Financial markets offer endless capacity to surprise. This is especially true when one adds politics and policy to the basic issues of economics and markets. Monetary policy has dominated market thinking since 2009; politics took over in 2016. One of 2017’s biggest surprises to date has to be that the markets Pres. Trump bashed the hardest in his campaign have performed the best, including Europe, China, Mexico and EM in general.
The question today is whether this is just a fluke, an oversold bounce that should be sold or something more sustainable, a fact on the ground that should be bought and built upon. High beta outperformance in a rising US equity market is not that unusual; being able to sustain that outperformance when the US is flat to down is more demanding.
If sustained, it could signal the beginning of a lengthy period of non-US market outperformance, something few are positioned for and a prize worth getting right. US equity over the past five years is up 70% vs. ex US equity up 9%. The US bull market is 8 years old and 2% off its all time high. We may well be due for a turn.
Lets utilize our Global Risk Nexus framework to ascertain the likely course of action based on the interplay between economics, politics, policy and markets. Given how the clock is running out on Pres. Trump’s First 100 days it makes sense to start with the US. We can then incorporate the rest of the world with a focus on European politics, given the French election, together with some thoughts on Asian ship sailing & saber rattling. We can wrap up with a stab at answering the title question and some asset allocation thoughts.
TICK, TOCK… TRUMP’S FIRST 100 DAYS
The Trump Administration’s first 100 days end on April 28th, the very same day a possible Government shutdown might begin as the US Govt.’s funding bill also expires on the 28th. Coming off a two week Easter break, Congress will have less than a week to avert a shutdown while the White House, desperate for a W, seeks to re open the healthcare debate… its mad scramble time in DC.
Far from the winning the President promised on the campaign trail the First 100 days tally to date is close to a policy zero as one headline put it. The political score is better as the President spent much of his first month in office focused on fulfilling campaign promises via executive order.
However the failure to repeal and replace ObamaCare has had numerous implications including: a gaping hole in the White House to do list, bruised feelings within the Republican Party, a sense of rejeueventation amongst Democrats and and an all round reminder that the so called “Trump Trade” was actually a Republican party sweep trade. The post election rally thinking was quite simple: Republican control of the White House, Senate and House of Representatives meant that the DC policy logjam would be broken.
The repeal and replace debacle has made clear however that the Republican Party has yet to fully switch from being an opposition party to being a governing party (only a small number of Republican legislators were in office when Republicans last controlled the Govt.) while an inexperienced (in the ways of Washington) White House & Cabinet has yet to figure out how to run the machine. As a result, the policy timeline assumed by those eager buyers of US equity back in Nov – Dec 2016 should be tossed out the window.
The health care debacle, record low Presidential approval ratings and the Senate’s use of the so called nuclear option to confirm Supreme Court Judge Gorsuch has resulted in a White House with limited political capital and a Democratic opposition loath to work across the aisle. Tighter than expected special House elections stir early Republican forebodings about next year’s midterms. The first 100 days of a President’s term is usually when key policy themes get enunciated and acted upon on the legislative front; the Trump Administration’s record to date does not bode well for the future.
The path to future policy success is also being undermined by an Administration whose team remains woefully incomplete. President Trump is far, far behind his predecessors in terms of nominations for the roughly 500 Federal Govt jobs that require Senate approval. Note we are discussing nominations, not approvals – in other words this is a self-inflicted wound rather than opposition party obstructionism.
The President seems intent on running the Presidency much as he ran his company, namely in very lean, classic NYC family real estate fashion. Of course the Federal Govt is a very different beast. As such one starts to wonder what the first year of the current administration will generate in terms of policy.
Fiscal policy is already being pushed back into 2018 at best as Treasury Sec Mnuchin takes the temperature of Congress. The longer it takes the more limited tax reform will be as House members will be loath to engage in root and branch reform in an election year (Fall 2018 midterms). Very little is heard of the President’s trillion-dollar infrastructure program. Big time fiscal stimulus seems off the table.
Far from the fiscal-monetary joint venture one might have expected to boost the economy we have gotten monetary tightening and no fiscal boost. The Federal Reserve has raised rates three times while Q1 GDP is expected to come in well under 1%, a combination that has led to murmurs about the old three steps and a stumble Fed rule. The Fed has gotten out ahead of the White House and perhaps a bit over its skis as well.
