As we close the books on the holiday season and begin looking forward to what 2017 might hold, I always enjoy reflecting on what’s happened in the world over the last 12 months. Not only for nostalgic reasons, but also to better understand the current state of the markets & how we got where we are today. I find that using such context always seems to help make sharper investment decisions over the upcoming year.
And looking forward to 2017, there are three themes I see as important for investors to follow. First, how the U.S. economy will respond to President Trump’s fiscal policies (however they’re implemented). Second, the growing populist sentiment in Europe, as we saw in the Brexit and more recent Italian referendum. And third, the increase in internet security breaches and how nations and corporations will respond.
The big economic news of the week comes from the most recent meeting of the Federal Open Market Committee. It was widely expected that the committee would decide to raise short-term interest rates from 0.50% to 0.75%. The committee did indeed decide to hike as the markets expected, but also increased its 2017 forecast, from two rate hikes next year to three. This is a jump in the committee’s expected trajectory of rate increases, and tells us the Fed believes we’ll see more economic growth and potential some inflationary pressures.
In the press conference immediately following the announcement, Fed chair Janet Yellen indicated that some of the committee members incorporated Donald Trump’s expected fiscal policies in their rate projections. While we don’t know exactly how his policies will evolve after “running the gauntlet” in Washington, I think we can safely expect a more lenient tax structure. Along with potential revisions in trade deals, it’s clear that the committee expects the economy to pick up steam and that inflation will follow.
Alongside the Fed’s decision and forecast, consumer confidence and investor confidence are both up since Trump’s surprise election win. The relevant term here (in investment speak, at least) is “animal spirits”. With the expectation of a more business friendly environment, the public generally tends to grow bolder and increase risk-taking activities. We often see this play out with more business starts, banking activity, and a pop in the stock market. While we don’t’ have business starts or banking data yet, we’ve already seen a nice pop in the stock markets, which we’ll discuss shortly.
From my perspective, this kind of fiscal policy should be a shot in the arm to the economy. There are still reasons to be cautious though - some of which are the same reasons many voters were reluctant to vote for Trump in the first place. His protectionist viewpoints and potential tariffs could easily harm international trade, and there’s the lingering concern that his approach to foreign relations is a major geopolitical risk.
The U.S. Dollar
Alongside the stock market rally and expectations for economic growth, the U.S. dollar has strengthened since the election. Typically there are three reasons the dollar might strengthen. First, since the dollar is the world’s reserve currency it can be used as a flight to quality. When international investors are fearful of what’s happening globally or in their home country they may seek safety by purchasing more “stable” U.S. dollars.
A stronger dollar can also be a vote of confidence too. If economic prospects are better in the U.S. than they are elsewhere in the world, investors around the globe might want to take advantage of the opportunity (think “animal spirits” here) by purchasing U.S. dollar. Along the same lines, if the economic prospects are better here in the U.S., interest rates are likely to be on the rise. Fixed income investors looking for yield may want to buy dollars in order to capture soon-to-be-higher rates. While we rarely have a concrete reason why the dollar strengthens or weakens, my sense is that the recent rally’s been fueled by a combination of all three. The global economy is pretty dreary in many areas, making U.S. assets an attractive offshore option for many. With all the strife occurring in the Middle East, mass exodus to the EU, and speculation that China’s debt fueled expansion may be slowing, the U.S. dollar is also the best & most stable currency for many international investors.
Britain’s decision to leave the European Union over the summer was a harbinger of growing populist sentiment throughout Europe. I won’t rehash what Britain’s exit could mean for the economy (see Investment Insights from 7/1/16 for commentary), but frustration with the state of the EU’s economy seems to be growing. Italy’s referendum in December was a resounding move towards populism, and if another major country departed from the EU it would leave many to wonder whether the organization can still survive.
After the presidential election results here in the U.S., we’ve learned to be skeptical of polls. Even so, early data indicates that other exits are unlikely. The next two European elections coming up are France’s in May, and Germany’s beginning in August. Polls in France and Germany both show that citizens are resoundingly against leaving the European Union in any capacity. And in Germany, Angela Merkel’s party currently has a 10-point lead over establishment opposition, and a 20-point lead over anti-establishment opposition. In short, despite the growing sense of frustration it seems unlikely that we’ll see another major economy leave the EU in 2017.
U.S. Fixed Income
The higher risk fixed income asset classes here in the U.S. performed exceptionally well in 2016. With unemployment low and the economy steadily gaining ground, defaults from high-yield corporate debt and bank loans remained consistently low.
Looking ahead, the fiscal stimulus coming from a Trump white house should continue to bode well for corporations across the country, and certainly the higher risk sectors. However, the spread of higher risk credits over U.S. treasury securities is somewhat slim, meaning that markets aren’t compensating investors much for taking on the additional risk.
The interest rate landscape here in the U.S. is a pretty consistent theme across the markets right now. And since longer dated fixed income securities are particularly susceptible to rate increases, preferred stocks fall into the same boat. Preferred stocks (even though they share the name “stocks”) are really fixed income securities. They fall above equities in the capital structure, but below more traditional corporate debt. This means that if a company ever enters bankruptcy proceedings, corporate debt owners are repaid first, then preferred stockholders, and then common equity shareholders.
