The US election was about three weeks ago and financial markets have wasted no time adjusting, making dramatic moves and confounding many along the way. While it will take at least several months to get a firmer handle on the investment implications of this election, we thought this would be a good moment for taking stock.
We will begin by reviewing the “early returns” in various financial markets—what markets have actually done from the market close on November 8 through November 30. Next we will consider the probable causes of the market’s recent movements. Finally, we will offer some cautionary thoughts—not to discourage anyone, but simply to keep ourselves well grounded as we look forward.
US stocks are up about 3.9% from their November 8 closing level. This figure measures the return of the whole US stock market—everything from large to mid to small cap—with the weightings proportional to total market value of each company.
The total market performance number, however, masks large differences within the different size categories. Small and mid-cap stocks have soared, rising 12.0% and 7.7%, respectively, while large cap stocks climbed a still very respectable 3.0%. The relatively small difference between the total market and the large cap segment illustrates the dominant role large cap stocks play in the market as a whole.
Overall returns also conceal major divergences across industry sectors. Defensive sectors such as utilities and consumer staples are doTwn 4.9% and 4.2%. At the same time, economically sensitive sectors such as industrials and materials are up 6.9% and 5.7%, respectively. Financials have done best of all, rising a whopping 12.4%.
International stocks, expressed in US dollar terms, have fallen since the election. Developed markets are down about 1.3%, while emerging markets have fared substantially worse, dropping 4.3%.
The US dollar index (which measures the dollar’s value against a basket of foreign currencies) is up 3.7% since the election. As discussed below, the impact of stronger dollar is felt widely.
US interest rates have climbed steeply since the election. The benchmark 10-year US Treasury note yield has jumped from 1.88% to 2.37%. Bond prices move inversely to market interest rates, with longer maturity bonds the most sensitive to rate changes. Looking again to the 10-year Treasury, its price is down about 4.3% since the election, reminding us that even the most creditworthy bonds are still subject to interest rate risk. This is an instance where the more conservative part of most portfolios has declined in value, while riskier assets (e.g., stocks) have risen. Municipal bond yields are up even more.
Factors at Work
We believe the following factors explain most of the performance of US stock market over the past three weeks.
- The election of a Republican President, combined with the Republicans retaining majorities in both the House and Senate, significantly increases the probability of tax rate cuts in 2017 for both individuals and corporations.
- Individuals could see lower marginal tax rates on interest, dividends and capital gains, which would increase the after-tax rate of return on most investments, other things being equal, and thereby push up prices.
- Corporations could see lower tax rates on profits, increasing their after-tax profits and making their shares more valuable. Corporations could also be offered a low one-time tax rate on profits repatriated to the US from foreign subsidiaries, which could result in substantial one-time distributions to shareholders.
- President-Elect Trump has vowed to ease regulatory requirements on many industries, which could boost profits. For example, rolling back parts of the Dodd-Frank regulations, which arose from the 2007-2009 financial crisis, would be a huge gain for the nation’s largest banks. (Note: bank stocks are also benefiting from higher interest rates, which increase the spread between the banks’ cost of borrowing and the rates they earn on their lending.)
- Trump has also promised to initiate huge infrastructure spending programs, expanding the budget deficit if necessary to finance them.
- Together, tax cuts and public works programs equate to substantial fiscal stimulus. It’s not hard to see many companies’ bottom lines bolstered in such circumstances. Economically-sensitive sectors (e.g., industrials and materials) stand to benefit most.
- There seems to be a general belief in the markets that economic growth will accelerate in coming years. Probably this reflects expectations of expansionary fiscal policy and a more business-friendly regulatory climate.
- We sense also a belief, or at least a hope, that President Trump turns out to be more flexible and pragmatic than Candidate Trump’s rhetoric might have suggested. Only time will tell.
- Like bonds, interest rate-sensitive sectors (e.g., utilities and consumer staples) have suffered in the face of rising interest rates. Higher interest rates on mortgages reduce home affordability and could weigh on residential real estate prices. Conversely, rising incomes, if they come to pass, would help offset the impact of higher mortgage rates.
As mentioned, international equity markets have lagged. We see the following primary causes.
