Tues, JAN 31st, 2017
In the United States, the fourth quarter ushered in the results of a much-anticipated election, a return to corporate profit growth (reporting on third quarter results) for the first time in several quarters, and the second Federal Reserve interest rate hike since mid-2006. To the surprise of many, equity markets responded favorably to all three developments. But why? Given all the hand-wringing from forecasters regarding these hurdles, how is it that stocks took them by surprise?
Election uncertainty was front and center for the whole of 2016. The widely accepted tune that a Hillary win would be status quo for the markets, while an unpredictable, wild-card Trump win – at least over the short-run – would be disastrous, permeated most investment thinking. The market’s reaction on election night demonstrated just how short the “short-run” can be in equity markets. After a nearly 1,000 point plunge in the DOW futures as election results rolled in, the market abruptly changed course as investors digested the possibility that a Trump administration may not mirror the more unruly candidate Trump, but rather it may be pro-business in nature and thus highly favorable to economic growth and corporate profits. A more affable tone during the President-elect’s victory speech late into the night helped cement this view for investors.
The reality is nobody knows what a Trump administration will bring. And, indeed, there are numerous political risks – i.e., more questions than answers – as we look out over the new administration and its path forward. How well will Congress work with the new President? Will they pass tax cuts, and, if so, what will they look like? Will they increase spending on infrastructure and / or other fiscal priorities? Are business regulations going to be rolled back in earnest and reduce the cost of doing business? Will this all spark more private investment? Equity markets are anticipating at least a portion of this to occur, but actual implementation is far less certain. Meanwhile, investors may be underappreciating the potential damage from isolationist trade policies, the stoking of geopolitical tensions, and potentially bellicose “Commander-in-Tweet” policy prescriptions. It’s impossible to know the outcomes of a new government. But we feel confident that while some optimism is warranted, it’s likely to be a more volatile environment.
Many who misread the election and markets’ reaction also overlooked the positive turn in corporate profits. For S&P 500 companies, most recent results showed a +3% year-over-year expansion in aggregate earnings, despite consensus expectations of a decline. A return to profit growth is invariably good for stock prices. Commerce in America is healthy, and provided the economy continues along its present expansionary course, we remain optimistic on the earnings power of American business. Albion companies – on balance – logged even stronger rates of corporate profit growth in the most recent quarter (and for the year).
Monetary policy remains accommodative. Nevertheless, at the Fed’s last confab of 2016 (December) the FOMC decided for only the second time in over 10 years to raise interest rates by 0.25% to 0.75%. The market’s takeaway was that the Fed raised rates for the “right reason” – that is, the general economy is improving and wages are rising. While it’s clear that if the current economic expansion continues, the Fed is probably on the path towards policy normalization (i.e. higher interest rates). Yet with the current very low levels of both nominal and real interest rates the Fed has room to raise rates without significant risk to the economy.
Jason L. Ware, MBA / Chief Investment Officer
Albion Financial Group