The U.S. presidential election had an immediate and profound impact on financial markets in 2016. An explicit pro-growth objective in Washington is likely to push stocks, bond yields and the dollar higher in the year ahead.
The beginning of 2017 marks the 25th time I have embarked on a new year of contemplating global financial markets for a living. In the past, each calendar year delivered some defining concept that captured prevailing investment themes and the results they produced. Consider these:
1994 — A surprise rate hike in February led to a mild bear market in Treasury bonds.
1999 — Tech stocks departed from all standards of fair value.
2002 — Green shoots.
2008 — I don’t want to talk about it.
2016 — The post-election period defined the year for financial markets.
Looking at the results for 2016, we see it was a fine year for U.S. stocks. Bond yields rose and the U.S. dollar strengthened. But ultimately, those results were determined during the short period between the presidential election and year’s end.
The U.S. election was an inflection point
Without a doubt, the U.S. presidential election represents a profound shift in context for investment markets. We are moving away from a world defined by policy gridlock and experimental monetary stimulus to one in which economic policymakers have access to the full suite of tools that includes deregulation, tax reform and fiscal spending. Further, we expect to see these tools deployed with an explicit pro-growth objective.
The trends in place since the election provide an outline of the key investment strategy themes for the year ahead: rising equities, rising bond yields and rising dollar.
Rising equities: a theme that will expand to international stocks
So far, the theme of stronger equity markets has been most prominent in the United States. This is not terribly surprising, since the catalyst for the move was the election of the country’s next president. However, we think that if this theme remains intact, it will inevitably expand to international markets as well.
For one thing, the relative valuation of international equities looks very attractive versus those in the U.S., where markets have outperformed heavily over the past four years. For another, we believe the popular support for high nominal growth policies is a worldwide phenomenon, not the exclusive purview of President Trump. We also note that, within equities, corporate sector success strategies will need to evolve under this new policy agenda. We think companies that have relied heavily upon cost-cutting and financial engineering (like share buybacks) to enhance profitability will be required instead to deliver top-line growth and operational leverage. If so, we could observe very different equity market leadership.
Rising bond yields: fixed-income allocations should be adjusted
Bond yields have moved relentlessly higher since the election. This makes perfect sense, particularly since we see good reasons to expect faster real economic growth in the year ahead as well as higher inflation, at least in the near term. Until headline inflation peaks, which we expect to see late in the first quarter of 2017, we do not expect bonds to recover much, if any, of the ground lost since November.
The implication for portfolios is that fixed-income holdings should be reshaped to be more compatible with these forces. It makes sense to substitute some inflation-protected bonds for traditional bonds and to reduce duration. Corporate credit risk is attractive but already optimistically priced. Relying on alternative investments rather than bonds for diversification also makes sense.
However, we see two reasons not to overdo it when it comes to shedding bond exposure. First, the negative correlation between stocks and bonds has been strong lately, suggesting that bonds could rally in the event of a sudden equity correction. Second, the spike in bond yields has improved the risk-reward dynamics for shorter term securities. We think it is unlikely, for example, that an on-the-run 5-year Treasury bond will generate a negative return over a 12-month holding period.
Rising U.S. dollar: a headwind for some asset classes
The U.S. dollar reacted to the presidential election with an immediate surge that, at its peak, reached nearly 4% (as measured by DXY, a U.S. dollar index) in a matter of weeks. This move resulted in a positive change in the DXY for the full calendar year and follows a gain of roughly 25% in the index since 2014.
The implication is that numerous asset classes show a negative empirical sensitivity to dollar strength. In particular, emerging market assets tend to struggle when the dollar is surging. We have observed a pronounced weakness in emerging market assets since the election, consistent with historical patterns. If dollar strength wanes, or even reverses, we would be excited at the prospects for emerging market assets in the absence of this headwind.
We also think that the risk of a tantrum event, in which numerous asset classes decline in value simultaneously, is much higher when the dollar is rallying. Therefore, with a strong U.S. dollar we remain cautious of potential tantrum-triggering events.
The theme of rising stock prices will spread beyond the United States in 2017, but expectations for corporate growth could produce new equity market leaders. Rising bond yields may require fixed-income allocation adjustments, but avoid shedding too much bond exposure. The risk of a market-tantrum event, in which numerous asset classes decline in value simultaneously, is higher with a strong U.S. dollar.