Investor Roundtable | May 5-11, 207 | Vol. 18.8
By Josh Molina
1) What does the new administration mean for the investment markets?
• Tharakan: If the new administration can implement its pro-growth policies – tax cuts
and reduced regulations – the markets will respond very favorably. However, the administration must be careful to not add to the already high federal debt levels.
• Madlem: Putting aside the cacophony of Animal Spirits, Trump Trade, Trump Bump, valuations, interest rates, the dollar, massive passive investing, debt burden, regulatory reform, tax overhaul, ACA repeal and replace, aggressive fiscal stimulus, we find that earnings momentum is currently bullish, but may reach unsustainable levels in the next two quarters, especially if just tax cuts from the above list fail to materialize. Prudent investors should favor companies that keep their cash.
• Swalley: At Arlington, we believe the new Administration will lead to increased volatility in the investment markets. The past five years have seen record low market volatility. The U.S. is now entering the late stages of the economic cycle, with the Federal Reserve continuing to raise short term interest rates. When coupled with the administration’s promises of increased spending on infrastructure and defense, and short term lowering of tax revenues, the resulting increase in deficits and thus overall debt in the late stage cycle imply more market volatility both to the upside and downside as the next recession approaches.
We are also concerned that the administration’s lack of governing experience will add to the volatility of the next recession cycle.
• Lowenstein: Markets have been incredibly resilient in the face of unending policy uncertainty and geopolitical risks. The learning curve for the Trump administration was always going to be steep given its outside- the-beltway experience. However, despite some unforced errors, investors remain sanguine and continue to discount the idea that productive fiscal stimulus policies will be enacted to replace waning monetary stimulus in accelerating economic growth beyond the 2 percent growth rate that we have seen this cycle.
To the extent positive reforms are undertaken to remedy vexing issues surrounding healthcare, tax policy and counterproductive regulations, this could unshackle unnecessary burdens holding back our growth potential, lengthen the business cycle and drive higher corporate earnings power. Our concern had been that markets became too optimistic on what can be accomplished.
Expectations were ahead of political reality, yet markets haven’t fully recalibrated, still pricing in the potential positives while overlooking the risks involved, not to mention uncertain impact surrounding new polices on protectionism, trade, and immigration.
• Frigon: If the Trump administration can deliver on tax reform and regulatory reform (which appears to have begun in some areas), then the markets will likely continue to respond very favorably. More importantly, this would open the capital markets to business formation in ways we have not seen in the 21st century.
The difficulty in gaining venture capital financing and ultimately the dearth of IPOs has severely held back progress in ways most investors don’t even realize. Besides holding back innovation and new products that come from it, the lack of options for new business in which to invest has been a roadblock for investors.
2) What sectors in the region should investors keep an eye on in 2017?
• Tharakan: Technology and health-care are probably the best positioned to respond to favorable tax treatments.
• Madlem: Based on current trends we see opportunities in Technology, Energy (yes, despite the oil ‘glut’), and industrials. Should the high reward-to-risk Energy trade prove otherwise in the next several weeks we would move the overweight to Consumer Discretionary.
• Swalley: Investors should keep a careful eye on rising interest rates. The normal late economic cycle rise in inflation, wages, and rates will have an impact on real estate valuations as borrowing costs increase.
The slower the increase of rates over time, the easier it will be for the market to absorb and adjust to the economics of higher rates. Innovative technology is another important area for the region. Arlington is seeing rapid growth in business valuations as investors search for high growth opportunities for capital deployment. Many local businesses could benefit from the late cycle search for return. Naturally, timing will be key in taking advantage of this trend, before the funding cycle dries up when the cycle turns.
• Lowenstein: Given the recent pullback in the pro-cyclical reflation areas of the market, we favor the reflation theme areas geared towards an improving economy over the defensive bond proxies based on improving fundamentals and compelling relative valuations. We saw these areas soar higher after the election only to give back most of the gains recently on a reset of elevated and perhaps unrealistic fiscal policy expectations.
