Global equity markets saw strong gains during the third quarter as global economic growth
strengthened. All 45 countries as tracked by the OECD (Organization for Economic Cooperation and
Development) are set to grow this year. This is very rare as there are usually a few countries or regions
experiencing economic contraction. The Canadian bond market posted negative returns as the Bank of
Canada twice raised it policy interest rate.
The two interest rate increases lifted short term rates from 0.5% to 1.0% and shifted the entire yield
curve upward. As an example, the ten year government of Canada bond yield moved from 1.75% to
2.1% during the quarter. As bond prices are inversely correlated with bond yields, the rise in interest
rates led to a decline in bond prices and negative bond returns.
This move was not a surprise to us at Condor and client's holdings were positioned accordingly. Client’s
fixed income holdings positively contributed to overall returns during the quarter as portfolios were
constructed using shorter duration bonds. Shorter term bonds were less impacted from the rate
increases than longer term bonds.
While we remain cautious on bonds due to their low yields, it is unlikely that Canadian interest rates
will rise in the near term. The Bank of Canada is moving to a more data dependent stance relative to
inflation and has signaled that they are more guarded about future rate increases.
The US stock market gained 4.0% during the third quarter. The rally was characterized by small
incremental daily gains resulting in multiple record highs with no big declines. We were a little
surprised by the lack of volatility. It was the economically sensitive sectors (financials, industrials and
energy) that powered the market move. Somewhat coincidentally these are among the cheapest
sectors in the market. The staples and utilities sectors which are historically expensive and not
economically sensitive, lagged.
Canadians investing in the United States also need to factor exchange rates when determining their US equity returns. With the recent weakness of the US dollar (-3.6%), Canadian dollar returns from US
stocks were virtually zero during the quarter. We believe this year's Canadian dollar rally has run its
course. The Canadian dollar has retreated from its recent highs as the Bank of Canada will proceed
more cautiously with respect to future rate increases.
The Canadian stock market gained on the strength of financial, energy and commodity stocks.
Financials benefited from rising interest rates while higher oil prices were the primary driver for energy
stocks. A less aggressive interest rate stance from the Bank of Canada and a short term peak in oil
prices will hinder future Canadian stock gains.
Our outlook remains unchanged. Bonds should at best provide coupon like returns in a world where
interest rates are projected to be flat to up. Rising rates will pressure longer duration bond prices.
Stocks should provide returns that are in excess of bonds, although with a higher degree of volatility.
While stocks are not cheap, the global economy is experiencing synchronized growth. This bodes well
for continued corporate earnings growth, which is the primary driver of stock prices.
By providing strategic portfolio diversification, Condor's client returns have significantly outperformed
Canadian stock and bond markets over the last five years. As always we welcome your thoughts and
comments.
Tuesday, October 17, 2017
Monday, July 24, 2017
Second Quarter Commentary
Accelerating US corporate earnings growth lifted US stock prices while the Canadian stock market
declined. Stock gains should continue in the US and resume in Canada. The corporate profit outlook
remains encouraging and there are no signs of a recession.
The yield curve (a graph of bond yields plotted against their time till maturity) is typically relied upon to provide signals of an impending recession. A normal yield curve (where short-term interest rates are lower than long term interest rates) is a sign that the economy is still growing. An inverted yield curve (short term rates higher than long term rates) typically signals the onset of a recession. Short term interest rates are currently lower than long term rates (albeit a little flatter than normal) signalling that we are not on the cusp of a recession.
Excesses in the economy (i.e. inventories) can also lead an economy into a recession but there are no obvious economic excesses. The fed dot plots (a prediction of future interest rates by the open Market committee members) are showing a steady, yet measured pace of interest rate hikes. If members of the Open Market Committee have recession concerns, they would not be forecasting a gradual increase in interest rates.
