One of the most reliable maxims in life is to always expect the unexpected. It’s true that after 80 per cent of U.S. presidential elections, the S&P 500 has rallied an average of 3.2 per cent between election day and inauguration day in late January -- with this year’s version up more than six per cent as of the time of writing this blog. It’s also true that economic cycles don’t die of old age. But with the current economic cycle poised to enter its eighth year and the S&P 500 trading at roughly 17.5x 2017 earnings per share, the holiday season marks a good time to sit back and reflect upon the pros and cons facing your portfolio entering 2017. Will financial markets have as easy a ride next year as they’ve enjoyed since Nov. 8? Broadly speaking, this answer comes down to four variables: oil, inflation, Donald Trump & Europe.
Before I continue, it needs to be said that I’m a hedge fund manager, hence my principal role is preserving capital and generating a risk- adjusted rate of return that is competitive and helps investors meet their financial goals. A main reason investors come to me is to enhance and complement their portfolios with a risk and volatility management strategy called shorting. Adding a “short book” to portfolios helps to diversify, lower volatility and ensure hard-earned savings don’t evaporate during market turbulence. It’s rare that you’ll find me unabashedly bullish, in other words, 100 per cent long only the market.
Getting back to markets, on the positive side of the ledger, WTI oil is above US$50 per barrel, enabling the global economy to breathe a big sigh of relief; and this oxygen is more important than you might think at first pass given that global debt to GDP sits at an eye-popping 2x and, ex-creditors China and Japan, it’s OPEC oil producers that were the largest suppliers of credit to the global economy prior to crude’s crash in mid-2014. Oil is currently trading nicely north of US$50 because OPEC ringleader Saudi Arabia, the world’s lowest cost producer, went back to its 1980s playbook during the fourth quarter and agreed to a production cut in an attempt to support prices. However, given that U.S. shale producers have nearly 5,000 DUCs (drilled but uncompleted wells) and have reduced their wellhead costs to roughly US$40 per barrel, it’s questionable whether the Saudis’ strategy will work to support prices beyond the first quarter of next year. But enjoy it while it lasts! All else being equal, I don’t think we see WTI oil trading above US$60 on a sustainable basis during 2017. As you can see from the graph below, neither does the market. While prices into 2019 have risen from levels of two months ago, notice that beyond mid-2017, the curve is in backwardation, meaning future prices are lower than current prices. The end result is that energy companies in North America may trade in a range in 2017; so stock picking will be important. Look to low cost U.S. producers, those in rich basins such as the Permian, and service companies that may see an uptick in demand. High cost leverage plays may see share price declines after a spectacular run in 2016.
Interestingly, while yields on Canadian and U.S. 10-year government bonds have climbed 72 & 96 basis points (bps) respectively to reach 2.48 per cent (highest since June 2015) and 1.75 per cent since Aug. 1, correlation analysis confirms the recent rise in the price of oil has had virtually no role in these moves. So, what’s been driving bond yields higher and will they continue to rise? I’m going to get a bit technical here, so bear with me. The one-year graph above displays the nominal or headline yield (white line) for a U.S. 10-year government bond along with its two components, break-evens (orange line) and TIPS (blue line). The blue line plus the orange line equals the white line such that the yield on a government bond is equal to the expected forward rate of inflation (called the break-even yield) plus the real yield (called the ‘TIPs’ or Treasury Inflation Protected securities in the U.S. or Real Return bonds in Canada). This latter component of a bond’s yield can be viewed as a proxy for the price an investor wants to get paid for the credit risk they’re assuming when buying that bond.
Notice that the TIPs barely budged between August 1st and the U.S. election, while the break-evens rose, especially during September and October. Since November 8th both variables have climbed, pushing yields to current levels. Fearful of further losses, this rise in bond yields caused investors to sell bonds and buy stocks, and within equities to sell shares in companies that looked and acted like a bond proxy, such as telco stocks (blue line), as shown in the graph below, in favour of companies that either offered greater potential to benefit from rising interest rates (banks stocks in white) or a growing dividend payout. Is this fear rational and should investors be selling more of their bonds?