There is an attractive opportunity to capitalize on fickle and constantly shifting investor sentiment based on headlines out of Washington. This would include pockets of technology, financials, industrials and energy sectors, however, investors must be selective, discerning and valuation disciplined to be successful.
We also favor international markets over domestic markets which are leveraged to ongoing favorable trends including central bank stimulus, cyclical economic rebound, and an earnings recovery still in its early stages and cheaper valuations.
• Frigon: Optical networking, Software-as-a-Service and bio-medical are the key areas of interest for us and this region has exposure in each of those spaces. While SaaS has been well-recognized in recent years, and rightfully so, the core technology sectors have not been as highly emphasized in this era that has seen investors become enamored with “apps.” We think this is changing.
3) What is the future of interest and mortgage rates in 2017?
• Frigon: We don’t predict interest rates but believe interest rates will likely continue to rise in 2017 as the Fed tries to get out from behind the curve with respect to unwinding their loose policies enacted in the wake of the 2008-09 financial crisis. If the economy should accelerate from its very slow growth of the past few years, the pace of interest rate increases could be faster and end up higher.
• Lowenstein: Our expectation is that rates are in the process of normalizing with the Fed more outcome dependent than data dependent, meaning their intention is to remove accommodation by raising rates and ultimately shrink their massive balance sheet in a passive, orderly way.
At this point, simply continuing on the same accommodative path has much risk as it can incentivize risky behavior, poor capital allocation decisions, and cause asset bubbles. Gradual unwinding of monetary stimulus will place upward pressure on rates across the yield curve, so we think the 10-year treasury ends 2017 around 2.75 percent and ends 2018 at 3 percent.
• Swalley: A third of the way through 2017, Arlington sees high probabilities that the Federal Reserve will continue on its path of raising short term interest rates.
Longer term rates, and thus mortgage rates, have been static so far this year, and how they progress over the year will be dependent on the rate of GDP growth, inflation expectations, and wage growth. The U.S. is approaching full employment as the unemployment rate approaches 4 percent, which implies wage growth acceleration as employees leverage business needs for expansion and growth. If the data continues to bear out these trends, we should see higher long term rates and mortgage rates by year-end.
• Madlem: Did you refinance your mortgage in 2016? If not, you might regret it. Mortgage rates ended 2016 at their highest levels since 2014, capping the end of a refinancing boom. After the election we saw mortgage rates rapidly rise to above 4.25 percent. They are expected to keep rising, but slowly, in 2017.
The Mortgage Bankers Association predicts that the 30-year fixed-rate mortgage will continue to rise gradually over the year, averaging 4.7 percent in the fourth quarter of 2017. The National Association of Realtors expects the 30-year fixed to be around 4.6 percent at the end of this year.
• Tharakan: Velocity of money continues to decline and therefore we expect rates to stay subdued through the rest of the year. I expect loan growth of 2 percent in the first quarter of 2017.
4) How will China’s trade deficit affect the U.S. markets?
• Frigon: We only believe trade deficits affect the markets if politicians try and do things to eradicate them. And that usually is a negative for investors. While most “trade agreements” are not really “free trade” agreements (in that they leave all kinds of subsidies and “protections” in place) we favor any progress being made to open all markets around the world whether it be China or any other country.
• Lowenstein: China’s trade surplus will likely persist for the foreseeable future but will diminish gradually due to a strengthening currency and narrowing of the unit labor cost advantage.
The underlying driver is we spend and invest beyond our present savings and investment capacity. Recently, the Chinese have relaxed the Yuan’s peg to the U.S. dollar, part of an evolutionary shift given their sheer economic size and maturity as well as outside political pressure.
Overall, the U.S. has benefitted from this symbolic relationship in the form of lower import prices but at the cost of certain manufacturing jobs. Equally important, the trade deficit with China has the benefit of recycling those dollars back into the U.S. financial assets, keeping U.S. interest rates lower than would have otherwise been the case.
• Swalley: China’s trade deficit is growing as many of its trade partners in Southeast Asia have lower production costs. We think the Chinese shift to emphasize consumer consumption is a result of their government recognizing this trend. Increases in cost of Chinese production have also slowed the rate of growth of the U.S. trade deficit with China.