Global PMI's (Purchasing manager Indexes) are currently in the low 50's. Anything above 50% indicates an expanding manufacturing sector. Global economic data suggests that the global economy is experiencing synchronized GDP growth. The International Monetary Fund (IMF) recently raised its forecast for global growth from 3.3% to 3.5% for 2017. They also see a slight acceleration in growth in 2018 to 3.6%. While these growth rates are less than they were before the financial crisis, most regions are contributing to this growth. As 40% of S&P 500 revenues and revenues and profits are linked to overseas economies, global growth will provide a boast to US corporate earnings. This will be most pronounced in the technology, healthcare, and industrial sectors, as they are most exposed to non-US markets. An expanding global economy is typically positive for stocks. US stock gains have benefited from both earnings growth and an expanding price / earnings multiple. Valuations can be justified based on accelerating earnings growth and future earnings projections but they are not cheap based on current earnings. Although there is no indication that the market has peaked, it will likely be more difficult to make large gains from these levels by investing in stocks. We are not predicting a market decline, but we believe it is prudent to be more cautious.
The Canadian stock market dynamics are vastly different from the US stock market. While technology, Healthcare and industrial sectors should benefit from their large foreign exposure, the Canadian market has limited exposure to these sectors. The financial sector, the largest sector in the Canadian stock market, lagged due to a moderation in interest rate expectations. With the Bank of Canada hinting at rate increases through the end of the year, the bank stocks are poised to rebound. Declining energy prices has depressed the energy sector, which is the second largest sector in Canada. Any stabilization or rebound in oil prices would provide a lift to investor sentiment and stock prices.
Although bonds ended the quarter on a sour note, they still managed to post gains for the quarter. The Bank of Canada is moving to a less accommodative stance. Rate increases will be gradual, but the direction of rates is clearly up. Rising interest rates will pressure bond prices in the near term. Longer term we believe bonds will provide investors with low single digit returns that are consistent with their coupons. We view bonds as a stable repository for portfolio assets, whilst acknowledging their potential to reducing overall portfolio returns as interest rates rise. Our client’s portfolios are positioned in shorter duration bonds, mitigating the impact of rising rates.
We continue to prefer equities over bonds but plan to trim equity positions as stocks continue their push to new heights. This is a tactical decision to boost client cash positions to opportunistically take advantage of any stock price weakness. As the Fed is beginning a tightening cycle, greater volatility is to be expected.
By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. Please refer us to your colleagues or friends who may be looking for a personalized investment service. As always, we welcome your thoughts and comments.
The yield curve (a graph of bond yields plotted against their time till maturity) is typically relied upon to provide signals of an impending recession. A normal yield curve (where short-term interest rates are lower than long term interest rates) is a sign that the economy is still growing. An inverted yield curve (short term rates higher than long term rates) typically signals the onset of a recession. Short term interest rates are currently lower than long term rates (albeit a little flatter than normal) signalling that we are not on the cusp of a recession.
Excesses in the economy (i.e. inventories) can also lead an economy into a recession but there are no obvious economic excesses. The fed dot plots (a prediction of future interest rates by the open Market committee members) are showing a steady, yet measured pace of interest rate hikes. If members of the Open Market Committee have recession concerns, they would not be forecasting a gradual increase in interest rates.
Global PMI's (Purchasing manager Indexes) are currently in the low 50's. Anything above 50% indicates an expanding manufacturing sector. Global economic data suggests that the global economy is experiencing synchronized GDP growth. The International Monetary Fund (IMF) recently raised its forecast for global growth from 3.3% to 3.5% for 2017. They also see a slight acceleration in growth in 2018 to 3.6%. While these growth rates are less than they were before the financial crisis, most regions are contributing to this growth. As 40% of S&P 500 revenues and revenues and profits are linked to overseas economies, global growth will provide a boast to US corporate earnings. This will be most pronounced in the technology, healthcare, and industrial sectors, as they are most exposed to non-US markets. An expanding global economy is typically positive for stocks. US stock gains have benefited from both earnings growth and an expanding price / earnings multiple. Valuations can be justified based on accelerating earnings growth and future earnings projections but they are not cheap based on current earnings. Although there is no indication that the market has peaked, it will likely be more difficult to make large gains from these levels by investing in stocks. We are not predicting a market decline, but we believe it is prudent to be more cautious.
The Canadian stock market dynamics are vastly different from the US stock market. While technology, Healthcare and industrial sectors should benefit from their large foreign exposure, the Canadian market has limited exposure to these sectors. The financial sector, the largest sector in the Canadian stock market, lagged due to a moderation in interest rate expectations. With the Bank of Canada hinting at rate increases through the end of the year, the bank stocks are poised to rebound. Declining energy prices has depressed the energy sector, which is the second largest sector in Canada. Any stabilization or rebound in oil prices would provide a lift to investor sentiment and stock prices.
