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Wishin’ and Hopin’
Can Post-election Market Optimism Be Sustained?
IN BRIEF
• Markets have become
ebullient in the election’s
aftermath, but given the
macro economic backdrop,
one must question the
sustainability of recent
moves.
• Along with headwinds to
earnings from the dollar,
higher interest rates and
oil, investors will need to
consider the US Federal
Reserve’s reaction once the
Trump economic agenda
becomes clearer.
• Market participants have
latched onto the potential
benefits of several very
broad policy proposals —
tax cuts and regulatory
relief, for example — while
ignoring the potential
economic drags from other
proposals — such as severe
restrictions on immigration
and international trade. In
other words, the market is
set up for disappointment.
After the election, the market leadership role shifted from defensive sectors like utilities and real
estate investment trusts into “riskier” cyclical sectors, benefiting formerly beaten-down segments
such as financials and materials as investors factored in faster US economic growth. Additionally,
anticipation of higher inflation sent US Treasury yields significantly higher, while hopes for a tax
holiday on repatriated overseas earnings by US companies helped narrow spreads in corporate
bond markets.
Markets have become ebullient in the election’s aftermath, but given the macro economic
backdrop — including the age of this elongated business cycle — one must question the
sustainability of recent moves. At present, markets are displaying a high degree of conviction that
the new administration’s agenda will be growth positive and reflationary, even with plenty of
uncertainty over the exact makeup of the policies. That’s why there is a significant chance, in our
view, that markets will be disappointed — investors may already have priced in positive programs
while ignoring potentially growth-depleting policies.
Exhibit 1: What are Trump’s policy priorities?
External Regulatory
First Quarter 2017
In the weeks leading up to the US presidential election, and especially in the election’s immediate
aftermath, investors began to take a more upbeat view of both the US economy and the outlook
for the stock market. Anticipation of a reflationary policy mix of corporate and individual tax
cuts, increased infrastructure spending and a less burdensome regulatory environment from the
incoming Trump administration helped boost equities into record territory and sent yields on US
Treasuries higher.
Fiscal
MARKET INSIGHTS
Policy initiative
Affordable Care Act reform
Effect on real growth
Unclear
Effect on inflation
Unclear
Dodd-Frank reform
Positive
Positive
Immigration reform
Trade protectionism
Negative
Positive
Negative
Positive
Leading to trade war
Negative
Negative
Corporate tax reform
Positive
Positive
Profit repatriation
Positive
Positive
Income tax reform
Positive
Positive
Infrastructure/defense spending
Positive
Positive
Potential positive for growth, but by how much?
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MARKET INSIGHTS
First Quarter 2017
Below, we’ll explore the possible pitfalls investors may be overlooking and examine the rally’s
sustainability.
Rich valuations becoming richer
To be sure, price action has been accompanied by an uptick in global economic sentiment
in recent months, illustrated most clearly by rising global purchasing managers’ indices and
consumer confidence.
In addition, we’ve had a marked rise in bullishness, as illustrated by investor sentiment readings
such as the American Association of Individual Investors Sentiment Survey and the Consensus
Bullish Sentiment Index. Given that investor optimism is often a contrarian signal, ebullient markets
bear watching.
Seasonal factors may also be playing a role in the recent price action. Historically, there is a bias
for stocks to rise in the fourth quarter of the year, the so-called “Santa Claus rally.” Additionally,
stocks tend to rise in the months following US presidential elections.
The recent rally pushed a seemingly fully valued US equity market into even richer territory.
Significant short-term earnings growth is needed to justify today’s lofty levels, and that seems
unlikely given a sharp climb in the US dollar, higher interest rates and increasing energy prices.
The post-election rotation from growth to value has pushed value indices to price/earnings ratios
last seen at the end of the last business cycle in 2007, and they are even higher today than before
the dot-com bubble collapsed in 2000. Small-cap stocks, with their mostly domestic orientation,
stand at record rich valuations too.
