AN OBJECTIVE APPROACH TO THE MARKETS
W. Edwards Deming was an American engineer, statistician, professor, and management consultant. (Source: Google.) He had an engineer's mind, evidenced by his words, "If you can't describe what you are doing as a process, you don't know what you're doing."
Clearly, Mr. Deming saw change as inevitable and process as the lifeline to survival and success.
We at Day Hagan agree wholeheartedly.
Therefore, with this update we are going to cover a broad swath of issues likely to influence markets for the coming year. Many of these inputs result from major changes in the investment landscape that unfolded over just the past six months. As changes occur, our process, models and indicators are designed to incorporate the ever-changing information flows and provide direction as to which investments are most likely to perform well with the changes—versus those likely to react poorly.
In our view, process is our most important ally—allowing the weight of the evidence to carry the day.
Before moving into our expectations for 2017, let's start with a review of a few of the major events in 2016:
- Most investors have already forgotten that the first 10 days of 2016 evidenced the worst start to a year on record for the DJIA (going back to 1897). Even the NASDAQ's January performance was the worst since May 2010, as the FANG stocks severely underperformed the already weak markets.
- By February 11, the S&P 500 was down -10.5% as investors worried about a slowdown in China (the Chinese stock market was down -23% in January) and crashing WTI crude oil prices, which hit a 12-year low of $26 on January 20 (natural gas prices hit a 17-year low). Furthermore, emerging markets and junk bond funds sold off significantly as investors moved away from risk.
- Investors also priced in concerns around mounting problems for energy loans, a potential U.S. recession, a potential global recession, and most importantly, fears that the Federal Reserve would raise rates three times or more in 2016, exacerbating the weakness.
- This early-year decline was sharp and occurred just four months after the August-September 2015 decline, lending credence to the view that the global financial markets' underpinnings were fragile.
- But then, as global markets were in a freefall, the FOMC started to walk back rate hike expectations, the ECB and PBOC announced huge stimulus measures (recall Draghi's "Whatever it takes" moment in January) and oil stabilized in the low $30s. And, perhaps the most important milestone in Japan's central bank policy in modern history, in March the Bank of Japan cut its benchmark interest rates into negative territory for the first time ever. This followed the ECB lead, which, due to persistent economic weakness and deflation, instituted negative rates in 2014. By the end of April 2016, $8 trillion of government bonds worldwide had yields below 0%. In other words, investors buying those bonds wouldn't get their money back. Bloomberg wrote that, "Negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored."
- Nonetheless, by the end of the first quarter, the S&P 500 had the largest quarterly reversal since 1933. The day of reckoning had been averted. The question is whether that day was delayed or repudiated.
- On June 23, the BREXIT vote (for UK's withdrawal from the European Union) came in with 52% of the votes in favor of exiting the EU. The market experienced a sharp decline—only to reverse within a matter of two days.
- Yet even though equities rebounded, we noted that for the first three quarters of 2016, there were net mutual fund outflows from U.S. domestic funds.
- Then, on November 8 came the U.S. elections. On the day before the election, based on several polls, approximately 81% of investors expected Clinton to win, with just 14% expecting Trump to win. That night, during the overnight equity futures session, S&P 500 futures were down limit, only to recover within 24 hours.
- On December 4, Italians voted on a constitutional referendum to amend their constitution, which ostensibly would have streamlined their government. It was widely considered the most significant vote in Europe for 2016, though Brexit is a close second. The result of the vote, however, was that no changes would be made to the constitution, which left Italy floundering.
- In fact, for the whole of this year, major EU banks have been under significant pressure. These include Germany's Deutsche Bank and Commerzbank, Italy's Monte dei Paschi and the UK's RBS. The overhang of a financial disruption loomed all year with the IMF pointing to Deutsche Bank (DB) as, "the most important net contributor to systematic risks in the global banking system." In other words, they possess circa-2008-AIG-like derivative exposures. By September, Deutsche Bank's shares were down by almost 50% for the year and down 80% from their 3-year high.
- Lastly, when reviewing corporate America's performance for 2016, when all is said and done, the S&P 500's earnings are likely to be up just 0.1%, with revenues up 2.2%. In other words, earnings barely increased. In fact, it wasn't until the third quarter of this year that the 5-quarter negative year-over-year earnings growth streak was finally broken. Stocks have only recently returned to positive annual earnings growth.
These were significant overhangs and each had the potential to ignite a global financial market contagion. In response, our models' overriding message was to maintain a cautious stance and a neutral to mildly bullish equity exposure relative to our benchmarks. Upon reflection and with 20/20 hindsight, our allocation to defensive areas such as cash were a drag on performance. Nonetheless, our clients expect us to manage risks first, and when central banks are flocking to negative interest rates, global economic growth is tepid, and earnings growth is nil while valuations are expensive, the prudent response in our view was to reduce risk and seek a rational return.
Looking forward to 2017, we view the following broader themes as likely to continue to have the most impact on the financial markets for the foreseeable future:
1) Higher interest rates
View: It is rare that when interest rates spike higher, the stock market reacts by moving higher as well. Higher interest rates are historically a headwind for economic growth as well as corporate profitability. Additionally, at some point if rates move high enough, investors will view fixed income as a good alternative to owning stocks. If global interest rates move substantially higher, expect a negative impact on stocks. Also keep in mind that one of the tax changes being trial-ballooned is a cessation of the tax-deductibility of interest by corporations. Clearly, this would be very negative for high-debt companies and has ramifications for how companies structure their capital in the future. Near term we view rates as stable, longer term we expect higher rates.