- The dollar has surged since the election. In part, this is due to expectations of faster US growth. Related to this (and discussed below), the rise in US interest rates since the election is likely drawing foreign capital into dollar-denominated bonds.
- Paradoxically, fears of a trade war might also explain both the dollar’s recent strength and the general underperformance of foreign stock markets since the election, since foreign economies generally are more trade-dependent than the US.
- Throughout his campaign, President-Elect Trump consistently rattled sabers on the trade front. Imposition of import tariffs and potential retaliation from trading partners would hurt economic activity worldwide and would fall hardest on businesses most dependent on international trade.
- A stronger dollar also reduces the return of foreign investments when expressed in US dollar terms and by itself explains a lot of the recent weakness in foreign markets, especially in emerging markets.
- Finally, the stronger dollar causes foreign currency translation losses for US multinationals earning substantial profits in foreign markets (think Coca-Cola and Apple).
On the interest rate front, we’ve seen rates make a significant jump in the past three weeks. At its most basic level, interest rates represent the price of money, so one can think of rising rates as a forecast of greater demand for borrowed money. We see that demand potentially coming from at least two sources.
- Trump has vowed to make large expenditures on infrastructure, probably funded with borrowed money, i.e., deficit spending. When the US Treasury needs to increase its levels of borrowing, interest rates tend to rise.
- If indeed growth expectations have improved, the private sector will also have increased capital demands, so government and business could both be ramping up their bond issuance at the same time.
- Inflation expectations have risen somewhat since the election, which also pushes up interest rates. As evidence of this, we see that yields on regular Treasury debt have risen faster than yields on inflation-indexed Treasurys; the inflation component explains about a quarter of the rate rise since the election. Higher inflation is consistent with expectations of more rapid economic growth.
- Municipal bond yields generally have climbed more (and, therefore, municipal bond prices have declined more) than taxable bonds. This probably reflects expectations of lower marginal tax rates, which would reduce the relative attractiveness of tax-free municipals.
Some Cautionary Thoughts
Before anyone gets carried away with the post-election rally, we think there are a number of cautionary items to keep in mind.
- Declining interest rates have been a huge tailwind for the stock market over the past 35 years. Conversely, rising rates are a headwind—not insurmountable, but a very important factor.
- That US stocks have climbed in the face of higher interest rates these past three weeks is quite impressive. It suggests that markets see enough good things ahead to more than offset the negative impact of higher rates. But remember—those “good things” are far from a reality; the new administration and Congress have yet to serve a day. Markets may not have left themselves much room for disappointment.
- Based on current corporate earnings forecasts, stocks are expensive. Price-to-earnings (P/E) ratios are now above the peak level preceding the 2007-2009 bear market. That is not to suggest a downturn is imminent—it’s never so easy to make such a timing call. But it does make the odds less favorable. Earnings would need to grow quite fast, or interest rates would have to retreat, in order to normalize stock market valuations at today’s price levels.
- Debt levels worldwide are elevated. The US debt/GDP ratio has more than doubled in the past decade. Historically, fiscal stimulus (government spending and tax cuts) has been less effective when applied to economies with high debt levels. Big infrastructure spending is likely no panacea.
- Finally, whatever one’s politics, no one can deny that we will be in uncharted waters with a President Trump. It’s not just economic policy that moves markets. It’s also foreign policy, social policy and the general state of the union. One can be optimistic or pessimistic about what lies ahead. What one can’t be is certain.
Balance and Diversification—Eternal Truths
Perhaps the most striking aspect of financial markets’ performance over the past three weeks has been how asset classes have diverged from one another. US stocks went up, US bonds went down; economically sensitive stock sectors went up, while the more stable, higher dividend yielding stocks dropped; domestic stocks as a whole were up, international and emerging markets declined; the list goes on.
This should reinforce for everyone the wisdom of maintaining a balanced portfolio, containing both stocks and bonds, and properly reflecting both return objectives and risk tolerance. Likewise, it reminds of the virtues of diversification both across and within asset classes.
We will continue to closely monitor the landscape, digest the developments in a deliberate manner, and keep you apprised of our thinking.