If inflation is going to come roaring back, absolutely you should sell your bonds and use those funds to pay down your mortgage. But is inflation actually going to come roaring back? At this juncture, I’m not convinced. Here’s why: headline CPI has picked up since August due to the easy year over year comparison of input prices. These phenomena will continue for several more months. However, once those easy comps have been lapped, for inflation to continue to rise it’s going to have to come from what’s called ‘demand push’ inflation. This type of inflation arises from consumers bidding up the price of goods in limited supply. But the graph above shows that nominal wage growth in the U.S. is stuck around 2.5 per cent, the lower end of its 36-year range (while sitting at about 1.5 per cent in Europe). Meanwhile, the amount of total personal consumption expenditures in the U.S. spent on what I’d consider to be necessities -- specifically shelter, health and insurance -- is the highest it has been during this post-Reagan time frame. Unless wage growth accelerates significantly from current levels, I’m not convinced that consumers will have enough extra cash to transition inflation to higher levels. Once again, security selection will be critical when it comes to dividend and income oriented equities. Unlike the last number of years when quantitative easing pushed all income oriented securities higher and valuations along with share prices, it is likely that the market starts to differentiate between “bond proxies” that can grow both earnings and dividends. Highly valued low growth income oriented securities may see share price declines or stagnation in 2017.
Then there’s U.S. President-elect Donald Trump. I showed you how the yield for TIPs only rose after the U.S. election, when investors became fearful that the debt-financed spending spree promised by Trump would materially increase the supply of bonds. This scenario would occur because his currently fiscal policy could boost the country’s debt to GDP ratio from about 77 per cent currently to as much as 105 per cent by 2026. And as we know, it doesn’t matter what’s being sold, if there’s too much supply relative to demand, the price goes down and its implicit return or yield goes up. So, for interest rates to rise further, either inflation has to climb or Trump is going to have to scare investors into demanding higher ‘real’ yields. As I don’t see inflation getting out of control, while traders could easily push yields higher during the next few months, I believe bonds will become a buy again before the end of mid-2017. And such a move in rates -- first up, then down -- will dictate how both broader equity indices fare and how individual sectors and stocks perform.
Last month on ‘Weekly with Andrew McCreath’, head of fixed income trading at National Alliance Securities Andrew Brenner opined that a three per cent yield on the U.S. 10-year would be the catalyst for stocks to swoon. Not that I’d pinpoint the specific level, but I do believe that given the current valuation of stocks, yields don’t have too much more room to rise for stocks to have a pricing problem. Remember, Trump has tabled bold plans, but outside of the U.S., growth is very scarce. Canadian GDP is expected to approximate 1.2 per cent this year and less than two per cent in 2017. Europe remains a mess, with significant risk arising from Italy’s debt and loan crisis, let alone other geopolitical events. Japan remains on the road to nowhere, while China’s government will do whatever it takes to keep a six handle on its rate of economic growth; but stability is about the best that country can hope for. As a result, even with the benefit of Trump’s potential tax cuts it’s tough to get 2017S&P 500 profits above $133 per share, valuing today’s market at a not cheap 17.5x. If I’m right, investors who can actively select securities that have strong fundamentals, are not too richly valued and aren’t tied specifically to an index may benefit.
A further headwind to U.S. corporate profits could be the rising dollar. While the Federal Reserve will undoubtedly wait to see how much of Trump’s talk becomes actionable before getting too aggressive on rate hikes, we know it’s highly unlikely the Bank of Canada, the European Central Bank or the Bank of Japan will raise interest rates during 2017. Consequently, unless there’s a significant reversal in current economic trends in any of these three regions, it’s tough to see how the U.S. dollar can become a tailwind for corporate profits, and hence U.S. equity indices.
So what’s an investor to do? Well, remember my comments about being a hedge fund manager: it’s rare that you’ll find me unabashedly bullish.
2016 was a year that featured four mini-cycles: the risk-off panic of January, the reflation rush of February through April, a reversion toward a more balanced market from May to August, and then rotation toward equities winning or losing from rising interest rates from Labour Day through year-end. My most likely scenario for 2017 is that a lot of good news will be priced into markets by the time Trump takes office on January 20th. And, thereafter, reality sets in: the impact of the rising dollar, insight into what policies he’ll actually be able to deliver upon, and the potential for risks around the globe, (such as the economy in Canada’s case, or geopolitical instability in Europe). For example, Trump is talking tough against China and Mexico while cooing softly with the Russians. We’ve got no idea how those theatrics play out, but markets never like uncertainty. Hence, I see a spring swoon in markets. For the back half of the year, if I’m wrong and inflation is running away and there are signs that the Fed’s going to get behind the curve: run away from stocks or buy some hedge funds. If I’m right and the fears of inflation are receding, then buy some bonds and shares in companies that pay a dividend and offer the potential to grow that dividend.