2) Strong U.S. dollar
View: Dollar strength has weighed heavily on U.S. multinational corporations' earnings and competitiveness. During the most recent spate of earnings reports, the strong dollar was cited as the top reason for weaker-than-expected earnings results. This was deemed more impactful than wage pressures, oil prices, the election, Brexit, higher interest rates and China's weakness (source: CNBC). With investors currently expecting more hikes from the Fed and higher rates overall, the dollar is likely to stay strong relative to its major trading partners. We've noted that the dollar is significantly overvalued, yet valuations can remain extreme for long periods of time. We would view a contained reversal in the dollar as positive for overall earnings growth, but aren't expecting it in the near future.
3) Loss of confidence in Central Banks
View: Based on recent commentary from major central banks, stimulus options are running thin. Attention is likely to shift to fiscal policies and areas of the world with sustainable economic growth (i.e., not growth simply attained as a by-product of monetary stimulus).
4) Potential fiscal stimulus
View: We'll be writing more on potential tax changes in the near future. Suffice it to say that there are huge implications of any dramatic change in fiscal policy for any country. Currently, ideas around a border tax, destination-based cash flow tax, corporate tax changes, deductibility of interest, etc. are being discussed along with personal tax rates and allowable deductions. All of these decisions will change investment and corporate behaviors. At this point, it is far too early to make a determination as to what the final outcome will be. It is important to note, however, that President-elect Trump's proposals to date are vastly different (and more accommodative) than the House Republicans' stated views, which are more conservative. They are likely to meet somewhere around the middle. For an interesting read, go to the taxfoundation.org for more details on the House Republican tax reform plan.
5) Oil price volatility
View: This is a manipulated market and guessing prices is almost futile. However, oil prices above $55 are good for U.S. shale, and will help oil-producing countries. Interestingly, the U.S. imports about 8 million barrels a day. On an annual basis, based on 2015 reports, the U.S. imported 1.37 billion barrels from Canada, 386 million from Saudi Arabia, 303m from Venezuela, 277m from Mexico, 143m from Columbia and 129m to Russia. This gives you an idea of why U.S. energy independence is a little scary for large suppliers to the U.S... As far as S&P 500 earnings are concerned, for 2017, most of the growth in earnings is expected to occur within the energy sector. If energy profits and oil prices fail to live up to expectations, then equity markets will adjust accordingly.
6) Sluggish global economic growth
View: Economic growth has stabilized in the U.S. and is poised to expand—as long as expectations are met. Consumer confidence is high, employment is strong, and manufacturing and services PMIs are still in expansion territory. The U.S. economy is okay, but still running slightly below the long-term trend. Similarly, most developed nations' economic growth is also slow, but stabilizing. Our overall assessment is that global growth is sluggish but positive. Our concern is that even with 0% policy rates, growth hasn't really been able to accelerate. Now that interest rates have cycled higher, will economic growth be able to emerge under more difficult conditions? We think it hinges on whether a new cycle of capital expenditures and corporate spending emerges, and so far capex has been light.
7) Inflation green shoots
View: Given full employment there are concerns about potential wage inflation pressures. Also, if oil were to spike higher, that would also have an inflationary effect. At this point, we see mild signs of inflation pressure, but the long-term reality is that pricing is very difficult in an age of technology-driven competition. The inflation we see is in housing, health care, college and food. Those aren't the "good" inflation points investors want. They want to see that corporations have the ability to raise prices and increase profits. At this point, overall pricing power at the wholesale and consumer levels remains weak.
8) Potential tax reductions
View: Yes, a reduction in the corporate tax rate would be helpful, assuming it isn't offset by a labyrinth of new rules and policies that once again distort free enterprise and trade. Our view is that changes are necessary, but we'll have to wait to see the final result and how best to position portfolios. We would also note that reductions in personal tax rates have mixed results from a broader-based investment perspective. When we look at the major tax cuts of 1981, 2001, and 2003 (as well as the tax increase that occurred in 1990 and 1993), there is no discernable pattern or correlation to support the notion that it will spur subsequent economic growth. In fact, most studies indicate that monetary policy has a much stronger impact (and we view monetary policy initiatives as having run their course). In fact, economic growth was much better after the 1993 tax increase than after the 2001 tax cut. Clearly, there are more factors at work than simply the taxation of corporate profits and individuals' compensation. (Main source: Brookings Institute)
9) Potential infrastructure investment
View: If we, as a nation, are going to spend, my view is that spending on projects that will provide a long-term return is smart. Spending on infrastructure provides a better ROI (return on investment).
10) President-elect Trump, a Republican House and a Republican Senate
View: We, as a firm, support our elected leaders regardless of party affiliation. We want them all to succeed. We will be monitoring policy changes closely for signals as to their potential impact on our investments, for while they have their jobs, we have ours. And that is to manage your, and our, capital in a prudent, risk-averse manner.
Based on our models' unemotional evaluations of the world economic outlook, corporate operating environment, earnings opportunities, valuation, sentiment and technical underpinnings, the quantitative conclusion is that a more neutral/mildly bullish stance is currently warranted. Our view, based on the models, is that this isn't the time to be overly aggressive when investing, nor is it time to be overly bearish. We are maintaining our measured approach to risk management. We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities. At this point, our marquee strategies have ample exposure to equities.
Have a wonderful week,
Donald L. Hagan, CFA
Day Hagan Asset Management
Day Hagan Investment Research
— Written 12.28.2016
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