Although bonds ended the quarter on a sour note, they still managed to post gains for the quarter. The Bank of Canada is moving to a less accommodative stance. Rate increases will be gradual, but the direction of rates is clearly up. Rising interest rates will pressure bond prices in the near term. Longer term we believe bonds will provide investors with low single digit returns that are consistent with their coupons. We view bonds as a stable repository for portfolio assets, whilst acknowledging their potential to reducing overall portfolio returns as interest rates rise. Our client’s portfolios are positioned in shorter duration bonds, mitigating the impact of rising rates.
We continue to prefer equities over bonds but plan to trim equity positions as stocks continue their push to new heights. This is a tactical decision to boost client cash positions to opportunistically take advantage of any stock price weakness. As the Fed is beginning a tightening cycle, greater volatility is to be expected.
By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. Please refer us to your colleagues or friends who may be looking for a personalized investment service. As always, we welcome your thoughts and comments.
Thursday, April 13, 2017
First Quarter Commentary
The post election stock market rally extended its gains into the first quarter. The US economy
continued to gain steam as corporations reported accelerating revenue and earnings growth. Canadian
stock market gains lagged US stock market gains related to weakening oil prices and tepid economic
growth.
The Federal Reserve Board hiked short term rates twice in three months, unusual in this cycle. Despite this, the Federal Reserve Board intimated that there would be additional rate hikes during 2017. The Consumer Confidence Report and the ISM US Manufacturing report have both sent out positive signals with respect to economic growth. The latter report provides an indication of future growth rates for industrial production. Thus, both economic and corporate fundamentals appear to be in good shape.
The Trump agenda continues to dominate the daily news. For the Trump team, winning an election is starting to appear relatively easy compared with governing. President Trump’s hastily conceived healthcare bill, intended to replace Obamacare, did not even achieve a floor vote in the House of Representatives despite a Republican House majority. There is no guarantee that the Trump team will be able to pass legislation and advance their agenda within their original planned timeframe. President Obama required a full year to pass his landmark healthcare bill, even with a filibuster proof Democrat majority in both the House and Senate. Under optimal conditions, governing and getting laws passed can be a messy process.
It is anticipated that President Trump will now shift his focus to implementing his priority policies such as tax reform, deregulation, and infrastructure spending. These initiatives have been the primary catalysts for positive stock gains since the election. Like President Obama before him, President Trump has begun to use executive order to enact laws and ensure his agenda is being carried out. He has used executive order privilege to reverse some of President Obama's environmental regulations. We would not be surprised if he signs more executive orders to move his agenda along.
The President has been talking a good game, but now that he has been in office for over two months, he needs some legislative wins. After losing the healthcare battle, we should expect him to tackle issues where he can successfully move legislation along. Infrastructure spending is an area where there is bi-partisan support. Tax reform can also happen, but the scope of the reformation will be more limited than what was originally envisioned by the President and the Speaker of the House.
Stocks have had an excellent run since the election. It has been a while since stocks corrected and we would not be surprised if this were to occur in the near term. Stocks are not cheap based on earnings but they are fairly valued based on based on book values and dividend yields. Stock market investors have responded positively to the Trump agenda, nonetheless uncertainty related to their ability to pass legislation may trigger market volatility. Corrections are a normal, albeit unpleasant, part of an investment cycle. We continue to prefer equities over bonds but we plan to trim equity positions as stocks push to new heights. This is a tactical decision to boost client cash positions to take advantage of any weakness in stock prices.
Canadian Bonds have provided investors with low single digits returns over the last couple of years. With no upcoming change in interest rates, bond returns will remain anemic. Accelerating growth in the US economy may lead to an increase in interest rates with a potential for further dampening of bond returns. The clients of Condor Asset Management are largely invested in shorter term bonds, limiting their exposure to interest rate fluctuations. We currently view bonds as a stable repository for portfolio assets, whilst acknowledging their potential for reducing overall portfolio returns.
By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. We look forward to welcoming new clients. Please refer us to your colleagues or friends who may be looking for a personalized investment service.
