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Thursday, June 22, 2017
Investment Strategy | June 2017
Director, Investment Research | Consulting Research Group
The synchronized global expansion continued in the first quarter, leading markets higher and pushing U.S. stocks toward expensive territory. With both U.S. stock valuations and near-term economic data close to historic levels, the recent rally in U.S. stocks may run out of steam. Those challenges, in addition to infighting about the direction of fiscal and foreign policy and the rise of political risks, likely mean diversification will play an important role.
A Firming Economic Backdrop
The global economic and market recovery that started late last year continued in the first quarter. In the U.S. especially, market returns continued above trend as the prospects of business-friendly fiscal policy, coupled with an acceleration in positive economic reports, propelled markets higher.
Outside the U.S., economies strengthened at the start of 2017, leading to the most synchronized global upturn in years. More than three-quarters of the world’s leading economies showed broad gains—a stark contrast to a couple of years ago, when that number was less than half.
Emerging markets have been especially strong. They have seen a noticeable pickup in trade and a nice lift in industrial production. Strong export numbers from India and import
numbers from China support those claims. China is of particular importance to the health of the backdrop. While Chinese consumption eased somewhat to start the year, growth in imports signals confidence in the prospect of future growth and suggests future economic momentum. Other reliable leading indicators have been flashing positive signs, supporting broad-based gains overseas both in developed and developing economies.
A dovish Federal Reserve helped matters and provided cover for the rally. While the Fed raised rates in March, it surprised markets by lowering expectations for rate hikes later this year. Longer-term interest rates have declined since and should not provide a serious challenge to economic prospects for the time being.
As stocks have risen, though, valuation has come more into focus. The rally that continued this year has moved stocks toward premium valuations. At the end of the first quarter, U.S. stocks were trading at roughly 20 times last year’s earnings—an expensive level. On a longer-term basis, stocks traded at almost 30 times earnings. By that measurement, U.S. stocks have been this expensive only two times in the history of the data: 1999 and 1929.
Recent U.S. economic data also appears to be bumping up against historic highs. For example, economic indicators, such as the Institute for Supply Management’s Purchasing Managers Index, have been strong and may be hitting peak levels. This creates a high probability that upcoming U.S. data reports will be weaker.
Moving beyond U.S. stock valuations and looking at other factors that unfolded this year, one major surprise has been the extent of Republican division on fiscal and foreign policy issues and the family feud that developed.
Given the sweeping Republican victory in November, a consensus view emerged that an aligned White House, Senate, and House of Representatives would tear through legislative priorities teed up from eight years of pent-up demand. But that has not happened to date. Republican infighting that led to an embarrassing setback in healthcare reform also called into question the future path of the Trump administration’s larger legislative agenda and created uncertainty around other major policy initiatives, such as tax reform.
On the foreign policy front, we saw the same thing when the globalist agenda being pushed by National Security Advisor H.R. McMaster collided with White House Chief Strategist Steve Bannon’s “America First” vision. During the first week of April, President Trump went from telling a trade group he didn’t want to be “the world’s president” to authorizing military action against Syria. Clearly, a struggle exists in the White House between a moderate globalist faction and an ideological, nationalistic one. It is unclear which side will prevail and whether the recent military action was a pivot away from the “America First” vision or an isolated event in a move toward creating a more inward-facing foreign policy.
From Russia with Love
Ironically, it may be the administration’s most recent struggle that ultimately gets the fiscal agenda back on track. A consensus view has developed that the appointment of a special counsel to oversee the FBI’s investigation into ties between the Trump campaign and Russian officials could distract and further slow the policy agenda. Yet there is a real possibility that the administration rallies through this adversity with a recommitment to key initiatives, reigniting and accelerating a fiscal policy push.
Historically, administrations under pressure have turned to policy to take pressure off negative headlines. Congressional Republicans, too, are seeing an increased likelihood they will lose some power next year during the election cycle. In similar instances—with Republicans in 2006 and Democrats in 2010—the result was an accelerated pace of legislation.
To put this into context, we expect details on the administration’s proposed $1 trillion infrastructure plans shortly and movement on health care and tax reform, although that progress has been masked largely by recent headlines. Other policy initiatives, such as the continued push toward deregulation and the repatriation of foreign profits, are either immune from the political distractions or command more bipartisan support.
While political risks have certainly risen with the appointment of the special counsel to oversee the Russia investigation, these events could also spur the administration and Congress into action and force the feuding family into real policy action.
Today’s short-term top and likely slowdown of good economic news—paired with high valuations—could mean slowing U.S. stock market momentum. This does not mean that the U.S. is headed toward recession or even that the economy has stopped growing. It does suggest we will experience a few challenges, at least in the short term. In similar historical circumstances, the economy continued to grow, albeit at a slower pace, after a short-term top in economic data. Often, markets paused around this point in the business cycle before advancing again. The U.S. stock market seems ready for this type of pause, given its recent rally and in light of high valuations and slowing economic momentum.
Abroad, the story is a bit different. Economic momentum is on the right track with room to run. Further, international stocks are less expensive than U.S. stocks, pointing to more and better opportunities abroad. A dovish Federal Reserve (for now), subdued inflation, a lower dollar, and low interest rates provide a nice backdrop for international stocks to outperform U.S. stocks, especially if the Trump fiscal agenda stalls.
Given existing policy and geopolitical risks and the U.S. economy’s placement in the later stages of the business cycle, now is not the time for bold portfolio risks. At the beginning of the year, the chance of extreme outcomes—both positive and negative—looked large. With the administration’s struggle to advance a coordinated fiscal agenda, the probability of the large positive outcome is diminished for now. Meanwhile, foreign policy uncertainty means that the possibility of a large downside still lurks. (But it, too, has diminished somewhat due to the absence of an all-out trade war.)
What this means is that diversification is more important than ever. Having exposure to stocks outside the U.S. that could do well if global markets continue to improve could provide a meaningful return opportunity. But being mindful of risks, having access to other asset classes in portfolios, such as core bonds and other diversifying strategic opportunities, is equally important given the uncertainties that remain.
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