Optimism with Elevated Risks: Stay Adaptive to Prevailing Market Conditions
As we begin a new year, investors are projecting their market predictions for 2017. Which sectors will be hot? Will the oil rally continue? What will be the election results in France and Germany? What will be the consequences of Brexit? Will tensions with China, North Korea, Russia, Mexico culminate to anything meaningful? Will U.S. monetary policy continue to play a vital role? How will a Trump presidency shape the capital markets?
Markets are enjoying an extended bull run and passive investing has attracted a lot of attention; however, we recommend staying flexible and maintaining risk-managed investment portfolios.
No degree of active management can insure against periods of underperformance, but by virtue of the research-based allocations, our adaptive management style allows us to take positions that are in tune with prevailing market conditions. This type of downside protection is a key part of Tompkins Financial Advisors’ value propositions.
Whether your forecast of the future leans more towards an optimistic or pessimistic outlook probably says more about your personality than it does about what is actually going to happen. 2016 confounded the expectations of pundits, pollsters, financial markets, and the voters themselves. The only truly robust prediction that we make about 2017 is that rational investors are going to be a lot more cautious about making predictions. Our base case calls for general optimism, while risks continue to climb.
Here at Tompkins Financial Advisors, we remain cautiously optimistic within equities as we include non-correlated liquid alternatives in order to mitigate downside volatility. In fixed income, we continue to position our holdings defensively by managing the duration and interest rate risk in light of recent interest rate increases. We remain committed to taking a conservative approach in managing our clients’ wealth, in order to pursue their long term financial goals.
2016: A Volatile Year Ends With Gains
Global equities ended 2016 with a level of optimism that stands in stark contrast to the pessimism that marked the beginning of the year. The year began with the U.S. corporate bond spreads (investment-grade and high yield) blowing out to levels that implied imminent recession if not outright financial crisis, and stock prices as measured by the S&P 500 dropped by more than -10% in the first six weeks of the year. That quickly led the Federal Reserve to put a hold on rate increases instead of continuing down the earlier projected path, which called for three or four rate hikes in 2016.
Credit markets responded in breath-taking fashion with prices recovering their end of year levels by the close of the first quarter. Yet pessimism lingered as government bond yields continued to move lower until mid-year. But promising signs of improving growth, especially in the US, waning concerns about global deflation, and a sense that Brexit might not be as bad as expected began to cut into the pessimism and government bond yields began to rise (prices fell.) That selling intensified following the U.S. presidential election as investors grew more optimistic about stronger growth and higher inflation, anticipating that the new administration will be able to move forward its proposals for tax cuts, less regulation and infrastructure spending -- and markets began pricing in the Fed rate hike that came in December. As government yields moved up from mid-year lows, high yield bonds continued to advance and investment-grade corporate bonds held up better than government bonds on a global basis, generally speaking, as spreads tightened.
Emerging market (EM) debt as measured by the Bloomberg Barclays EM USD Aggregate generally performed well into early September, but hit a bump with the rising US dollar and concerns about potential changes in US trade policy; however, the sector’s performance has been positive in December. Global equity markets generally moved higher over the second half of the year with major indexes in the US setting record highs; evidence also emerged that investors were moving some money out of bonds and into equities for the first time in a long time.
2017: Key Themes
The Tompkins Investment Committee has identified key themes they anticipate will guide investment decisions in 2017. These themes are summarized below.
Macro: The rise of populism continues to upset the establishment
After political upheavals in the U.K. and U.S. during 2016, French and German voters will be among those in 2017 to test the persistence of anti-establishment/anti-globalization trends.
The impact of central banks begins to fade. Global central banks appear to have reached an inflection point and will likely drive an increase in interest rates, inflation expectations and market volatility, and a stronger U.S. dollar.
Fixed Income: Normalization resumes
Real interest rates continue to push higher in the U.S. Expectations for higher growth and inflation are likely to drive higher Treasury yields and a steeper curve, though we don’t anticipate a break from the global rate tether.
Credit still holds appeal. The credit cycle is mature, but it doesn’t appear ready to turn just yet; when it does, more supportive fundamentals are likely to help absorb the impact.
Equities: Back to basics
Pro-growth Trump administration fuels outperformance of U.S. equities. A more business-friendly environment – characterized by lower taxes, loosened regulations and robust fiscal spending – could provide a tailwind for corporate earnings and stock markets in the U.S.
Alpha – and active managers able to generate it – may stage a comeback. The removal of artificially low interest rates could result in individual stock performance once again being differentiated by company fundamentals, to the benefit of high-conviction, fundamental investors.
Emerging Markets: Both winners and losers emerge
Economic orientation counts. In our view, fears that U.S. policy will drag down the entire emerging world are overblown; improved global growth should be generally supportive, though countries likely will be differentiated based on their key economic drivers – manufacturing vs. commodities vs. domestic.