The Federal Reserve Board hiked short term rates twice in three months, unusual in this cycle. Despite this, the Federal Reserve Board intimated that there would be additional rate hikes during 2017. The Consumer Confidence Report and the ISM US Manufacturing report have both sent out positive signals with respect to economic growth. The latter report provides an indication of future growth rates for industrial production. Thus, both economic and corporate fundamentals appear to be in good shape.
The Trump agenda continues to dominate the daily news. For the Trump team, winning an election is starting to appear relatively easy compared with governing. President Trump’s hastily conceived healthcare bill, intended to replace Obamacare, did not even achieve a floor vote in the House of Representatives despite a Republican House majority. There is no guarantee that the Trump team will be able to pass legislation and advance their agenda within their original planned timeframe. President Obama required a full year to pass his landmark healthcare bill, even with a filibuster proof Democrat majority in both the House and Senate. Under optimal conditions, governing and getting laws passed can be a messy process.
It is anticipated that President Trump will now shift his focus to implementing his priority policies such as tax reform, deregulation, and infrastructure spending. These initiatives have been the primary catalysts for positive stock gains since the election. Like President Obama before him, President Trump has begun to use executive order to enact laws and ensure his agenda is being carried out. He has used executive order privilege to reverse some of President Obama's environmental regulations. We would not be surprised if he signs more executive orders to move his agenda along.
The President has been talking a good game, but now that he has been in office for over two months, he needs some legislative wins. After losing the healthcare battle, we should expect him to tackle issues where he can successfully move legislation along. Infrastructure spending is an area where there is bi-partisan support. Tax reform can also happen, but the scope of the reformation will be more limited than what was originally envisioned by the President and the Speaker of the House.
Stocks have had an excellent run since the election. It has been a while since stocks corrected and we would not be surprised if this were to occur in the near term. Stocks are not cheap based on earnings but they are fairly valued based on based on book values and dividend yields. Stock market investors have responded positively to the Trump agenda, nonetheless uncertainty related to their ability to pass legislation may trigger market volatility. Corrections are a normal, albeit unpleasant, part of an investment cycle. We continue to prefer equities over bonds but we plan to trim equity positions as stocks push to new heights. This is a tactical decision to boost client cash positions to take advantage of any weakness in stock prices.
Canadian Bonds have provided investors with low single digits returns over the last couple of years. With no upcoming change in interest rates, bond returns will remain anemic. Accelerating growth in the US economy may lead to an increase in interest rates with a potential for further dampening of bond returns. The clients of Condor Asset Management are largely invested in shorter term bonds, limiting their exposure to interest rate fluctuations. We currently view bonds as a stable repository for portfolio assets, whilst acknowledging their potential for reducing overall portfolio returns.
By providing strategic personalized portfolio diversification, over the past five years, Condor's clients have enjoyed returns that significantly outperformed the Canadian stock market. We look forward to welcoming new clients. Please refer us to your colleagues or friends who may be looking for a personalized investment service.
Monday, January 16, 2017
Donald Trump Wins!
There is an old saying on wall street “that nobody rings a bell at the top or the bottom of a market”. With the surprise Trump victory it's almost like the bell has rung as we are witnessing one of the most significant market pivots in history. Irrespective of your personal thoughts of President-elect Trumps environmental policies, his attitudes to women and minorities and his behaving like a bully, the recent election is positive for the US stocks.
President-elect Trump promises to lower taxes and reduce the regulatory burden on companies. The hope is that these actions will boast economic growth and unleash pent up consumer demand. Trump has reinforced his commitment to reducing regulations with his initial cabinet choices. Selecting Rex Tillerson as Secretary of State, former Texas governor Rick Perry as Energy Secretary and Oklahoma attorney general Scott Pruitt as head of the EPA signal a friendlier regulatory environment. Strategas Research estimates that there is $48 billion in energy projects languishing due to environmental concerns. These projects should now move more quickly through the approval process.
The banking industry has also faced a progressively onerous regulatory burden as it has been sued for both real and imagined misdeeds. With the US government continuing to levy fines on the banks, banks are effectively being treated as the governments piggy bank. This has become an expensive cost in the financial sector. The government has sued J.P. Morgan for the errors of Bear Stearns, after J.P. Morgan rescued Bear Stearns at the behest of the government and immunized (from lawsuits like this) J.P. Morgan for the violations of Bear Stearns that preceded the rescue. Regulatory over reach has resulted in banks reducing their balance sheet risk by not making loans thereby limiting their typical role of financing economic growth.
