2017: Themes and Investment Strategies
You may have heard of the fable about the six blind men and the elephant. Attempting to identify the animal, each man touches a different part of the elephant, such as a tusk or the tail. But as a result, each develops a unique interpretation based on their differing tactile perceptions. To truly determine the nature of the elephant as a whole, the men needed to consider all perspectives. In much the same manner, the markets in 2016 were difficult to interpret as falling oil prices, the Brexit vote and the surprise victory of President-elect Donald Trump all had an impact on market conditions. Considering only one of these events in isolation could have led some investors to exit the market and miss out on potential gains throughout the year. Just as the blind men learned, it is important to examine the component parts of a whole and the relationship among them when forming an opinion. By considering multiple aspects of the market, we avoided reactive asset allocation shifts and positioned client portfolios for the long term.
Our view entering 2016 called for the continuation of this late-stage bull market in stocks, albeit with some bumps along the way, as well as an expectation for slightly higher rates. Both of these general themes came to fruition. Our view of 2017 is slightly more optimistic than 2016, but includes many of the same themes that played out last year. With that in mind, let’s take a closer look into our major market themes and strategic positioning for 2017.
Shift to Fiscal Reform
For the past eight years, the Federal Reserve’s accommodative policy has helped fuel the rise in U.S. stocks and guide the economy back to near full employment, by some measures. In light of the election results, we expect to see reliance on monetary policy fade with a greater focus on fiscal spending and tax cuts as new ways to spur economic growth. The degree to which fiscal reform impacts economic growth will depend not only on the new administration’s agenda, but also on what will get passed through Congress. The effectiveness of fiscal stimulus will also depend on the economy, as stimulus has less of an impact during late-stage economic expansions than during post-recession economic conditions. Nevertheless, accelerating domestic economic activity will likely facilitate faster GDP growth in 2017 and will have an even greater impact in 2018.
While fiscal reform will help economic growth, it might also have consequences, such as a strong dollar and the potential for higher inflation through consumer-led spending. These reforms should also put upward pressure on interest rates, which we believe will move higher, albeit at a slow pace.
Modest but Favorable Gains in Equities
While last year’s market often had to take a step back in order to move forward, we believe many headwinds, such as an earnings recession, uncertainty around Fed policy, and stringent regulatory constraints, are beginning to dissipate. We expect this bull market, while getting long by historic standards, will endure with equities most likely posting modest gains again in 2017 (although 2016’s strong post-election rally may be borrowing returns from the new year).
In light of this pro-growth policy regime shift, we think investors will benefit from a domestic bias in their equity exposure with an emphasis on cyclically oriented sectors, and exposure to both growth and value styles. In late 2016, in anticipation of policies that would benefit domestically oriented companies, we increased exposure to small and mid cap equities. This shift has been rewarded in the short term and we expect U.S. equities to maintain an edge over international equities in an environment where trade policies may become more stringent. The only significant equity underweight in the portfolio is emerging markets, as we see some countries in this asset class facing many near-term challenges under a Trump administration. While we like the asset class longer term, we await some more tangible evidence of a more attractive entry point before increasing our exposure. Our preference for stocks over bonds has been a consistent, long-term theme and one that we believe will endure in 2017.
Moderately Rising Rates
The long-awaited move higher in rates seems to be underway, finally. While many anticipated rates to rise in 2016, it wasn’t until it became apparent that the Fed would resume its normalization of rates at its December meeting that short-term interest rates moved higher. Inflation expectations also began to rise as the market digested potential shifts in trade policies, infrastructure spending and tax reform. Overall, we expect global rates will rise gradually, but that the U.S. will lead as growth and inflation expectations increase.
Rising rates can be tricky for fixed income investors, as they may suffer loss of principal, yet we believe interest income will more than make up for this (slight) capital loss. Although high yield bonds have done well as of late, we continue to recommend exposure, but with a greater emphasis on those bonds that are less susceptible to interest rate risk, such as floating rate debt. Bonds should continue to play a diversification role within overall portfolios with attention to diversifying across sectors and maturities.
A Strong Dollar Persists
As it became apparent that the Fed would resume its normalization of rates, the dollar strengthened against other currencies. We expect the Fed to be a ‘tentative tightener’ of rates while other central banks continue to ease. The combination of divergent policy and pro-growth, American-centric policies out of the new U.S. administration should keep the dollar strong during 2017. As we have noted, a strong dollar does put downward pressure on the earnings power of large multinational companies, making it harder to export. Smaller companies that generate their earnings domestically should benefit relative to larger U.S. companies. A strong dollar also helps constrain inflation, because it makes imports less expensive.
Disinflation to Reflation
Since the election, we have seen a pickup in inflationary expectations based on the type of policies favored by the Trump administration. In addition, commodity prices as measured by the CRB Raw Industrials Index lifted as 2016 came to a close. I have often said that bull markets tend to end the traditional way, with the Fed needing to aggressively increase rates in order to combat inflation. Thus, it’s important to keep an eye on this measurement, as inflation tends to have a dramatic impact on asset class returns. We will continue to monitor this variable closely, but believe it will remain well-behaved with a modest move higher in 2017.
Bouts of Volatility
Volatility, unfortunately, is one theme that hasn’t changed in our forecast. We enter 2017 in a -late-stage bull market with markets that are slightly over fair value by our valuation method—two conditions that typically encourage volatility. While we believe this market will be able to digest bad news and grind eventually higher, we could see the market wrestle with new headwinds including fears of inflation, geopolitical tensions, the fallout from Brexit or uncertainty under the Trump administration. While volatile markets are never comfortable, they do create opportunities for disciplined investors to capitalize on short-term downdrafts by leaning into weakness and deploying assets from elsewhere in the portfolio to true-up their equity weightings.
Don't Forget the Elephant Metaphor
While we are optimistic about 2017 from an economic and stock market perspective, there are still a lot of unknowns. Although we may only see a modest pickup in economic activity, equity markets should benefit from expectations of growth and stronger corporate earnings. Given this backdrop, expect modest equity returns with developed economies outpacing emerging markets, interest rates to move modestly higher across the maturity curve, and bouts of volatility. Investors should remain confident in their investment plans amid any uncertainty, but stand prepared to take advantage of opportunities as they present themselves. In the end, 2017 may turn out to look much like 2016 from a return perspective, once again rewarding investors who were able to consider multiple aspects of the market, manage their emotions and see the whole picture.