Exhibit 2: Valuation — Not bubble, not cheap
S&P 500 Shiller price-to-earnings ratio
50x
40x
30x
28.3x
20x
Average = 16.7x
10x
0x
1904
1912
1920
1928
1936
1944
1952
1960
1968
1976
1984
1992
2000
2008
2016
Market valuation high based on cyclically adjusted earnings
Source: http://www.econ.yale.edu/~shiller/data.htm — as of 31 December 2016. Chart from 1900–2016. Average calculated
over full history (1/1981 to 12/2016).
Along with headwinds to earnings from the dollar, higher interest rates and oil, investors will need
to consider the US Federal Reserve’s reaction once the Trump economic agenda becomes clearer.
Should the administration’s plans lead to increased inflation expectations, the Fed could act more
aggressively to tighten monetary policy than markets currently anticipate, a further headwind. As
such, stocks look decidedly stretched at present valuations.
As noted above, investors are growing bullish. In addition, day traders are back in force after
sitting out much of the nearly seven-year-old bull market. Day trading volumes have increased
substantially in recent weeks, lately exceeding institutional volume, according to trading volumes
reported by discount brokers. Retail participation has picked up too, frequently a contrarian sign,
as the average investor tends to buy during periods of euphoria and sell during times of despair.
Upticks in day trading and in retail volumes both tend to be late-cycle phenomena.
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MARKET INSIGHTS
First Quarter 2017
Professional investors have also contributed to the recent rally, particularly short-term-focused
hedge funds. These funds, which have on average badly underperformed their benchmarks in
recent years, have been largely responsible for much of the recent market movement. They’ve
opened the throttle in an attempt to improve their performance figures, and in the process have
set off a highly leveraged momentum-driven trade into cyclicals and riskier companies. These types
of strategies tend to ignore underlying fundamentals and instead attempt to latch on to rising (or
falling) prices to capture short-term gains.
Despite our current concerns about the market, certain sectors may benefit from a shift in the
regulatory landscape. Financials may find their burdens lightened considerably, as may energy
companies. Increased investment in the energy sector, along with infrastructure spending, could
benefit the materials and industrials sectors. Hoped-for tax provisions could lead to pharma and
technology firms repatriating the vast quantities of cash they currently hold offshore to avoid the
US corporate tax rate, the highest statutory rate in the developed world.
Macro hurdles abound
Is it possible, after years of relative malaise, that a new administration in Washington can revive
animal spirits? Without a doubt. It would be foolish to preclude the possibility of a large, diversified
economy such as the United States kicking back into gear after nearly a decade of idling in neutral.
Indeed, in recent weeks several high-frequency data series such as purchasing managers’ indices
(PMI) and consumer-confidence and small business–optimism surveys have all shown significant
upticks. But, in our view, growth is unlikely to shift into a higher gear in a sustained way, based on
the vague policy proposals floated before and since the election.
Exhibit 3: Sentiment measures improving since election
55
ISM Manufacturing PMI SA — on 12/31/16 (R)
Conference Board Consumer Confidence SA 1985=100 (R)
NFIB Small Business Optimism Index (L)
53
115
110
105
51
100
49
47
Jun-2015
95
Dec-2015
Jun-2016
90
Dec-2016
Bloomberg, as of 31 December 2016. Shaded area = post US election.
ISM = Institute for Supply Management. PMI SA = Purchasing Managers’
Index seasonally adjusted. NFIB = National Federation of Independent Business.
So far there’s no clear-cut
“first 100 days” plan on which
investors can base judgements.
Instead, we fear, in the absence
of specific proposals, that
market participants have latched
onto the potential benefits of
several very broad policy
proposals — tax cuts and
regulatory relief, for example —
while ignoring the potential
economic drags from other
proposals — such as severe
restrictions on immigration and
international trade. In other
words, the market is set up for
disappointment.
Where might disappointments arise? A few areas seem particularly ripe:
Infrastructure spending
Trump has proposed $1 trillion in infrastructure spending using public-private partnerships. Those
partnerships can work well in revenue-generating situations like airports, toll roads and bridges
and water works, but as the recession that followed the global financial crisis illustrated, there
are relatively few “shovel-ready” projects, so any economic stimulus from infrastructure could be
some years in the future. The stimulus also comes at an unusual time in the business cycle. Most
observers would acknowledge we are most likely in the later stages of a nearly eight-year-old
cycle. Significant fiscal stimulus has historically tended to be deployed toward the beginning of
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MARKET INSIGHTS
First Quarter 2017
a cycle rather than toward the end. For the sake of argument, let’s imagine there are projects on
the drawing board with permits in place and environmental impact statements approved. With
the US economy near full employment, where would the qualified workers come from to build
these projects? For this reason and others, the infrastructure piece of the policy puzzle will likely be
smaller and take longer to put in place than markets presently anticipate,
in our view.