The Dodd frank bill of 2010 as originally envisioned was supposed to be a six-page document. It was passed as a 2,000 plus page law with few people having read it prior to its passage. This law has fuelled growth in non-productive (from an earnings perspective) compliance departments. The newCommerce and Treasury secretaries are more pro-business and less ideological than their predecessors. Even if the new government does not reverse President Obama's executive orders, the psychology has shifted as banks will be less fearful of doing the wrong things.
Blackrock’s CEO Schwartzman says that the Trump administration will usher in the most profound regulatory and tax changes that he's seen in 45 years. He says “the changes as a result (of the election) are going to be very substantial in many areas, but particularly in the business community and the financial area. You’re going to have a very substantial reversal in regulations of all types… if you look at the architecture of the financial world, it’s going to change substantially…this is as big a change happening all at once. I’ve been in finance for, I don’t know, 45 years? This will be the biggest. When you have changes like this that are so profound, it’s going to drive higher GDP. It’s going to make the US a friendlier place for foreign capital. And it’s going to have significantly accelerated growth not just for the financial institutions but for the country as a whole. So, this is like very important. It’s very important. And it’s not just about some stocks for financial companies, although that would be a nice thing. It’s much bigger and more impactful over a much longer period of time.”
The US election provided more surprises than just Trump winning the presidency. As expected, the Republicans (GOP) retained their majority in the house but the big surprise was their maintaining
more than half of the seats in the Senate. The GOP senate majority is not filibuster proof, meaning the GOP will need to get some Democratic votes to enact legislation. This should not be arduous if the GOP understands that the key to constructive government and passing sustainable legislation is negotiation and compromise.
One of the meaningful changes that is rarely discussed is the transition in the senate leadership. Harry Reid, the outgoing senate minority leader was an obstructionist, “my way or the highway” type of guy. He was replaced by Chuck Schumer, who is more open to negotiations and getting things done when the two parties are generally in agreement (like tax reform).
During the recent election, the Republicans had the most at risk senators up for re-election. In two years’ time, it will be the democrats who will be most vulnerable to losing seats. (As senators terms are six years, they only run every six years, meaning that only 1/3 of sitting senators are running to retain their seat during an election cycle). The Democrats cannot afford to be obstructionist as the Republican's might pick up enough seats to have a 60 seat, filibuster proof majority. One of the big issues Democrats had in the last election was that Harry Reid brought so few bills to the senate floor for a vote. Democratic senators in swing states were not able to vote on important local issues and demonstrate to voters how their views were differentiated from the leadership of the party.
President-elect Trump will be a president like no other. While President Obama had his blackberry, Trump has his twitter account. This allows him to berate company managements (United Technologies, Ford) or negotiate in public (Boing or Lockheed Martin). We have also seen that the President-elects’s policies can be fluid. This will increase volatility as stock market movements can now be triggered by presidential tweets and increased policy uncertainty.
GDP growth has averaged only 2% during the Obama presidency. The economy is in year eight of a tepid expansion and there is currently no obvious reason to expect an expansion ending recession. The economic cycle has not been overly robust, but it is enduring. Growth should accelerate in 2017, due to lower taxes and a pro-growth environment.
President-elect Trump has discussed corporate tax reform as a primary goal for 2017. There is a high probability this will happen as both parties have agreed it’s a priority. Trump has discussed a 15% rate, while the house GOP plan is closer to a 20% rate. Assuming the new rate is closer to the house version, this would translate into an almost 10% boost to corporate earnings. Repatriation of foreign earnings, increased defense spending and deregulation (especially in banking, energy and healthcare) would all be additive to earnings.
Equity upside will be linked to improving earnings. Current policy neutral earnings (meaning we do not consider potential economic, taxation or regulatory policy changes due to Trump’s victory) growth for 2017 is forecasted to be 6 – 8%. This assumes accelerating revenue growth, neutral margins, and continued stock buy backs. Stocks are not cheap, especially with the move since the election. If the Republicans are successful in making a fraction of their proposed changes, we would expect acceleration in economic growth and corporate earnings. On this basis, the stock market will appear cheap fuelling another increase in stock prices.