Weak economic data, especially on the retail front coupled with a growing sense that inflation (driven more by oil fumes than sustained price increases) may have already peaked has led currency and fixed income markets to reprice the “reflation trade”. Bonds have rallied sharply while the USD has softened. Stocks are left as the one main financial instrument that remains in thrall to the idea of a stronger US economy, better earnings and higher stock prices.
The financial sector is a key one to observe as we move to midyear. A post election rally leader, financial stocks reaction to Q1 earnings over the past week has been both disappointing and illuminating. Experienced investors know to watch the reaction to news as well as the news itself; bank stock reaction to earnings news is worrisome.
Earnings were good, even with easy comps given how lousy Q1 2016 was. Yet bank stocks sold off leaving the financial sector ETF (XLF) roughly flat for the year though still up over 15% since the election. Up 15% plus in 5 months suggests one of the challenges for US equities going forward; the market is extended and fully priced.
Bank stock weakness may be reflecting a few issues: slowing overall loan growth and rising bad debts in the auto finance space; a flattening yield curve as the 2/10 yr. UST curve has flattened from 135 bp wide to 100bp which calls into question the potential for banks to profit from curve steepening and finally the idea that banks would benefit from Trump deregulation efforts (recall the campaign promise to kill Dodd – Frank).
Yet, suddenly bank deregulation talk been replaced by talk of re regulation in the form of a 21st Century Glass – Steagall Act no less. This calls into question the operating environment for the big banks and financial companies that make up the XLF and is likely to represent a serious overhang for the sector.
Absent financial sector leadership it’s hard to see the broad US equity market do well given the bank rally rationale is effectively the America First thesis. Another market segment to watch along the same lines is the small cap space which took off like a rocket right after the election on hopes of growth, tax reform & deregulation but has since marked time. If banks and small caps struggle, it’s hard to see the broad US market perform very well.
THE ANTI TRUMP TRADE
Notwithstanding all the ink spilled on the “Trump Trade” the place to be in 2017 has been outside the US, in Europe, Asia and Latin America. Global ex US equity is up about 7.5% ytd versus the S&P up roughly 5%. Only Japan has struggled and even it is up roughly 4% in USD terms given yen strength. Emerging Markets, of which so many were so fearful, is up 11% ytd.
The world economy is in the midst of a gentle upswing, an upswing that should help the rest of the world perhaps more than it helps the US. Central Banks in Europe and Japan are unlikely to begin pulling back on their monetary accommodation, unlike the US where the Fed is well on its way to try and normalize financial conditions. Emerging markets should be beneficiaries of this global environment, free from worries about excessive dollar strength or a strong US equity market that sucks capital in from the rest of the world.
EUROPE – COMING INTO ITS OWN?
Europe is front and center given its electoral calendar in general and this weekend’s French elections in particular. Given the two round nature of French elections the final outcome wont be known till early May but investors, who shunned European equity last year (record outflows) seem quite sanguine with recent equity inflows the best in over a year, the Euro solid as a rock and sovereign rates quite stable.
Should France fail to elect either National Front leader Le Pen or Communist Party stalwart Melenchon, the outlook for European financial assets would seem quite bright. Election concerns center around an expected low turnout and a high number of undecided, both of which were hallmarks of Brexit/Trump upsets. On the plus side the latest polls suggest En Marche! leader Macron is pulling away from Le Pen whose support peaked a month ago, suggesting a final run off between the two. Should le Pen and Melenchon make the run off the market reaction will be ugly.
Beyond the French election things seem to be getting better in Europe. Economic activity is better than in the US with private sector activity at six-year highs. Inflation seems a bit more entrenched (a good thing), the Euro is reasonably valued (and supported by record current account surpluses) and rates have room to rise. Unlike the Federal Reserve, the ECB has no plans to unwind its monetary stimulus and there is no sense of more onerous bank regulation.
I continue to feel Brexit and Trumpian rhetoric will serve to unite Europe and bring it closer together. (See Trump, Trade & the Markets, Feb. 2017) Being forced to contemplate a future without the UK and perhaps without the US standing shoulder to shoulder will tend to have that effect. Amidst all the negative press, public support for the Euro is at all time highs and Macron among others in Europe are now campaigning in full-throated support for the EU.
It’s worth considering whether Europe might not be entering some very good years as political risk fades, growth recovers, efforts to deepen integration bear fruit and political risk shifts elsewhere. A quite contrarian point of view but one well worth considering.