Tax cuts
Tax cuts may not materialize to the extent that investors expect. During the campaign, Trump
espoused across-the-board personal income and corporate tax cuts. Since the election, however,
his tune has changed. Treasury Secretary–nominee Steven Mnuchin has called for tax reform that
lowers personal income tax rates but eliminates certain deductions, making the cuts more revenue
neutral. A deficit-focused Republican House of Representatives has its own tax plan, one with some
very complicated provisions, such as border adjustability, making swift passage unlikely. Border
adjustability also risks breaking World Trade Organization rules. One area of political agreement
seems to be reducing corporate tax rates and repatriating some of the trillions of dollars held
offshore by large US multinational corporations. Overall, however, we expect tax cuts to provide
less economic stimulus than investors presently anticipate.
Trade disruption
International trade disruption is a distinct possibility if Trump governs as he campaigned.
Congress has granted the presidency broad powers in the trade area, including the power to
unilaterally impose temporary tariffs. One reason that small-cap stocks have outperformed so
dramatically in the aftermath of the election is their mostly domestic orientation. They are less
likely to be negatively impacted by potential trade wars. The S&P 500 Index has lagged small caps,
partially owing to index constituents deriving approximately 40% of their revenues from outside
the United States.
Debt and demographics
Two other inhibitors of growth are often paired: debt and demographics. These are secular
headwinds against which potential tailwinds from tax reform and regulatory rollbacks might falter.
On the demographic front, the aging US workforce is an impediment to growth that cannot be
overcome by a revival of animal spirits. An average of 10,000 baby boomers retire every day, and
85% of those over 65 don’t work. Given that the US economy is near the Fed’s definition of full
employment, it is hard to foresee where the workers will come from to build the highways, bridges
and airports America so desperately needs without a fresh influx of skilled workers. Economies with
aging populations tend to be less dynamic, less productive and slower growing than economies
with younger populations. Looking ahead, companies may run out of workers and customers.
Liberal immigration laws could be the surest way to maintain or increase the size of the US
workforce, but given Trump’s campaign rhetoric, that seems unlikely.
An aging US population also means fewer workers are paying into Social Security and Medicare,
while the demands on those programs are rapidly rising as retiring boomers tap benefits. With
average life expectancies increasing, millions of recent retirees will potentially spend more time
collecting Social Security than they did paying into the system. That will add to the US’s already
substantial debt burden.
The US, most G7 countries and China have very high debt burdens, along with aging populations
and declining labor force growth rates. Academic studies have shown that rising debt from a low
level can boost economic growth, but beyond a certain point, additional debt has a negative effect
on growth.
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MARKET INSIGHTS
Still pretty low, for longer
First Quarter 2017
Given the macro headwinds described above, it should come as little surprise that we’re not in the
camp of those looking for a continued dramatic rise in US Treasury yields. Rates are likely to remain
elevated versus 2016, but we expect rates to stay low by historical standards, though not at the
extremely low levels of mid-2016. Very wide interest rate differentials between, for example, the
US and Germany, where the European Central Bank continues quantitative easing, are helping
push the dollar to multi-year highs. Those wide differentials continue to attract foreign investors
into the US Treasury market, since most developed markets outside the US offer only measly yields.
Also, the drag from the strong dollar could limit US growth and inflation, and keep further rises in
US bond yields in check.
The backdrop for credit could be quite constructive if Trump’s policy proposals play out as investors
hope. Repatriation of overseas earnings should limit issuance in the investment-grade segment,
while the high-yield market has been supported by the same reflationary hopes that have spurred
equities to new highs, making that segment somewhat pricey at present.
Return of the “petulant child”?