The caveat to this rosy scenario is if President-elect Trump is not successful in passing his pro-growth agenda. Growth would then continue along at its recent tepid pace and the stock market would languish at current levels. While both parties have incentives to move proposed legislation forward, passage of these changes is not guaranteed.
While pro-growth policies are positive for US equity markets, they are bearish for bonds. Since the election, there have been record outflows out of bonds into equities. The interest rate on the ten Year US Government bond has risen almost 1.0%. The Federal Reserve Board is discussing two to four interest rate increases in 2017. For the first time since the great recession, investors believe that there is a high probability that this will occur.
Here in Canada, economists continue to forecast an anemic expansion (sub 2%). There are few expectations that the Bank of Canada will raise short term interest rates during 2017. Rates for five and ten-year Canadian government bonds have recently increased, but that is in response to the rate increases seen for similar maturities in US bonds. As US rates increase, Canadian mid to long term bond rates (which are set by the market and not by the Bank of Canada) should also continue to rise. This does not auger well for bond returns in 2017. We have already seen the negative effects rising rates have on bonds, with Canadian bond returns being negative for the latter half of 2016. Bond coupons were not high enough to offset the decline in bond prices due to the rise in rates.
With US economic growth accelerating, and the expected increase in both earnings and interest
rates, we continue to prefer equities over bonds. Those bonds that clients hold are short term in nature and not materially impacted by the recent rise in rates. US equities overall should perform better than Canadian stocks due to better growth dynamics. We expect a heightened level of volatility due to elevated valuations, the uncertainty related to the passage of the new administrations pro-growth agenda and the President-elect being more unpredictable than any preceding president.
Contact us to discuss how to navigate the opportunities and pitfalls.
President-elect Trump promises to lower taxes and reduce the regulatory burden on companies. The hope is that these actions will boast economic growth and unleash pent up consumer demand. Trump has reinforced his commitment to reducing regulations with his initial cabinet choices. Selecting Rex Tillerson as Secretary of State, former Texas governor Rick Perry as Energy Secretary and Oklahoma attorney general Scott Pruitt as head of the EPA signal a friendlier regulatory environment. Strategas Research estimates that there is $48 billion in energy projects languishing due to environmental concerns. These projects should now move more quickly through the approval process.
The banking industry has also faced a progressively onerous regulatory burden as it has been sued for both real and imagined misdeeds. With the US government continuing to levy fines on the banks, banks are effectively being treated as the governments piggy bank. This has become an expensive cost in the financial sector. The government has sued J.P. Morgan for the errors of Bear Stearns, after J.P. Morgan rescued Bear Stearns at the behest of the government and immunized (from lawsuits like this) J.P. Morgan for the violations of Bear Stearns that preceded the rescue. Regulatory over reach has resulted in banks reducing their balance sheet risk by not making loans thereby limiting their typical role of financing economic growth.
The Dodd frank bill of 2010 as originally envisioned was supposed to be a six-page document. It was passed as a 2,000 plus page law with few people having read it prior to its passage. This law has fuelled growth in non-productive (from an earnings perspective) compliance departments. The newCommerce and Treasury secretaries are more pro-business and less ideological than their predecessors. Even if the new government does not reverse President Obama's executive orders, the psychology has shifted as banks will be less fearful of doing the wrong things.
Blackrock’s CEO Schwartzman says that the Trump administration will usher in the most profound regulatory and tax changes that he's seen in 45 years. He says “the changes as a result (of the election) are going to be very substantial in many areas, but particularly in the business community and the financial area. You’re going to have a very substantial reversal in regulations of all types… if you look at the architecture of the financial world, it’s going to change substantially…this is as big a change happening all at once. I’ve been in finance for, I don’t know, 45 years? This will be the biggest. When you have changes like this that are so profound, it’s going to drive higher GDP. It’s going to make the US a friendlier place for foreign capital. And it’s going to have significantly accelerated growth not just for the financial institutions but for the country as a whole. So, this is like very important. It’s very important. And it’s not just about some stocks for financial companies, although that would be a nice thing. It’s much bigger and more impactful over a much longer period of time.”
The US election provided more surprises than just Trump winning the presidency. As expected, the Republicans (GOP) retained their majority in the house but the big surprise was their maintaining
more than half of the seats in the Senate. The GOP senate majority is not filibuster proof, meaning the GOP will need to get some Democratic votes to enact legislation. This should not be arduous if the GOP understands that the key to constructive government and passing sustainable legislation is negotiation and compromise.
