- Equities have risen on optimism rather than on actual economic improvement.
- Pro-growth policies expected in the United States have been delayed by political wrangling.
- Consider selective profit-taking as markets wait for policy to take shape.
At the end of 2016, we wrote that the improvement in macroeconomic data in the second half of the year had been underappreciated and underpriced by global equity markets. The election, in and of itself, simply provided the resolution of some uncertainty. It is a subtle distinction, but it is important to separate the event from the outcome in that regard. And while we believed that markets were "catching up" with economic fundamentals early in the post-election rally, during the first quarter markets surpassed levels justified by the rebound in growth that began in the second half of 2016. The markets have even begun to price in a premium on what some have referred to as the Trump Trade.
Distinguishing substance from effervescenceThe narrative of the Trump Trade (or what some have referred to as "the reflation trade") is that economic growth will receive an additional boost in coming years from a combination of 1) diminished regulatory burdens on the private sector, 2) lower personal and corporate taxes via comprehensive tax reform, and 3) fiscal stimulus, primarily in the form of infrastructure spending. We believe the current market premium exists due to the divergence between hard data — that is, measurements of actual output, production, and new orders — and soft data, which primarily consist of surveys and sentiment.
Investors trying to discern the trajectory of future earnings growth are reminded of classic advice: "Watch what I do, not what I say," e.g., follow the hard data rather than the surveys.
Placing greater confidence in hard data rather than soft does not mean to dismiss the role of animal spirits, that is, the emotions or sentiments that can motivate investment behavior, as articulated by John Maynard Keynes in The General Theory of Employment, Interest, and Money. Far from it. The optimism evident in the market rally can easily lead to tangible effects like greater spending and hiring by corporate CEOs and CFOs. However, optimism is often fickle, and even when it persists, there can be a long lag between the onset of optimism and when the real economic impact becomes tangible. Sentiment can also be viewed skeptically because this unusual divergence between hard and soft data, in both magnitude and duration, is not solely a U.S. phenomenon. There are many developed countries around the world, including Germany, that recently have shared this conundrum.
Can the Trump train run on time?With respect to pricing President Trump's reflationary policies, risky assets play the role of oddsmaker and serve as a discounting mechanism for the future value of incremental cash flows. Markets are assigning a probability of whether the policies are implemented — an if question — and then weighting the probability of a "yes" answer, in order to discount the future cash flow benefit of such an outcome. This second point addresses the question of when reflation might have tangible effects.
As we watched the drama unfold around Congress' consideration of the American Health Care Act (the Republican replacement for the Affordable Care Act), we were essentially seeing the timeline expand for enactment of the reflationary policies of the Trump campaign. An earnings boost that arrives in 2018 is worth less than an immediate boost. By definition, then, as the effort to repeal the ACA has faltered, we must lower the expected value of both the if and the when. The equity market actually began moderating expectations when, on March 21, we experienced the first decline of more than 1% in the S&P 500 Index in 109 trading days — the longest such streak since 1995. If expected tax and infrastructure initiatives stall in Congress, the market will need to adjust more.
Global political climate remains at riskWe also continue to be concerned about political risk in Europe. While the election in the Netherlands provided temporary relief from a wave of populism, it is not the end of the story. In France, opinion polls have been showing lower risk of Marine Le Pen winning the presidential election in May. This trend has helped to narrow the yield spread between French and German government bonds, a reflection of that perceived diminished risk. But polls got Brexit and Trump wrong, so should we really trust them now? Greek yields have also been widening again, highlighting the risk that the promised funding for Greece as a quid pro quo for some difficult structural reforms does not follow the same path as it did for Ireland and Portugal.
Europe is not the only question mark. South Korea may be in the midst of political transition. President Park Geun-hye was impeached in December and removed from office, and the prime minister is now serving as president until an election scheduled for May. Leading the polls is an opposition candidate who would take a different, more conciliatory approach with North Korea than the current government. In Japan, Prime Minister Shinzo Abe is now mired in controversy surrounding a government land grant to a planned school at which his wife served as honorary principal.
As we begin the second quarter, we start the clock ticking on the two-year countdown to the United Kingdom's exit from the European Union. In a recent investor forum, former British Prime Minister David Cameron said that while he was optimistic that both sides would behave in an economically rational manner, they had to get the politics right for that to be the case. Both sides need to be able to demonstrate to their constituents a clear "win" in the outcome. Any grandstanding or antagonizing could jeopardize a good deal, and a bad deal would certainly be capable of stomping out the green shoots that appear to be taking hold in the European economy.
Politics will also continue to dominate the headlines in the United States as Congress in April approaches the end of the continuing resolution passed last December to keep the government funded. It will be important to continue to monitor the Republican party for signs of fracture between the establishment, moderates, and fiscal hawks. After the health-care mess, intra-party turmoil could make advancing other agenda items more difficult.
So while the economy's stronger pulse gives us confidence of a continued earnings recovery in several areas — particularly financials, materials, and large multinationals — we have concerns about all risk assets for the time being while we evaluate how some of these big global policy issues are likely to play out. We expect to see better entry points in the near future.