“Some people see the glass half-full. Others see it half-empty. I see a glass that’s twice as big as it needs to be.”
In this edition of Market Monthly, we focus on some of the cross currents at play in global markets. A failed effort at health care reform may alter the substance of tax reform but is unlikely to halt it. When combined with the current path of sustained global economic growth, we continue to see the glass as half-full.
Recent Fed Meeting: The Fed liked what they saw in the economy and they acted by hiking rates for the third time in 15 months. Their actions and projected path were hawkish while their new language around inflation was perceived by the markets as dovish. The Fed played their hand quite well.
Failed Health Care Reform an Obstacle to Tax Reform: The failure on March 24, to repeal/replace the Affordable Care Act (ACA) represents a detour, not a roadblock to overall tax reform or tax cuts. The path to tax reform will not be a straight line but the likelihood of passage in 2017 may have improved. The upcoming Supreme Court confirmation vote for Judge Neil Gorsuch could be a political litmus test for the Trump agenda in the coming months.
Brexit and French Elections: The March 29 triggering of Brexit by Prime Minister Theresa May and the first round of elections in France on April 23 are potential market catalysts. We will dedicate a more detailed edition of Market Spotlight to this issue soon but will identify key points here.
Earnings and Stock Valuations are Under the Spotlight: As we head into first quarter earnings season, investors will digest earnings reports to see if post-election optimism transforms into bottom line results. Earnings growth is expected to continue its recent success but downward revisions may be required to normalize post-election enthusiasm. International stock returns are outpacing U.S. stocks YTD.
Recent Fed Meeting:
On March 15, the Federal Reserve hiked rates for the third time in the last 15 months shifting the Fed Funds target rate to .75 percent – 1 percent. The Fed’s message was somewhat mixed. Markets read the Fed’s new language on inflation as reassurance they would not fall behind the curve.
Actions were Hawkish:
- They anticipate three hikes in 2017 and three more in 2018.
- A 3 percent Fed Funds target is considered “normalized” with a 2019 target date.
- The Fed’s balance sheet could be addressed as early as the fourth quarter of 2017.
Language was Dovish:
- A “symmetric” inflation goal allows for inflation to hover around a 2 percent moving target.
- Fed Funds will likely remain below long term targets of 3 percent which remains accommodative.
A quick resolution of pro-growth tax reform could prompt a more hawkish Fed while delays could prompt a more dovish Fed. For now, the Fed liked what they saw in the economic data and they acted independent of what Washington may or may not do regarding tax reform. Well done!
In a perfect world, we could take a page out of an old Fed playbook, use it and get the same results. Unfortunately, historical comparisons are unavailable this time around given that the starting point in this interest rate cycle was zero percent. Instead, we are making history.
What is the Fed’s speed limit?
Historically, the path and speed of a rate hike cycle has a larger impact on asset prices than the hike itself. A slow cycle, like we are in now, is one where the Fed pauses between rate hikes. The stock market takes comfort in a slow rate hike cycle. There have been thirteen rate hike cycles since 1948 with no two exactly alike. After the third hike in a tightening cycle (like we had in March), asset prices have historically behaved as follows:
- Stock returns have averaged 2.6 percent one year later.
- The yield curve flattened for the first six months and then stabilized.
- Bond prices suffered weakness six months out but then recovered some of their losses.
Traditionally, stock and bond returns have been subdued in an environment of slowly rising interest rates. This is not lost on the Fed as they are keenly aware of the role that asset inflation has had in this economic recovery.
Failed Health Care Reform an Obstacle to Tax Reform:
We think the failure of the American Health Care Act (AHCA) on March 24 represents a detour, not a roadblock, to tax reform. Abandonment of the “repeal and replace” AHCA bill gives Republicans the right to fight another day on health care. The $1 trillion tax savings that could have been gained from repealing ACA could have been a down payment on the full tax reform package but lacked significant economic stimulus.
This was a political setback that creates new challenges for the Trump agenda. A successful health care effort would have allowed the Trump administration to claim victory. Instead, Democrats and members of the Freedom Caucus within the Republican Party gained leverage for future debates.
Will Tax Reform Become Tax Cuts?
The probability that we get tax cuts instead of full tax reform increased with the failed ACA repeal. Timing becomes important this month as Washington will also debate the 2018 budget, the debt ceiling and confirmation of Neil Gorsuch as Supreme Court Justice. The Gorsuch confirmation should be watched closely as a political litmus test for what to expect with tax reform. If the Senate invokes the nuclear option approving Gorsuch by a 51 vote simple majority, then tax cuts become more likely than re-writing the tax code. Either is market positive.
Republicans will be motivated to get tax reforms/ cuts done in 2017 so their constituents can feel tax relief before next year’s election. The Senate seems to be firmly in Republican control. Of the 33 seats up for election next year, 25 are Democrat and eight are Republican. The House is a bit more of a wild card and could be in play. Historically, first term Presidents with low approval ratings often lose a significant number of House seats. Independents were the swing vote in 2016 and they could be again in 2018.
