January Market Report: Embrace Uncertainty
January Market Report:
Investors and markets don’t like surprises. Will interest rates rise slowly or quickly? Will Congress appropriate mega-funding to US infrastructure, slash taxes, or both? Are Trump’s growth plans mere dreams, or rooted in reality? What will happen to the Affordable Care Act? As financial pundits pondered these post-election questions, the January markets quietly defied expectations. There’s a lesson in that.
Markets often shift course in the least expected ways. When Trump was elected, analysts expected US markets to slump and emerging markets to take an even bigger hit. That’s not what happened. Between November 8 and Dec 31, 2016, US markets rallied 5.46% while the S&P Global Broad Market Index (BMI) rose just 2.97%. Ex the U.S., the BMI was up just 0.36%, with emerging markets in the red by -4.12%. Then the wind shifted. In January, global markets advanced 2.67% as the US underperformed with a 1.85% gain, while non-US markets gained 3.57% for the month. In other January news, the Dow Jones Industrial Average Index crossed the 20,000 mark for the first time, and the S&P 500 set three new closing records and hit the 2,300 intraday mark.
There were also surprises and unexpected developments in the Oval Office. In less than two weeks after becoming president, Mr. Trump issued executive orders to withdraw from the Trans-Pacific Partnership (TPP); renegotiate the North American Free Trade Agreement (NAFTA); approve the Keystone and Dakota pipeline projects; freeze federal hiring; build a wall between the US and Mexico; halt refugees from Syria, and restrict immigration from seven Muslim countries—a decision that sparked immediate airport chaos, protests and court battles. Trump also indicated that he plans to repeal and replace Obamacare, though Congress has been largely silent about the “replace” part.
Whew! That’s a lot to digest, even for buy-and-hold investors who aren’t typically rattled by the news. In this report we’ll look at the potential impacts of what could happen next. We’ll also offer tips on how to live with uncertainty (read: market volatility) and still sleep well at night. But first, a look at January numbers.
US Stocks: Momentum slowed as the S&P 500’s post-election gain of 4.64% through year-end 2016 was followed by a more modest 1.79% climb in January. Still, it was far better than January 2016, when the index fell -5.07% on its way to a YTD loss of -10.51% by February 11, 2016. The S&P MidCap 400 also lost momentum as it posted 1.60% in January after increasing 2.03% in December and 6.82% in November. The S&P SmallCap 600 was the worst performer of headline indices, declining -0.45% after a broad 3.19% December gain and robust 24.74% 2016 gain.
Emerging Markets: Emerging markets defied expectations to continue a December rebound, becoming one of the shining starts of the new year. For the month, emerging markets gained 5.10%. Nineteen of the twenty-two markets posted gains. Poland did the best, up 10.97%, while Brazil added 10.76%. Turkey added 2.75%. Russia added 1.51%. Mexico added 1.51% but remains down -13.87% since the U.S. election.
International Developed Stocks: International developed markets added 3.19% for the month. New Zealand did the best, up 7.87%, after being down -2.13% in December, followed by Singapore (7.85%) and Hong Kong (6.69%). Germany, whose leaders expressed disapproval of some of Trump’s executive orders, gained 3.29%. European equities, widely viewed as a loser in the current geopolitical climate, added 2%. The valuation gap with the US stock market remains wide, as many investors have embraced US stocks in an effort to avoid perceived European political risks. Fundamental valuations suggest that this consensus is too negative. Eurozone growth is picking up, rivaling the US for the first time since 2008, and the European equity outlook remains attractive for long-term investors.
Commodities: The Bloomberg Total Return Commodity index gained 0.14% for the month, for a one-year gain of 13.83%. Industrial metals turned in a stellar 7.45% return. Precious metals were another good performer with a January gain of 6.27%, again reflecting investors’ anxiety over the global political landscape. Net bets on a higher gold price by speculative investors doubled since the beginning of the year. The worst-performing category was energy, at negative -7.6%.
Fixed Income: Interest rate fluctuations across the US fixed income markets were mixed in January. The yield on the 5-year Treasury note rose three basis points to close at 1.93%. The ten-year T-Note yield was unchanged, finishing at 2.45%. The 30-year Treasury bond shed one basis point to end at 3.05%. The 1-year and 2-year T-bill yields were more or less unchanged at 0.84% and 1.19% respectively. Short-term corporate bonds increased 0.37%. Intermediate-term corporates gained 0.39%. Short-term municipal bonds added 0.36%, and intermediate-term municipal bonds returned 0.70%. Intermediate-term high yield bonds returned 1.3%.