One of the meaningful changes that is rarely discussed is the transition in the senate leadership. Harry Reid, the outgoing senate minority leader was an obstructionist, “my way or the highway” type of guy. He was replaced by Chuck Schumer, who is more open to negotiations and getting things done when the two parties are generally in agreement (like tax reform).
During the recent election, the Republicans had the most at risk senators up for re-election. In two years’ time, it will be the democrats who will be most vulnerable to losing seats. (As senators terms are six years, they only run every six years, meaning that only 1/3 of sitting senators are running to retain their seat during an election cycle). The Democrats cannot afford to be obstructionist as the Republican's might pick up enough seats to have a 60 seat, filibuster proof majority. One of the big issues Democrats had in the last election was that Harry Reid brought so few bills to the senate floor for a vote. Democratic senators in swing states were not able to vote on important local issues and demonstrate to voters how their views were differentiated from the leadership of the party.
President-elect Trump will be a president like no other. While President Obama had his blackberry, Trump has his twitter account. This allows him to berate company managements (United Technologies, Ford) or negotiate in public (Boing or Lockheed Martin). We have also seen that the President-elects’s policies can be fluid. This will increase volatility as stock market movements can now be triggered by presidential tweets and increased policy uncertainty.
GDP growth has averaged only 2% during the Obama presidency. The economy is in year eight of a tepid expansion and there is currently no obvious reason to expect an expansion ending recession. The economic cycle has not been overly robust, but it is enduring. Growth should accelerate in 2017, due to lower taxes and a pro-growth environment.
President-elect Trump has discussed corporate tax reform as a primary goal for 2017. There is a high probability this will happen as both parties have agreed it’s a priority. Trump has discussed a 15% rate, while the house GOP plan is closer to a 20% rate. Assuming the new rate is closer to the house version, this would translate into an almost 10% boost to corporate earnings. Repatriation of foreign earnings, increased defense spending and deregulation (especially in banking, energy and healthcare) would all be additive to earnings.
Equity upside will be linked to improving earnings. Current policy neutral earnings (meaning we do not consider potential economic, taxation or regulatory policy changes due to Trump’s victory) growth for 2017 is forecasted to be 6 – 8%. This assumes accelerating revenue growth, neutral margins, and continued stock buy backs. Stocks are not cheap, especially with the move since the election. If the Republicans are successful in making a fraction of their proposed changes, we would expect acceleration in economic growth and corporate earnings. On this basis, the stock market will appear cheap fuelling another increase in stock prices.
The caveat to this rosy scenario is if President-elect Trump is not successful in passing his pro-growth agenda. Growth would then continue along at its recent tepid pace and the stock market would languish at current levels. While both parties have incentives to move proposed legislation forward, passage of these changes is not guaranteed.
While pro-growth policies are positive for US equity markets, they are bearish for bonds. Since the election, there have been record outflows out of bonds into equities. The interest rate on the ten Year US Government bond has risen almost 1.0%. The Federal Reserve Board is discussing two to four interest rate increases in 2017. For the first time since the great recession, investors believe that there is a high probability that this will occur.
Here in Canada, economists continue to forecast an anemic expansion (sub 2%). There are few expectations that the Bank of Canada will raise short term interest rates during 2017. Rates for five and ten-year Canadian government bonds have recently increased, but that is in response to the rate increases seen for similar maturities in US bonds. As US rates increase, Canadian mid to long term bond rates (which are set by the market and not by the Bank of Canada) should also continue to rise. This does not auger well for bond returns in 2017. We have already seen the negative effects rising rates have on bonds, with Canadian bond returns being negative for the latter half of 2016. Bond coupons were not high enough to offset the decline in bond prices due to the rise in rates.
With US economic growth accelerating, and the expected increase in both earnings and interest
rates, we continue to prefer equities over bonds. Those bonds that clients hold are short term in nature and not materially impacted by the recent rise in rates. US equities overall should perform better than Canadian stocks due to better growth dynamics. We expect a heightened level of volatility due to elevated valuations, the uncertainty related to the passage of the new administrations pro-growth agenda and the President-elect being more unpredictable than any preceding president.
Contact us to discuss how to navigate the opportunities and pitfalls.
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