China risks remain significant. The world’s second-largest economy faces a number of ongoing issues – from asset bubbles to currency management – that require a particularly deft touch from Beijing.
Alternatives: Helping narrow the return gap
Volatility can work for investors. We anticipate that the difference between long-term investor needs and what can be generated from traditional sources of beta is likely to persist, highlighting the value of alternative risk premium and volatility-capture strategies.
President Trump campaigned on promises to stimulate the economy and boost real U.S. GDP growth above 3%. However, we believe a 2.0% - 2.5% annual GDP growth rate is more realistic, falling in line with the average 2.1% GDP growth rate that was recorded for the first seven years of the 2008 recovery. While consumer spending has been the main growth driver fueling the economy, a shift to a mix that includes business investment (manufacturing, capital expenditures etc.) and government spending could fulfill Trump’s goal of 3% or more real GDP growth. While Trump’s fiscal stimulus plans may very well boost GDP, it may take up to a year or longer for these policies to be implemented in Washington, rather than the first half of 2017, which the market currently expects.
A quote from a Caterpillar executive attempts to temper the enthusiasm and set more realistic expectations: “Even if you step back and thought about when we would start to see some impact from any sort of infrastructure program, I think the best case scenario you are talking about late 2017. It takes some time for large infrastructure projects, for the funding to come in, for the projects to be planned, and for the equipment to be delivered.” We caution investors not to get in the cart before the horse has even left the barn.
Compiled by Bloomberg. * Represents forecasts.
Global Reflation and Interest Rates
The battle with deflation in much of the world looks to be over. The rise in inflation is increasingly broad-based − particularly in the US. A tighter US labor market is pushing up average hourly earnings at the fastest pace since 2009, and we expect core inflation to increase on the back of rising services inflation. We see this giving the US Federal Reserve the confidence to raise interest rates further in 2017. The prices of more than half the goods in the US Consumer Price Index (CPI) basket are rising at an above-average historical pace for the first time since 2008.
The US appears to be leading a global rebound in inflation, but the roots are shallow in other developed economies.
China’s Producer Price Index has clawed out of five years of deflation. Eurozone headline inflation has hit a two-year high, yet core inflation is largely moving sideways. We see the European Central Bank (ECB) keeping policy easy after recently extending its bond-buying program. And we expect the Bank of England to stand pat and look past any inflation spike caused by a weaker British pound.
We believe the market’s perception of inflation will have the greatest impact on asset prices. In the event of expectations becoming unanchored, assets that can benefit may be hard to come by; bonds and equities will likely suffer and commodities will probably offer a limited cushion. US inflation-linked bonds (“TIPS”) may benefit, but after a substantial rally in 2016 we think TIPS are fairly valued relative to corporate credit and equities.
U.S. Politics: The First 100 Days in the Trump Presidency
We believe the change in US policy regime may generate several cross-currents for investors to consider. Currently Trump’s agenda appears to emphasize elevated fiscal spending, tax cuts and de-regulation, all of which may spur economic growth, inflation and rising interest rates. However, heightened protectionism and tighter immigration laws may constrain long-term economic growth, while also driving inflation higher. Put another way, more emphasis on fiscal spending and de-regulation could generate both growth and inflation, whereas an emphasis on trade tariffs might bring on more inflation than growth. The Trump administration’s agenda during the first 100 days will be crucial in providing visibility into its priorities and preferences on trade, regulation, fiscal stimulus, and monetary policy in 2017.
Potential Investment Implications
With the US creating more than its fair share of global policy uncertainty, the range of possible scenarios has increased. Markets have reacted by factoring in stronger growth, higher inflation risk, and high expectations for de-regulation. We believe there is a risk that the market could be underestimating the potentially negative consequences of protectionist trade policies, an area where the president has ample discretion, while at the same time overestimating the positives of tax cuts and fiscal spending, which require more difficult congressional approval.
The interaction between fiscal and monetary policy will be essential in measuring the overall impact of Trump policies and the consequences for interest rates, risk assets and volatility. In our view, regulatory changes have the potential to first affect industry sectors like financials, energy or healthcare, but may also gradually impact larger parts of the US economy (as after effects percolate through businesses and consumers.) Tax cuts may have more of an immediate broad-based effect on the US economy; however, it is important to note that this impact could be muted if inflation continues to rise and the Federal Reserve becomes more hawkish.
Global Politics: Populist Push for Power in Europe
The populist movement has influenced right- and left-wing political parties throughout Europe in recent years, largely fueled by Eurosceptic, anti-austerity, and anti-immigration sentiment. However, mainstream parties continue to remain in power and as such the populist impact on policy has been limited. Recent populist victories in the UK referendum (Brexit), the US election (Trump), and Italy (the defeat of the constitutional referendum) have brought more attention to the upcoming 2017 national elections in France (April/May), Germany (September–October) and the Netherlands (March).