The important point to remember about preferred shares is that they typically have very long (if any) maturity dates. This means that when you buy a preferred stock it’s usually to capture the yield, since you won’t get your principal investment back for many years, if at all.
Because of the longer maturities, preferred stocks have significant duration, or interest rate risk. And since we’re expecting a rise in interest rates as the economy picks up steam over the next several years, preferred stocks should be considered a high risk asset class.
In fact, preferred shares were hit hard by the sharp rise in Treasury yields over the second half of 2016. Since mig-August, the BofA Merrill Lynch Fixed Rate Preferred Securities Index has fallen 7.6%, to its lowest mark since March of 2014. Over longer time horizons the high coupons often offered via preferred securities will certainly make up for near term interest rate risk. But for investors with shorter time horizons preferred shares hold a substantial amount of risk.
It’s rare that I get through an entire edition of Investment Insights without at least mentioning the emerging markets. And surprise surprise, this edition will be no different! Emerging markets are an asset class with one of the highest risk/return propositions. Emerging economies have a huge opportunity for outsized growth and investment returns, but will also experience growing pains and large, irregular corrections.
Up until 2016, the emerging markets as a whole (using the MSCI Emerging Markets Index as a proxy) have been negative in each of the last three years, and in five of the last eight since the financial crisis in 2008. The slump finally ended in 2016, with the index gaining 8.5%.
Volatility in the emerging markets normally translates to inconsistent corporate earnings. But over the last three years earnings per share have started to stabilize, thanks in part to a rally in commodities over the last 12 months. Many countries in the emerging markets are closely tied to commodities prices, and with oil & gas and mined metals surging, it’s no surprise that 2016 was a strong year for the index. Looking ahead, the rally could continue with more strength expected from commodities & metals.
The emerging markets are also attractive from a relative valuation perspective. The MSCI Emerging Markets Index’s P/E ratio currently sits at a reasonable 14.6, which is below its long term average.
Commodities are not invulnerable though, and emerging economies will always be susceptible to political risk. Just in 2016 we saw corruption scandals in Brazil and South Korea, where presidents Dilma Rousseff and Park Geun-hye were both impeached.
Finally, Chinese government debt continues to grow unabated. Borrowing and spending to fuel economic growth is tricky business (and something we’re quite familiar with here in the U.S.), where taking the foot off the gas pedal at the perfect time is imperative. Borrow & spend too much and inflation can spiral out of control, while braking too early could squash any forward momentum. Coupled with the possibility of another yuan devaluation, the risk of a hard landing in China is greater today than it was 12 months ago. Such an event would be very hard on the emerging markets, and would ripple across the entire global economy.
Commodities prices across the board saw sizable gains in 2016. Mined commodities like coal, iron, and copper all had large spikes in price, largely thanks to China’s debt-fueled stimulus. Approximately 80% of China’s steel is used for investment-oriented activity, making steel and its inputs particularly sensitive to the country’s fiscal policies. With “all systems go”, there is a huge demand in China for such metals.
Oil prices have also jumped after several lagging years. WTI Crude Oil, which began the year at $37.04 per barrel, ended 2016 at $53.72 / barrel, for a gain of 45%. After 8 years of consistent oversupply, OPEC finally agreed to cut production and stabilize oil prices in late November. The agreement will remove more than 1 million barrels of oil from world markets per day. Today OPEC accounts for about a third of global oil production, and this cut signifies about a 3% drop in the group’s daily yield.
Morningstar believes OPEC’s move will cause a meaningful supply deficit in 2017, boosting prices further. But longer term the company’s analysts don’t think it’ll make much difference in the world’s supply and demand dynamics. During the supply glut over the last several years, many shale producers here in the U.S. were forced to go offline and basically walk away from fully operational production facilities. As prices stabilize it won’t take long for them to get the rigs running again.
As prices stabilize and it again makes economic sense, production capacity here in the U.S. will likely replace what was lost from OPEC’s reduction. We’ll likely see a nice rise in oil prices again in 2017. But beyond that any lost supply will probably be easily replaced, meaning our longer term outlook shouldn’t change.
With interest rates at rock bottom lows since the financial crisis, a very popular investment strategy over the last several years has been buying shares with high or increasing dividend yields. For income oriented investors, dividends can be a good way to replace lost income from depressed interest rates. Plus, they’re even taxed favorably when they’re considered “qualified” dividends in the eyes of the IRS.
In fact, this strategy has been so popular that shares of companies that pay stable, decent sized dividends have surged in the last several years to the point of being overvalued. Looking ahead, they could be in for a “mean reversion” slump as interest rates start to creep back up to historic norms.
To reinforce this view, Charles Schwab Investment Management rates all the sectors that comprise the S&P 500 on a continuous basis. Currently, the only two sectors rated “Outperform” are Financials and Technology, whereas the only two sectors rated “Underperform” are Telecom and Utilities. Not coincidentally, the Telecom and Utilities sectors are both known for paying high & consistent dividends, and are two of the three sectors with the highest dividend yields in the entire index.
Today, consistent dividends are expensive and investors will be better off looking for short duration fixed income securities. With the Federal Reserve poised to raise short term rates another three times in 2017, yields on these securities will shortly start to rebound. They also come without the interest rate risk of longer dated bonds & preferred stocks, or the high valuations dividend paying stocks.