. presidential election. Indeed, there has been an abrupt change in market sentiment, and asset prices have largely taken their cues from a recalibration of economic expectations in the wake of the surprising Trump victory and Republican sweep of Congress.
While policy specifics under the incoming administration are still being fleshed out, markets aren’t waiting around for the details. There have been sharp moves in certain areas of the market since the election, and we believe these moves are sending signals that are influencing asset allocation in a world where the political landscape has shifted dramatically. Below are some of our initial thoughts on how the election may impact the investment landscape in 2017.
A Roadmap Developing?
From a pure investment standpoint, the recent election seems to be creating a roadmap for macro developments and portfolio positioning under a Trump administration. The basic narrative is one of stronger growth, higher inflation, and less regulation.
Economic growth is expected to pick up through fiscal stimulus. From a big picture perspective, the idea that a sizable fiscal package could be enacted at this point in the business cycle is a big deal and comes at a time when markets were beginning to wonder if the monetary authorities were running out of bullets. In terms of the fiscal initiatives expected, perhaps the biggest change will come through tax cuts and possibly tax reform that would benefit both consumers and businesses. Some type of infrastructure spending also looks like a good possibility over the coming year, which should also support growth.
Higher growth, tighter immigration policy, and possible protectionist policies should all be inflationary. For many years, the global backdrop has been highly disinflationary, but that dynamic may be changing, and the recent election may be the catalyst that unlocks this transition. If so, this could mark a significant shift in the bond market towards higher interest rates, after more than three decades of declining rates.
Heavy regulation has long been cited as a significant headwind by large and small businesses in the current cycle. The incoming administration seemingly favors less regulation, which should produce a more business friendly environment and has the potential to boost confidence in those who control business investment.
Translation to the Portfolio
Using these broad principles as a starting point, the next step is to assess what these developments might mean for portfolio positioning. From our perspective, these are some of the likely winners and losers assuming the backdrop just described comes to be.
Stocks jumped following the election, and in general they should continue to benefit from a more pro-business environment that helps corporate profits grow faster. However, there’s been a large discrepancy in performance between the various sectors of the market, and that’s likely to continue, too. Specifically, the Financial sector appears poised to outperform due to positive factors like a steeper yield curve and the prospect of less regulation. In addition, mid cap and small cap companies may outperform multinational large caps due to less foreign exposure in the event that tariffs or other trade impediments are enacted, and they may disproportionately benefit if corporate tax policy is reformed.
The U.S. dollar appears poised to continue rallying, with ramifications throughout the portfolio. Within equities, that would suggest favoring domestically oriented sectors and industries over globally exposed areas, and overweighting domestic equities at the expense of international equities (since a stronger dollar erodes the total returns of U.S. investors due to currency losses). Another option is to hedge the currency exposure in certain international markets.
Within fixed income, the winners are likely to be positions that are less sensitive to higher interest rates, including inflation-protected bonds, credit-sensitive sectors such as floating rate debt, and fixed income alternatives.
Traditional bonds stand to be one of the primary losers if interest rates begin to increase due to better growth and hotter inflation. In this scenario, we would likely reduce exposure to the most rate sensitive bonds like Treasuries and municipals. We wouldn’t be keen to abandon them completely since they can still play an important role in a diversified portfolio, especially during periodic outbreaks of volatility in the equity market. Nevertheless, there’s plenty of room to meaningfully reduce exposure relative to current positioning.
In addition, there are several sectors of the equity market that are very rate sensitive (such as Utilities and REITs) that would be likely candidates to underweight. If the dollar continues to appreciate, then international equities may suffer due to weaker currencies. And emerging markets could also come under renewed pressure from a stronger dollar after enjoying a rebound in 2016.
The Risk of a Hangover
While the roadmap of how to position over an intermediate timeframe appears to be coming into focus, the timing of fully transitioning the portfolio for a changing environment is more complicated. Quite simply, the market has been partying since November 9th, and we think it might be susceptible to a hangover as we enter the first quarter of 2017.
There are several reasons why the market might be due for a pause or a pullback soon. For starters, the moves since the election appear to be getting a little ahead of themselves. As mentioned earlier, investors are still lacking important details about future policies. It could very well be that the market is set up for some disappointment relative to current expectations when final agreements are reached. For example, the presumed size of a tax cut could be reduced in order to move it successfully through Congress.
There’s also a question of timing, with plenty of pundits anticipating that the benefits of any fiscal stimulus will be felt more fully in 2018 rather than in 2017.
In addition, the moves that have occurred in interest rates, the dollar, and inflation expectations may result in some degree of financial tightening that actually causes growth to cool off after accelerating in the second half of last year. There’s also the question of how the Federal Reserve will react to all of this. They have consistently pledged to proceed gradually in normalizing interest rates from very low levels, but if they begin to see signs that the economy is heating up, they may feel compelled to increase their pace of rate hikes, causing growth to choke off.
How to Position Now?
The investment team has been spending a considerable amount of time weighing the impact of the election for financial markets. There are several changes to the portfolios that we anticipate making based on longer-term roadmap we believe has emerged as a result of the election outcome. However, there are also some shorter-term risks to consider based on recent outsized moves in the markets. Therefore, the timing of the transition comes down to a matter of tactics.
After plenty of deliberation, we feel that the first quarter could present a more attractive opportunity to fully implement the changes that we’d like to make if some of the recent moves partially reverse themselves. We executed a few trades recently in order to begin the process and plan to remain patient and use any upcoming pullbacks to complete the process. While we don’t anticipate making a significant change in overall risk considering the age of the business cycle and elevated valuations, we think there’s plenty of room to make shifts within both our equity and fixed income holdings to take advantage of a changing environment.