You Can’t Have It All
(Even if You’re the President)
Going forward, it may be more difficult for Mr. Trump to act so quickly. Wall Street, multinational corporations, Congress, and millions of Baby Boomers eyeing Social Security and Medicare won’t like it. That said, it seems reasonable to anticipate heightened market volatility until the new administration gets its house (and messages) in order. We’ve already seen the market effects of at least one presidential decision: The Dow Jones Industrial Average immediately dropped 1% and foreign stock markets fell even more following Mr. Trump’s executive order on immigration. And that was before major American universities, medical schools and Silicon Valley weighed in.
Many of Mr. Trump’s goals appear to be at odds, or to cut both ways for investors considering their own course of action. Massive spending on infrastructure and tax cuts don’t add up to a pretty picture for the federal deficit. And while the president has boasted of creating “millions of jobs” and a 4% growth rate, the reality is that the US economy has grown at approximately 2% since 2008. As for tax cuts—another Trump goal—Republicans who have long railed against the federal deficit may be hard-pressed to vote for tax cuts that increase it.
All these issues circle around two big questions, which is what will happen to interest rates and whether Trump will be able to deliver the growth he’s promised.
Let’s look at interest rates. The general consensus is that they must go up, given Trump’s ambitious goals. But higher interest rates are not a foregone conclusion, says Russ Sorkin (New York Times, 6-Feb 2017). Here’s why:
• “The Trump agenda could pack less punch than some have imagined.” It’s hard to tell, since so far “Trump hasn’t put much meat on the bones of the plan,” Sorkin says.
• Until there’s proof that the economy and job growth are growing rapidly, the Fed may feel little pressure to raise rates. Congress also may be wary of cutting taxes.
• In addition, “Some elements of the Trump plan could end up being a drag on growth,” Sorkin writes. Among investor concerns: trade wars with China and Mexico, immigration policies, disputes with long-time allies, and more. All could slow interest rate hikes.
Sorkin imagines two scenarios that could undo Trump’s agenda. First: if the economy does take off and the Fed raises rates aggressively, bond holders would take a hit…a growing economy plus a higher deficit would raise rates even further…which in turn would make Congressional funding for a big infrastructure plan less likely. Alternatively, keeping rates too low, too long, could be a big mistake if the economy overheats and inflation ignites…leading to swelling national debt and long-term harm as the dollar drops and anxiety, interest rates and inflation rise.
Bottom line, the future of interest rates is up in the air. Bond analysts are falling over themselves to suggest defensive strategies. What should you do? At Cardiff Park, our advice hasn’t changed. Fixed income portfolios are carefully considered and tailored to each client’s income, liquidity, inflation protection and total return priorities. So there’s no reason to overhaul one's bond strategy based on the ebbs and flows of the bond market unless one's priorities have changed.
Growth: Miracle or Mirage?
So what about Trump’s big plans for growth? Is it time to double down on stocks? Probably not, say most analysts, some of whom compare the current growth cycle to the late innings of a ball game. And yet stocks provide the extra premium for taking on risk and staying in the game.
Here in the US, domestic growth is lackluster. Personal consumption slowed in 2016 compared to the previous two years, and business spending pulled back. A plunge in oil prices has put a damper on the energy sector and business investment. Productivity growth has flattened.
How to rev it up? Tax cuts could boost short-term economic growth but would also put pressure on interest rates and increase long-term debt. And by carving up brackets, tax cuts proposed by Trump would disproportionately benefit wealthier citizens, not the lower middle class who helped him get elected. Rising interest rates generated by tax cuts could also have unintended consequences by hurting American manufacturing exporters as the dollar strengthens.
Ease regulations? Dismantle Dodd-Frank? The effects on growth would be negligible, writes economist and former Fed Vice-Chairman Alan Blinder. But the harm could be considerable.
“Mr. Trump’s best hope for a supply-side miracle is sheer luck,” he says. But if productivity growth snaps back, Mr. Trump could get lucky and the US growth rate could climb as high as 3.1%, he says.
Meanwhile, as the dance between tax cuts, infrastructure investment and interest rate hikes plays out, investors should consider their options with care. There are many ways to take risk, but diversifying risk is still your best bet. Consider emerging markets, which rose so unexpectedly. Consider the Eurozone, which is doing better than expected.
Trump-era policies can cut both ways, and there’s no way to accurately predict future outcomes. Make sure your investment strategy is aligned with long-term goals. Rebalance if needed. Invest in short- and medium-term bonds. Don’t chase specific stocks or sectors, hoping for a quick windfall (you know we wouldn’t let you do that).