February 2017 market commentary
Eugene Yashin

Markets Treading Water Since Inauguration Day

For that matter, stock and bond markets have not done that much since the big November rally. Given the stream of political headlines in recent weeks, that might surprise a lot of people. It makes a good case to tune out the noise. Sure uncertainty is high, with so many policy proposals and ideas floating around. But for now, our analysis indicates the state of the markets is sound, and economic, fundamental and technical measures look solid.

Inflationary Pressure

As the US economy has moved further into expansion, inflation expectations have picked up. The year-over year Consumer Price Index (CPI) exceeded 2% for the first time over 2 years. Inflationary expectations measured by the difference between the nominal and inflation-adjusted Treasuries continue to rise. This is not the hyperinflation that some investors fear; it is benign, long overdue, and cyclical, in our opinion.

Fed and Interest Rates

During the Federal Open Market Committee (FOMC) meeting this week, the Federal Reserve (Fed) left rates unchanged, as widely expected. The Fed’s post-meeting statement featured minimal changes compared with its December explanation. Even if the Fed does continue to slowly raise rates, it could have a relatively modest impact on long-term rates. The muted response from financial markets in the immediate aftermath of the release suggests to us that markets believe gradual hikes (perhaps 2 to 3 small increases in 2017) could be appropriate policy.
In Search of Alpha – We believe investors will need to do more than simply rely on passive market exposures in 2017 and beyond to generate attractive returns. The last several years benefited index investors in both equities and bonds, but we see a future where position in the business cycle, trends in earnings growth and interest rates, as well as fiscal, tax, and trade policies could favor certain asset classes, regions, styles, and sectors over others. This should lead to – and has already – greater dispersion and less predictable correlations, making passive investing more risky, and increasing the importance of analysis, judgement, and risk management. Overall, the environment ahead is likely to present active managers with opportunities to add value, in our opinion.

Presidents May Not Have Much Power over the Economy

Some economists and news media have predicted that the new Trump administration could create the next recession, while others predict economic expansion. But the reality is that presidents have far less control over the economy than you might think. We believe presidents get way too much credit for good economies and strong markets and assign way too much blame for the bad. We think looking at markets in political terms can lead to poor decisions, so we implore clients to separate their personal voting preferences from their investments. Instead focus on the fundamentals, manage risks, and invest for the long-term.

Equities

Return to Profit growth: US companies are set to report their strongest profit growth in 2 years for the last quarter, based on consensus estimates from FactSet. While the reporting season for earnings has only just begun, early indications suggest that the projections for continued earnings growth are sound, and potentially a bit conservative. With one-third of companies reporting, fourth quarter results are beating expectations by 3%, according to RBC Capital Research. We believe better economic growth should remain positive for corporate earnings and this, for equities.

Potential Regime Change from Value to Neutral: Empirical Research’s regime indicator recently
changed its forecast and is now neutral on value vs. growth stocks. Over the past year, value stocks have outperformed the market by around +10 percentage points. This rise in price caused valuation spreads to narrow by two standard deviations and now sit between a ¼ and ½ a deviation below their norm. They remain above average in the consumer durables sector, a function of the skepticism about the durability of the autos cycle, and in pharmaceuticals/biotech where pricing concerns have mounted. Empirical also points out that investors are no longer fleeing from capital-intensive, volatile businesses, which are generally classified as growth stocks.

In a more neutral regime, which Empirical forecasts, valuation continues to matter, although by less than before, and growth stocks are faced with fewer headwinds. It appears that the low-lying fruit has already been picked, and now we need the fundamentals to progress to make a pie. Momentum strategies, quality, and earnings growth may take on increasing importance in this setting.

Small Cap and Cyclical Sectors: Small Caps still look a bit more attractive than Large Caps fundamentally. We also forecast Cyclical Sectors, like Financials, Industrials, Materials and Energy, to outperform the broader market over the next 12 months according to our proprietary Macro framework.

Foreign Stocks on Sale: A 7-year bull market has lifted valuations in the US, but many parts of the world are trading at discounts. Emerging markets and international developed markets are both below their 10-year average price-to-earnings ratio, according to Bloomberg. Political and economic risks remain, but we believe there are bargains to be found for active investors seeking solid companies at attractive prices.

Income

Bond Markets Steady: Following a challenging fourth quarter in 2016, bond markets are off to a good start in 2017. We believe high quality bonds will continue to offer attractive diversification benefits to investors, but we remain defensive on interest rate exposure. In an environment of rising inflation expectations, Treasury Inflation Protected Securities (TIPS) are attractive as a portfolio hedge and complement to traditional bonds, in our opinion.
Generating Income at a Reasonable Risk. The need for income generation remains as real as ever, but the threat of rising rates from low levels has created a challenging environment. To mitigate interest rate risk without limiting income potential, investors may consider select investment in individual bonds, and prudent exposure to more credit sensitive sectors, such as high yield bonds, floating rate bank loans, preferred equities, and emerging markets debt. We believe an actively managed fixed income strategy may play a critical role in a portfolio by seeking to provide stability, diversification, and income, even with uncertainty over the path of interest rates remaining high and difficult to predict.

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