We don’t see a substantial impact to U.S. markets as a result of these natural economic shifts. U.S. companies will find other cheaper Asian production partners, or bring production back to North America, where manufacturing costs are becoming much more competitive.
• Madlem: China’s trade deficit affects their market much more than ours. U.S.-China trade has about four times the impact on their GDP relative to U.S. GDP.
The political differential is even greater — a slight slowdown in U.S. growth will hurt politicians’ poll ratings.
In China, a slowdown can mean the literal end of a politician’s career and possibly actual revolution in the streets.
This is a key reason why Trump was so willing to rattle (trade) sabers and why China is doing somewhat more to rein in North Korea.
• Tharakan: We do not expect the trade deficit to affect the markets this year unless the administration brings trade sanctions against China. Sanctions could spur a countervailing response from the Chinese leading to an all-out trade war, in which case all sides will lose.
5) Would you please forecast the S&P 500 level and 10-year treasury interest rate at year’s end?
• Tharakan: Dow Jones at 18,500, S&P 500 at 2,150 and 10-year at 1.95 percent.
• Swalley: Arlington Financial does not make short-term forecasts of specific future market results. Generally, if the current trends of continued economic growth continue, we think interest rates will work their way higher, and stock prices will benefit as the year goes on.
We are early in the Federal Reserve interest rate hiking cycle, and stock prices historically have risen during these periods. When the Fed rate rising cycle ends, recessions and market declines become much more probable. Arlington doesn’t see that happening this year.
• Frigon: We don’t know where the S&P 500 or interest rates will be at the end of the year, and make a point not to make such predictions.
In our shop, we focus on buying great businesses and fortunately we have been able to do that successfully for decades by only looking at what we think each of our businesses can do in their specific space, in the future. We think far too much emphasis is put on “guessing” where the market will be at some future date and that this ultimately does a disservice to investors.
• Lowenstein: The high end of our target range for the S&P 500 in 2017 is 2425 while our expectations for the 10 year Treasury is to be about 2.75% at the midpoint.
• Madlem: A reasonable price target for the S&P 500 index is 2450, which translates to bottom-up earnings of around $131 per share, and a P/E multiple of just over 18 times. We expect bond yields to continue a process of normalization taking yields modestly higher as sustainable economic growth reasserts itself. If the 10-year rises above 2.6 percent, it’s time to take notice. Above 3.1 percent would signal a bond bear market.
6) Final thoughts?
• Tharakan: The market has run up this year in anticipation of promised tax cuts and regulatory relief. The market may correct if these promises do not materialize in short order.
• Madlem: It has become ever more apparent that it is far better to have a less elegant model for the real investment world than an elegant model of an imaginary investment world. Long-term investors should seriously consider systematic risk control for their portfolios.
• Swalley: Today, we see many wild cards in the investment landscape, both positive and negative. Most of the short-term noise of daily headlines will try to shake investors out of their long-term investment strategies.
We are advising patience and focus on the economic fundamentals driven by innovation and global growth as economic cycle matures. More vigilance will be required in this environment to make good decisions, but we do think there are still excellent opportunities to make good investments over the near term.
• Lowenstein: As the Fed normalize rates and its balance sheet, volatility and performance dispersion will rise and correlations will fall. Active management will find the market conditions much more fertile in the search for mispriced asset classes than recent times as governments role in stabilizing markets diminishes.
Basically, its role as not only referee but as a player on the field has distorted markets, suppressed volatility and inflated asset prices indiscriminately across the board. Investors should be prepared for different market conditions going forward, focusing on risk adjusted returns and emphasizing downside risks relative to upside potential.
• Frigon: We are more encouraged than we have been in some time at the prospects for businesses and the economy, if some of the proposed policies are enacted.
Perhaps the most important of those policies, and most overlooked, is regulatory reform. We speak to businesses in every sector and of every size in our investment endeavors, virtually all of them state that the enormous burden put on them from the regulatory environment thrust upon them in the last ten to fifteen years has been stultifying. And the smaller the business, the more burdensome these regulations have become.