With these elections coming into play there is potential for a real populist influence at the national level, whether that be through additional parliament seats or partnership in a coalition government or perhaps a national leadership position. The outcome of these elections will surely allow us to more accurately gauge the true strength of the populist movement. Until then, we have to contemplate the fact that this political trend could have implications for broader European policy, the economy, and the Eurozone itself.
The possibility of significant populist gains within core European nations may be the largest potential risk of a significant market inflection point in the coming year. At this point in time, European cohesion seems fragile at best, especially following the UK referendum. Moreover, concerns surrounding a Eurozone breakup could trigger stalled businesses and investment decisions, while at the same time provoking increased volatility in financial markets.
Populist movements within other countries could also materially impact European financial markets. If new US policies lead to heightened fiscal spending but also protectionism, the result may be higher inflation, rising interest rates and an even stronger dollar. All of these macroeconomic trends may begin to put pressure on emerging markets, which represent important end markets for several large European companies. Conversely, European companies with business lines in the US may benefit from these new market conditions.
Opportunities In 2017
We see opportunities in alternatives, emerging markets and dynamic asset allocation.
In our opinion, going into de-risk mode would be premature, especially with developed economies likely to continue growing, albeit at a slow pace, and emerging market growth revamping as both Russia and Brazil begin to rebound out of recession. Equities may potentially benefit from a combination of recent earnings improvements and the market’s elevated expectations of increased fiscal spending and talks surrounding de-regulation, but this is counterweighted by the possibility of rising bond yields and political uncertainty. When considering all of the aforementioned factors, our belief is that return prospects for traditional equity and fixed income assets are on the low end of the spectrum. In the near term market environment alternative sources of return may offer more attractive investment opportunities.
We hone our attention on sources of return that go beyond traditional investment vehicles; this begins by considering alternative investment strategies. Some prime examples include lower-beta strategies with equity long/short and macroeconomic strategies that seek opportunities across several different asset classes. In our view, exposure to alternative investment strategies works to improve overall diversification, while at the same time acting as a useful tool in the pursuit of attractive risk-adjusted returns.
In our opinion, in the five years leading up to 2016, underperformance in emerging markets was primarily caused by excessive valuations, economic pressures from trade imbalances, slowing growth, and overly optimistic investor expectations. Over the course of 2016, emerging markets made a notable comeback, demonstrating progress on all these fronts and creating attractive opportunities across equities and fixed income. Moreover, even in spite of probable policy shocks from the Trump administration, the primary conditions that were conducive to emerging markets assets growth in 2016 still remain in place. These factors include but are not limited to: improved currency reserve coverage, continued demand for higher yielding assets, a cyclical uplift from improving emerging market growth, and supportive valuations.
Additionally, emerging markets offer a wide variety of investment dimensions. This affords investors the opportunity to customize their exposure on several different levels, choosing between importers versus exporters, consumption-driven versus investment-driven economies, state-owned versus private companies, and local currency versus external currency fixed income. We think this diverse investment landscape yields fertile ground for security selection and enhanced diversification.
Dynamic Asset Allocation
As we look toward the onset of the new year, we expect several underlying themes to play a central role in the way we shape our investment views in 2017. These include: 1) inflation superseding low growth as an area of concern; 2) the increasing importance of fiscal versus monetary policy; 3) populism challenging globalism; and finally 4) a transition from new regulation to de-regulation within several developed nations throughout the world. As these central themes begin to unfold, we will be looking at a variety of indicators along the way to gauge the corresponding investment implications.
Expect equities, corporate bonds and emerging market assets to potentially begin trading in a wider range, where momentary spikes of volatility provoke periods of weakness followed by recoveries. This type of market environment increases opportunities for strategic asset allocation and a more dynamic investment management approach. We feel that a more active approach to security selection will be essential within the context of overall valuations, proving to be more meaningful to portfolio returns in a world of modest returns on major asset classes.
As a final aside, we believe the migration from monetary to fiscal policy, and from globalism to populism, could possibly lead to further differentiation and a divergence in fundamentals. These overarching trends may have asymmetric influences, benefiting some segments within asset classes more than others. Put differently, although valuations may be higher at the asset class level, dispersion within asset classes is elevated, providing ample opportunity to seek returns via security selection.
About Tompkins Investment Committee
Our in-house investment committee develops portfolios and manages the securities and asset allocation within the portfolios. The team evaluates economic and market conditions to determine appropriate level of asset mix needed in our investors’ portfolios and Tompkins’ investment philosophies.
Our Investment Philosophy
Our Commitment to Buy-and-Hold at Right Price
Tompkins Financial Advisors believes that a passive buy-and-hold approach is not in the best interest of our clients. In contrast, we remain dedicated to our clients’ financial longevity through adaptive risk management. At Tompkins Financial Advisors, we are committed to practicing a more responsible and sustainable Common Sense Investment approach that partners “Right Kind, Right Reason” diversification with proactive risk management.
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