In this month’s commentary, the Smart Money portfolio team will outline macroeconomic trends that shaped the markets in 2016 and provide their outlook for global markets in 2017.
2016 was a year which was characterized by volatility, first from the December 2015 rate hike, followed by further uncertainty from Brexit and capped by the Trump election. Like 2016, 2017 starts with a December Fed rate hike in its rear-view mirror. The low in rates occurred in July 2016, with the 10-year Treasury yield spiking below 1.40%, before rising to 1.80% pre-election, in anticipation of the much talked about Fed rate hike and increased rhetoric from leading economists advocating higher fiscal deficits. Following Trump’s victory, the 10-year Treasury yield jumped 56 points in November, spurred by Trump’s $1 trillion infrastructure spending and tax cut promises; its biggest jump since 2009. Global bonds suffered their worst monthly meltdown, as $1.7 trillion was lost.
There has been a change in trend from a decade of historic low rates due to the perceived threat of deflation, to a more reflationary environment. The Smart Money portfolio team reduced exposure to traditional bond strategies in 2016 and increased allocations to private debt and managers who are less focused on rate-sensitive special situation bonds. We believe there is a very high probability we have seen the low in rates.
After the surprise results of the US election, US stock indexes jumped to record highs in anticipation of corporate tax cuts, income tax cuts, reduced regulations and a generally more business-friendly environment. Almost all sectors other than Utilities and Consumer Staples were winners. They were led by Financials, Industrials, Energy, Materials, Consumer Discretionary, Telecom Services and surprisingly Healthcare, though short-lived. The real question overhanging the market is whether the policy changes will translate into improved earnings to support current values. Consensus suggests the market is ahead of itself and the first “100 days” will provide greater visibility and potential policy direction. We suggest equity markets will experience more volatility as we move forward. We favour contrarian value and long and short equity strategies that are able to take advantage of equity mispricing during periods of volatility. We have a slight tilt to US equities for broader diversification and improving fundamentals.
The Rise of Nationalistic Populism
What has become increasingly evident with Brexit and the US election is that the rise of populism is a force to be reckoned with. The US middle class and Europeans faced with elections this year in the Netherlands, France and Germany, have become increasingly disenchanted with the ruling elite. Their policies have resulted in unsustainable levels of debt, while globalization and rapid technological change have eliminated jobs and caused alarming wealth inequality. As protectionist policies gather stream, capital will move from one region to another. To date, the US has been the beneficiary of fund flows with a relatively strong dollar and higher bonds yields than other nations. Trump’s planned expansionary fiscal policy (deficits from infrastructure spending combined with tax cuts) and the Fed’s restrictive monetary policy (three rate hikes scheduled in 2017) portends a furthering in these trends. However, protectionist trade policies could eventually result in reduced fund flows to the US, thus leading to slower economic growth and falling equity prices. Trump’s desire to renegotiate NAFTA and other trade agreements could all but stall one of weakest economic recoveries in history.
We generally do not take bets on sectors, but instead rely on our managers’ expertise on such matters. However, there are special situations where we deem it prudent to make an allocation to a sector when the fundamentals warrant. In the past, we felt demographics would drive the healthcare sector and accordingly added an allocation. When it became apparent that healthcare would come under political scrutiny, we exited the positon and realized a substantial profit. Recently, with all the geopolitical uncertainty, unsustainable levels of government debt and the rise of populism which is a precursor to a loss of confidence in government, the Smart Money team decided it was appropriate to add a small allocation to precious metals in the Growth and Long Term Growth portfolios. Precious metals are often thought of as a hedge against inflation. Historically, precious metals are also a hedge against bad government. When confidence erodes, it becomes a safe-haven. The recent price action gave us an attractive entry late last year. While we may not be at the absolute bottom, the recent shocks to global confidence in the ruling elite gives us confidence that time is on our side if we are patient investors.
Global events and themes suggest we are at a major turning point economically, politically and socially. As strategic investors with a longer-term horizon, the Smart Money portfolio team will be re-assessing our positions and strategies in discussions with our managers as the first 100 days unfold.