ASIA – THE WORLD’S PROACTIVE REGION
The Trump Admin’s unprecedented ability to shift points of view has been on vivid display in regards to Asia. From promising to label China a currency manipulator to then saying the USD was too strong and from recommending that the US stay away from the North Korean issue to threatening to send a mighty Armanda, Asia has been front and center of the Trump Admin efforts to recalibrate.
Yet, the Trump – Xi summit accomplished little on the surface and time will tell if more was achieved, especially in the context of North Korea. In the case of Asia writ large, President Trump’s decision to pull out of Trans Pacific Partnership (TPP) talks would seem to give China the green light to lead Asian integration. While Japan, South Korea and India will all seek to have a say in how Asia is put together it seems clear from this armchair that China has the inside edge.
Japan is growing above potential while signs of reflation take hold with even core CPI showing year over year gains. Trade gains suggest Japan is enjoying its usual position as a global growth winner with export volumes running in high single digits. Unemployment is at record lows and like the ECB, the BOJ has no plans to end its monetary support of the economy.
In the Americas the economic opportunity and strategic imperative of building deeper relations between the NAFTA countries and South – Central America awaits US leadership. Mexico has been one of the world’s best stock markets in Q1 while auto production soars and domestic demand grows. Mexico’s ability to jump start domestic consumption would be a real shift in its growth profile and one that would hedge against US trade risk. The country is already looking to Brazil and Argentina in regards to food imports, an example of how the US does not hold all the cards in these potential trade disputes.
I think there is a very good chance that US equity will underperform the rest of the world in 2017. Absent a sharp fall in US stocks the developed markets of Europe and Japan have room to run on earnings growth, valuation and ownership grounds. EM equity, where allocations have surged to 5-year highs, is more case-by-case in my point of view. It is too early to say we are off to a multi year period of US equity underperformance but I am leaning in that direction. Tactically underweighting US equity makes sense while preparing the long-term strategic underweight case.
The US equity market is priced not for the status quo ante but rather a US economy boosted onto a higher growth path by what I have termed a “fiscal – monetary policy joint venture” that supports a mid teens earnings rebound and a Shiller CAPE PE of 30x. Failure to implement policy that helps the US reach that new growth path implies a downward repricing to rebalance the equity market for an economy & earnings that grow more in line with the past few years. At the moment US equity is being supported by a robust Q1 earnings season… what comes next remains to be seen
Europe, on the other hand, is growing faster than the US, with earnings growth running roughly double that of the US and valuations that in Shiller Cape terms are roughly 50% that of the US. Double the earnings growth for half the price – now that’s a statement an investor can get behind!
Of course there is the political risk, but it is not a surprise; if anything it runs the risks of being overanalyzed to death. That not to say a negative surprise cannot happen but rather that many have decided to stay out until there is more clarity and once that clarity is there, especially if there is no political upset (represented by a Le Pen – Melenchon runoff), then higher prices and perhaps significantly higher prices will prevail.
I continue to like Europe in three ways; broadly from the regional context, country specific where Spain is my preferred option as a housing recovery (one of the world’s best real estate markets in 2016 with much the same expected this year) should help the banks which in turn make up a good slice of the index and sectorally, with EU banks being one of my Top 5 Trades for 2017. (See 2017 Outlook: America First? Dec. 2016)
Japan may represent the most interesting opportunity at the moment. The stock market has been weak, notwithstanding earnings expectations in the mid teens coupled with rising revisions as the domestic economy does better than expected, the global economy picks up and the BOJ continues to hold rates down. The Abe Govt continues to push labor and productivity reforms, which if implemented should be quite constructive. Should concerns over Europe and North Korea abate, one could expect to see a weaker yen and hence hedged equity remains the preferred vehicle here.
Broad emerging markets have done better than expected and may also be on the cusp of a longer-term rebound. If so, it could be the markets segment that helps lock in US underperformance in the years ahead and thus bears careful watching. Specific country selection is warranted today; one can consider countries such as Mexico (another top 5 trade) and China where better growth, some inflation and the continued need for domestic investment opportunities suggest that a stock market down close to 50% from its recent high is well worth a look.
On the fixed income side interest remains in financial preferreds and high yield in the US as well as EM USD debt. The search for yield continues; unlike in the equity space the best opportunities reside in the US or in USD. Gold remains favored in the commodity space; recent weakness in industrial metals suggest that the low growth, low rate world may yet remain.