Earnings Repatriation: A bi-partisan agreement on a 10 percent repatriation tax tied to infrastructure spending is likely to be a starting point in tax reform discussions. When this was done in 2004, roughly half of the $600 billion in cash held overseas came back to the U.S. at reduced tax rates. Most of that cash however was used by companies for share buybacks. The light blue line in the chart shows that companies “repatriated” their cash. The dark blue line shows that after 2006, companies quickly resumed parking cash overseas to avoid high U.S. tax rates.
In theory, there is bi-partisan agreement regarding infrastructure spending. Ideally, the increased tax revenue would fund infrastructure spending and corporations would invest repatriated cash in new plants, equipment and people. If this was done in conjunction with cuts in corporate tax rates, the thought is that money would come home and, most importantly, stay home stimulating economic growth.
The sector winners in the event of a repatriation tax holiday are health care and technology companies whose overseas cash represents 20 percent and 18 percent respectively of their outstanding market cap.
Brexit and French Elections:
Brexit: The U.K. triggered Article 50 on March 29 signaling their intent to exit the E.U. The two year negotiation window has been opened where the U.K. will negotiate with the E.U. on the terms of trade. The E.U. is in the driver’s seat but has already signaled a willingness to deal by offering a three year transition period and an openness to accept the U.K. back if British voters changed their minds.
French Elections: The first round of elections in France will be held April 23. Front National candidate Marine Le Pen seeks to exit the E.U., return to a national currency and take a hardline on immigration, but the odds of her winning are low and risks likely overblown. In a two-way race with leading candidate Emmanuel Macron she trails by 24 percent.
Brexit and Trump have taught us all about the unreliability of polls as populist causes/candidates have more traction than previously thought. A French exit from the E.U. would cause significantly more damage than Brexit but again is unlikely.
There is a seemingly smooth start to negotiations between the U.K. and the E.U., a low probability of a Le Pen win and continued strength for Angela Merkel of Germany and her party who have elections in September. The stability implied by these outcomes could be positive market catalysts.
Earnings and Stock Valuations are Under the Spotlight:
Earnings Season: We are expecting a good earnings season for the first quarter with continued earnings and revenue growth. The S&P 500’s current forward P/E of 18 exceeds its long term average so a continuation of natural earnings growth combined with pro-growth tax reform are needed to advance the rally for U.S. stocks. It would be a mistake to build an investment strategy around anticipated tax reform which has not yet occurred. The advance in stock prices since 2011 has been driven by P/E expansion. In a mature bull market such as this, future gains will be centered on high quality earnings growth.
Stock Valuations: We have seen a marked difference in performance between high quality and low quality stocks. In the fourth quarter, markets rallied on the optimism behind reflationary Trump Trade themes. This rally was led by low quality/high beta stocks. During the first quarter, the Trump Trade quietly unwound as high quality stocks have significantly outperformed those same reflationary themes. Even though the S&P 500 is within 2 percent of its record high and the NASDAQ recently set another record high, there has been a modest stealth correction occurring underneath the market’s surface. Roughly 1/3 of S&P 500 names have already seen a correction of 10 percent or more.
International Resurgence: International markets move in cycles with periods of underperformance versus U.S. markets followed by periods of outperformance. We think international stocks could be entering a period of outperformance in 2017 following several years of U.S. market dominance since the Great Financial Crisis. The economic and earnings case for International stocks has improved significantly while valuations remain cheaper than the U.S. The chart below compares the MSCI EAFE Index of developed international stocks vs the S&P 500. It illustrates that sometimes these cycles can last for several years. We maintain allocations to both U.S. and International stocks over a full market cycle for purposes of diversification.
The chart below illustrates Year-to-Date outperformance for international equities and U.S. large cap growth.
The March 15 Fed rate hike nudged 10-Year Treasury yields from 2.61 percent to today’s 2.39 percent. The interest rate path for the rest of the year into 2018 is pricing in lower interest rates than the Fed’s projections. As the yield curve has flattened, with short-term rates rising more than long-term rates, we continue to be anchored in a range of 2.3 percent – 2.65 percent on the 10-Year Treasury. Unexpected changes in the rate of GDP growth or inflation are primary data points that could alter the Fed’s path. Either of these could cause the Fed to move more aggressively than currently expected without respect to what happens in Washington.
Credit spreads remain tight between corporate bonds and 10-Year Treasury Notes. This is unlikely to change in the nearterm absent signs of a slow-down in the U.S. economy. Municipal bonds remain attractive and as the chart below shows, lead the U.S. bond market YTD along with High Yield.
- A natural economic and earnings recovery that began prior to the election is still underway.
- The Fed has hiked three times in 15 months because it likes what it sees in the data.
- Pro-growth tax reform/cuts are likely in 2017 and could add 7 – 10 percent to earnings growth.
- Interest rates may rise gradually but remain low and range bound.
- A long period of international stock underperformance may be nearing an end.
- European elections and Brexit remain a risk but once resolved, could be positive catalysts.
- U.S. equity valuations remain elevated and could consolidate further in the near-term. Many investors have abandoned hedging strategies, becoming complacent.
Bottom Line: We are not in the business of making market “calls” because markets have a mind of their own and those calls often go unanswered. April has many potential headwinds that could cause near term volatility, but we believe that the longterm bull market remains in-tact and any correction would be an opportunity to put sideline cash to work. We continue to believe that the glass is half-full.
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar
This piece is produced by BB&T’s Wealth Portfolio Management Team.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.