After a decade of lethargy, we’re hopeful that a pro-growth tax and regulatory regime will
ignite animal spirits and propel the US, and ultimately the global, economy into a faster growth
trajectory; however, we fear the macro headwinds will be difficult to overcome. Since the election,
financial conditions have tightened amid a sustained rise in the foreign exchange value of the
dollar and higher interest rates (though these have been offset somewhat by higher equities and
narrower credit spreads). Recent history has shown that rising interest rates and a firming dollar
can create a vicious cycle of broad-based risk-off “tantrums” like those experienced multiple times
during this business expansion. These episodes have caused economic activity and inflation to fall,
risky asset valuations to retrench, rates to decline and the Fed to forestall tightening.
Exhibit 4: The ‘petulant child syndrome’
Fed signals rate
hikes ahead
Dollar strength &
falling commodity prices
Market volatility abates
Falling EM
"blow up" risk
Rising EM
"blow up" risk
Dollar weakness &
rising commodity prices
Market volatility spikes
Fed backs off
on rate hikes
0($+),"$-&."%
Interplay between the US Fed and the market had made tightening very difficult
Source: Wolfe Research as of 21 March 2016. EM = emerging markets.
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MARKET INSIGHTS
What’s missing?
First Quarter 2017
In our view, the missing ingredient for sustained economic growth is investment spending. With
low global demand creating economic slack in recent years, companies have not increased their
capital expenditures (capex). But perhaps an uptick in consumer and business confidence could
change that paradigm. In the best of worlds, market-friendly reforms of the tax and regulatory
codes could induce a sustained rise in capex and wages, in which improved productivity would
hold inflationary pressures at bay. This, in turn, would allow the Fed to raise rates gradually so that
yields and the US dollar would not rise too precipitously. However, with significant excess capacity
in manufacturing and the uncertainty on policy, a wait-and-see approach seems more likely in the
short term.
Exhibit 5: Weak US capex cycle needs a lift
Tied to profits and jobs
Business spend - YoY% in capital goods
(new orders ex-defense and aircraft – 3mma)
Not just energy &
commodity-related
20%
10%
0%
-10%
-20%
-30%
Negative or low for much
of the since 2012 period
1995
1998
2001
2004
2007
2010
2013
2016
Capital goods spending has been weak
Source: Bloomberg as of 30 November 2016. Shaded areas = US recessions. Chart shows the year-over-year change of the
3-month moving average.
All of this suggests to us that investors should approach the ninth year of a prolonged business
cycle with a great deal of caution, mindful that optimism can quickly fade when confronted with
reality. There is significant risk that fiscal stimulus will not be as immediate or as large as investors
expect, thus setting the stage for sizable disappointment later in 2017.
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CAPITAL MARKETS BOARD
First Quarter 2017
MARKET INSIGHTS
Fourth Quarter 2015
We travel the world conducting our own investment research, evaluating corporate
management teams and analyzing the competitive landscape. We listen to central bankers
and other policymakers to put together a picture of where world economies are heading.
We collaborate across our global research platform to share our best ideas.
James T. Swanson, CFA
Ben Kottler, CFA
Chief Investment Strategist
Joined MFS in 1985
Institutional Equity Portfolio Manager
Joined MFS in 2005
William J. Adams, CFA
Benjamin R. Nastou, CFA
Chief Investment Officer, Global Fixed Income
Joined MFS in 1997
Quantitative Portfolio Manager
Joined MFS in 2001
Kevin Beatty
Sanjay Natarajan
Chief Investment Officer, Global Equity
Joined MFS in 2002
Institutional Equity Portfolio Manager
Joined MFS in 2007
Robert M. Almeida, Jr.
Robert Spector, CFA
Institutional Equity Portfolio Manager
Joined MFS in 1999
Fixed Income Portfolio Manager
Joined MFS in 2005
Robert M. Hall, Jr.
Erik S. Weisman, Ph.D.
Institutional Fixed Income Portfolio Manager
Joined MFS in 1994
Chief Economist, Fixed Income Portfolio Manager
Joined MFS in 2002
MARKET INSIGHTS presents the collected perspectives on global markets emerging
from our research process and designed to help our clients make prudent long-term
investment decisions.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be
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