- By: Sanjay Pawar
In my opinion, the best way to talk about market outlook for 2017 and beyond would be in the context of the Presidential transition. The reason is obvious. Both the Bond and equity markets here in the US and all over the world have moved a lot since the Presidential election results. And there has been a significant change to the economic outlook not just in the US but Globally, since.
In October of 2016 when I wrote about the economy and outlook for interest rates, things were very different. Economic growth was slow, inflation was low and it appeared to me that we would see a cyclical down turn in the economy and in the markets. It is mind boggling how things changed over the period of a week (November 2016).
As you all know, as soon as the Presidential election results were out, over night the markets saw a huge sell off with Dow being down over 800 points. But initial negative reaction changed just as rapidly, as the S&P 500 and Dow Jones indices actually closed 1.25% higher that day. The pessimism gave way to optimism over night.
Pros for 2017: The changed outlook for the new President is for the following reasons and expectations:
1) High infra structure spending, which should lead to economic growth, more jobs etc.
2) Boost in domestic Energy sector per campaign promises made. Again a revival of domestic energy sector bodes well for economic growth and jobs growth.
3) Changes to International bilateral Trade agreements with the intent to encourage domestic manufacturing and consequently create more jobs domestically. Of course, it remains to be seen what the negative fall out of trade restriction and anti-globalization policies will have on US products and services going overseas (and there will be some…). As we all know, about 50% of the S&P 500 companies’ revenue come from overseas.
4) Reduction in regulations across industries. Reduced regulations are expected to create a better (more profitable) business environment for businesses across industries (particularly Banking, Energy and Pharmaceutical).
5) Reduction to corporate tax rates should result in immediate accretion to corporate bottom lines and could make stocks look cheap at current prices because P/E ratios should compress with higher after tax profits.
6) Policy changes to encourage (or force) repatriation of corporate funds that are held overseas could arguably lead to boost in economic activity because corporations could utilize repatriated funds for M&A, stock buy backs, research & development, capital reallocation for growth etc.
All the above reasons seem very positive for the markets, especially equity markets. And may lead us to think that we are heading for another bull run in the equity markets.
Cons for 2017: However I do not think that it is that simple. There could be some potentially negative fall out of the expected fiscal and economic policies:
1) With higher infrastructure and energy sector spending there are expectations of higher inflation. While inflation in the short term could be good for growth, in the longer term inflation will result in lesser buying power in the hands of consumers and consequently lower consumer spending. As we all know, 70% of the US economy is consumer spending.
2) Higher inflation will result in higher interest rates. Higher interest rates mean higher rates on consumer loans, credit card, mortgages etc. Higher cost of borrowing could lead to lower demand for housing, cars and other discretionary big ticket spending.
3) Higher interest rates could result in stronger dollar. Which would make our goods and services more expensive in the export markets. Some of the effects of higher interest rates could be mitigated if we see corresponding increase in interest rates and higher growth rates globally. However a lot of economies around the world are experiencing easy monetary policies and lower interest rates.
4) Expectation of higher interest rates has already taken a toll on the Bond markets. Although I do not think that the Bond market is over. Certainly, double digit or even high single digit returns on bonds could be very difficult to achieve in a rising interest rate and rising inflation environment. Bad fixed income markets combined with high inflation cannot be good for the millions of retirees that depend on income generating securities for their monthly household cashflow requirements.
5) Where would the money, to fund fiscal stimulus and to spend on infrastructure, come from? With budget deficit and rising national debt it is not going to be easy to execute on everything that has been talked about by the new President. Not to mention if a huge part of the infrastructure budget is spent on building the much talked about ‘Wall’.
6) In other words, It is going to be extremely difficult to deliver on every promise that the new President has made.
7) It remains to be seen what our foreign policy and diplomatic relations are going to look like over the next few years. Any failure of diplomatic relations with countries like China or Russia could have serious consequences.
Portfolio Management: Finally, here are my thoughts about what this means for portfolio management:
1) As always, diversify but smart diversification is the key. There is no need to be in a lot of asset classes just for the sake of asset allocation and diversification.
2) Strategically allocate to the right asset classes.
3) Allocating to bonds is necessary for income generation and portfolio volatility. However, allocate to the right kind of bonds. I would not eliminate bonds from the portfolio.
4) Do not over commit to any particular asset class or classes.
5) Utilizing high conviction individual securities could help the portfolio in the long term.
6) Remember we are at historically high levels in the equities markets. Therefore, I realize that switching from Bonds to Equities entails substantial systematic risk due to cyclical market correction or downturn.