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Capital Markets Outlook  |  Q4 2017

Goldilocks environment to persist, but valuations limit upside

Global allocation insights


  • The market has learned to take geopolitics, and even North Korea, in stride.
  • Any benefit to stock prices from tax cuts might be disappointing.
  • Watch and wait for the effects of central bank balance sheet unwinding.

Asset allocations chart

Despite a very brief spell of volatility in August triggered by American and North Korean saber rattling, global equity markets and risk assets have continued to enjoy a stress-free year. The VIX Index, which measures market volatility, briefly touched 17 (its intraday high of the year) on August 17, but then quickly settled back into the low teens, where it has resided for most of 2017.

We believe August volatility receded quickly for two main reasons. First, markets have been trained to dismiss geopolitical risk ever since the Brexit vote in June 2016. Second, there is suddenly a bit of renewed optimism around the potential for meaningful corporate tax reform in the United States.

However, neither of these reasons gives us particular comfort when we think about allocations to equities and other risk assets for the coming quarter.

An accident could trigger conflict in Korea

The amped-up rhetoric regarding North Korea's nuclear weapons program is not particularly troublesome in and of itself, but the continued pace of missile tests and the actual firing of ICBMs over neighboring countries' airspace create the possibility, even if remote, of accidents happening. Nate Silver's FiveThirtyEight website recently posted a sobering article written by Oliver Roeder exploring the game theory of a nuclear standoff: "By talking tough, the Trump administration knows, or should know, that there's a higher chance of an accident — that some radarman in Pyongyang will sound the alarm at the first hint of a possible attack ... In many game theoretic models, nuclear war only ever happens by accident." Using the phrases "nuclear war" and "by accident" together in the same sentence about a live situation doesn't really seem consistent with the VIX remaining in the single digits.

Tax cut expectations have not affected portfolios of high-tax and low-tax stocks

What tax cuts could mean to equities

As we wrote at the beginning of the year, a substantial cut in the effective corporate tax rate would have a positive impact on U.S. equity prices. More recently, many market commentators have suggested that there is virtually nothing priced into current market levels regarding tax reform or even tax cuts. We have a hard time believing that.

What equity prices suggest about tax-cut expectations

It stands to reason that stocks of highly taxed companies would react more significantly to prospects for lower rates, and so we studied stock prices of companies that pay high rates and compared them with companies that pay low rates to discern whether optimism for tax cuts has had an impact on relative performance. With awareness that isolating companies in the equity market based on effective tax rates is fraught with data challenges, we ranked companies in the Russell 1000 Index by tax rate and isolated the top and bottom 20% of companies (by number). We could then analyze a portfolio that is long high-tax stocks and short low-tax stocks.

Such a portfolio includes some interesting tilts in risk factors and industries, even while the overall beta to the equity market of the two baskets is essentially equal. We found that it would also include industry group overweights to energy, Internet, and health-care providers, along with underweights to REITs and biotechnology stocks. It would also have substantial risk factor tilts; namely, this long/short portfolio would be tilted toward companies that are larger and more profitable, and that yield lower dividends.

Given the industry dispersion and the divergence between large-cap and small-cap stocks in year-to-date performance, trying to use this bottom-up analysis to glean any insights regarding the probability of a favorable tax reform deal in Washington yields murky results at best. In any event, even controlling for these biases, it was very hard to detect any movement relative to the overall volatility in the long and short quintiles around the time of the November 2016 presidential election. If the date of the election were not displayed at the bottom of the chart on the previous page, it would be hard to identify it based on the move in these portfolios alone.

Business leaders show greater optimism

We think a better indicator of how much optimism there is regarding tax reform continues to be the elevated level of the NFIB Small Business Optimism Index: It has sustained its multi-decade highs since the election. This is corroborated by the continued high level of the CEO Confidence Index — as published by Chief Executive magazine — which likewise skyrocketed in the immediate aftermath of the election.

The optimism for tax cuts is easiest to see in surveys of CEOs

Ultimately, we may see something positive on the corporate tax front, but there is a risk that whatever is enacted will have only a modest impact on stock prices.

Stocks are drifting as central banks drain liquidity

In the meantime, the major global central banks in aggregate have started the process of balance sheet normalization. It began with the Fed, and soon the European Central Bank (ECB) is also likely to provide clarity on winding down its asset purchase program. The Bank of England has recently sounded hawkish notes as well, leaving the Bank of Japan as the sole major monetary authority with a foot still on the accelerator. The following chart shows the aggregate balance sheets of these four major central banks relative to the combined GDP of their respective countries.

Given the substantial uptick in the growth rate of the liquidity backstop during 2015 and 2016, it is hard to imagine that the simultaneous growth in short volatility strategies is unrelated.

Of course, the lack of realized volatility is part of the story. However, given the current message of caution coming from most of our forecasting models, we feel that the impending announcements of active central bank balance sheet reduction is worthy of our attention. We will know soon enough whether this bull market is self-sustaining without the help of ever-growing liquidity. Also, given the reasonably high year-over-year earnings comparisons that companies will be facing at the beginning of 2018, the cost of waiting is relatively low.

Central banks have slowed balance sheet growth and Markets are short volatility charts


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The market appears to have little confidence in tax reform, and little concern about North Korea or Fed policy.