Market Outlook: 8 Areas to Watch in 2017
The big picture for Smith & Howard Wealth Management is always going to be framed by valuations. As long-term investors, we recognize that as interesting as it is to speculate and debate about near term events and breaking news, investment returns are ultimately driven by valuations. Shifting portfolios towards cheap assets and away from expensive ones “wins” over time. It not only generates a higher long-term return, but typically results in smaller drawdowns or losses along the way. Put more simply, it’s the amazingly simple, but difficult to execute philosophy of “buy low, sell high.”
The Market (Still) Isn’t Cheap
While I look forward to the day that I can excitedly write about how cheap everything is, today is not that day. Generally speaking markets are expensive. Despite several rate increases by the US Federal Reserve bond yields remain near all-time lows and credit spreads remain tighter than average. Equities by most any metric are expensive, in particular here in the U.S. The accompanying chart, while a bit busy, helps provide clarity on just how expensive equities are. What we’re attempting to show is the historical levels and relationship between bond yields (BarCap Aggregate Index) after subtracting out inflation expectations and normalized equity yields for the S&P 500 (as the graph indicates by yield we simply mean earnings divided by the index level). The larger black squares and line depict the average for each over the time period while the blue diamonds and line show the current level for each. As an example the average real bond yield has been 2.67%, but today is only 0.82%. As is obvious in the graph both bonds and equities are well below their historical averages.
There is Hope in the Slope
While both of those are sobering items of note, there is one rather interesting aspect to this graph. The line that is drawn between the two averages and the line between the current levels has roughly the same “slope”. What that tells us is that equity valuations when compared to bonds are actually not “out of whack,” for lack of a better term. What we expect to receive in “extra” return for investing in equities versus bonds is not all that different than normal. It is for this reason that when clients ask if we should reduce equities in favor of bonds that our answer is typically no.
This is a key difference between markets today and markets like the tech bubble. During the tech bubble this “slope” was actually negative. In that scenario bonds were yielding nearly 2x what equities were, yet investors continued to pile into equities! Equities may be expensive, but until bonds present an attractive alternative, they are likely to stay so.
International and Alternatives Bring Balance
Before anyone thinks we are too dire in outlook, the chart we just reviewed reflects valuations of US stock and bond markets. International stocks, of both developed and emerging countries, are fortunately more attractively valued and are priced to return what investors have come to expect from their equities. While markets generally may be on the expensive side there are always pockets of opportunity and we’re working hard to identify them and take advantage of them.
As most clients well know by now we have also emphasized the use of alternatives in our portfolios. The above chart hopefully helps make it obvious as to why. What “alternative” means is a topic for another discussion, but given the valuations present in the more traditional US markets it is a must for clients who want to simply do more than ride the public market roller coaster! Historically when equities were expensive bonds were cheap or vice versa. That is unfortunately not the world we live in today, so the traditional two-asset-class portfolio approach needs to be adjusted.
On the Horizon: Eight Areas To Watch
We know we painted a rather bleak long-term picture, but as discussed in our Market Recap much of the recent news has been positive. In addition to low bond yields, it is another reason why equities have remained at elevated levels and can remain there for quite some time. One downside that comes with positive current news, however, is that investors increasingly begin to expect the continuation of positive news. Expectations gradually build and are harder and harder to exceed or even meet the longer the period of time between disappointments.
Much of what happens over the next quarter and remainder of the year will be not just about whether the news is positive, but whether it is positive “enough”. There will always be things out of left field that will get our attention, but there are also some areas that one can reasonably expect will provide market- moving developments. In this section we hope to highlight some of those areas and some brief thoughts on each:
- Washington D.C. – There is no question that what happens in D.C. will have a large impact on markets for the foreseeable future. Some portion of the strong returns on the equity side since last fall can be attributed to the aggressive, pro-growth agenda espoused by the Trump administration. The initial euphoria has started to wear off, however, so any gains from here will be dependent on actual results and not just talk (or tweets!). As can easily be seen in the following graph, the confidence level among CFOs polled by CNBC as part of their CNBC Global CFO Council has dropped significantly in just the last 3 months regarding the passage of various campaign promises made by the President and Republicans.
- European elections, particularly in Germany – this item could have potentially been a bigger hot button had the recent French elections turned out differently. Given the results in France and the sizeable lead the current German Prime Minister Angela Merkel holds, this is likely to be a non-event. Stranger things have happened though (and rather recently) and if her lead does narrow between now and the election in late September, speculation and volatility will likely pick up.
- Brexit – does anyone remember the Brexit scare from June of last year? As “fun” as that selloff and immediate recovery were, the real risks to the UK and their economy are only beginning. The negotiation process for their withdrawal from the EU is likely to play out in the headlines and with the recent election results weakening the hand of Prime Minister May it may be very difficult for them to strike a deal that doesn’t weaken their long-term economic prospects. That is obviously negative for the UK, but for EU supporters this would be viewed as a win as other countries are less likely to follow suit if the negotiations lead to a one sided, pro-EU deal.
- North Korea – I’ve been in this business for 20 years and every year this is cited as a potential market disruptor. With that said, there is no question the rhetoric and stakes have been escalating and there doesn’t appear to be any reason to expect them to deescalate. At best, we can hope that this remains mostly a war of words and gamesmanship.
- The Fed – much like the North Korea mention above, this is likely to always be among the list of items to watch. The Fed has, however, been very deliberate and seemingly overly communicative. Surprises out of them are certainly not out of the question, but probably not likely.
- Oil & Gas prices – the recent pullback there could lead to some jitters around the health of the companies in that industry along with the banks that lend to them. Angst is likely to be somewhat contained though, as prices remain far above the prior year low and the breakeven level needed for most producers has also come down significantly in a short period of time allowing them to remain profitable at lower and lower energy price levels.
- China – outside of the US, no country plays a bigger role in the global economy and strikes more fear in investment manager’s hearts than China. China continues to work through a difficult process in which they are attempting to slow growth from an unsustainable rate earlier in the century and evolve from an export oriented economy to a domestically oriented one, all while trying to control the rapid growth of credit via banks and a shadow banking sector. Fortunately most agree they have the currency reserves and ability to withstand any near term hiccups. That doesn’t mean the market might not experience intermittent periods of panic and doubt (remember August 2015?).
- Global Economy – while there is still optimism for renewed growth in the US driven by the potential for tax reform and pro-business initiatives out of D.C., economic growth outside of the US has actually already seen a pickup. Markets will be watching closely for signs that this was either short lived or continues to accelerate. Obviously acceleration would cause good volatility!
To be clear, the items above are fun to speculate on and will certainly move markets over the short term, but trying to predict them and shift portfolios based on those predictions is essentially a fool’s errand. Nobody has a clear enough crystal ball and if they did I suspect the market reaction to the news would still confound them.
My favorite example of this was in August of 2011 when S&P downgraded US government debt from AAA to AA+, a move that took the world by surprise. While stock markets declined precipitously as a result, US Treasury Bonds, which were the subject of the downgrade, actually rallied.
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.