2017 – What’s past is prologue
By David Nelson, CFA
“What’s past is prologue.” – The Tempest (Act 2 Scene 1) William Shakespeare
Before we look into my crystal ball for some insight into 2017 let’s take a walk down memory lane and review a few of the events that shaped the year.
Right out of the gate trading halts in China, the rollover in FANG stocks and fears that the Fed had hiked interest rates too soon put investors in a defensive posture. In just a couple of weeks the S&P 500 (SPY) was down double digits as the broadcast and print media ran stories of the impending bear market.
For most of the year oil and stocks had been highly correlated so when crude hit the skids in early January, fears for the financial sector started to rise adding to market concerns forcing many traders to the sidelines. With many central banks pursuing negative rates to help lift their economies it was easy to miss the fact that fundamentals in the U.S. were starting to bottom.
Jamie Dimon CEO of JP Morgan (JPM) probably did more to save the market in 2016 than anyone. Mr. Dimon’s purchase of 500,000 shares of his company stock marked the bottom for both (JPM) and the market. In an interview with Yahoo in February I discussed the trade along with other evidence that could be pointing to a potential market bottom.
Head Fake #1
Markets pushed higher as we headed into summer confident that the BREXIT vote in June would end the potential challenge to the European Union. In the first of two shocking failures pollsters missed the rising populist movement in Britain as the country turned its back on the EU voting to leave. The sell-off lasted all of two days recouping its losses in less than a week. Who knew that the best hedge against BREXIT was to buy U.S. stocks?
Challenges and Opportunities
The promise of higher rates from the Fed which never materialized until year end was in stark contrast to other central banks like Germany and Japan who were still pushing the virtues of negative rates.
Rising rates here along with a push higher in the U.S. Dollar presented both challenges and opportunity for investors. The Greenback certainly created headwinds for U.S. multi-nationals and rising rates weighed on interest rate sensitive assets like utilities and fixed income.
However, it created some opportunities as well. A strong currency was certainly good news for small caps led by domestic producers and importers whose purchasing power rises with the dollar. Rising rates also help boost net interest margins for banks which started to rise long before Election Day.
Lost in the bear market rhetoric of February & March was that earnings estimates for the S&P 500 (SPY) had started to rise. Earnings in the second half of the year confirmed the U.S. exited a profits recession which began in late 2014.
Head Fake #2
Election night confirmed the media and pollsters we’re making the same mistakes as earlier in the year, underestimating the potential for an Electoral College upset. Bets that a Trump victory would send the markets into a tailspin looked smart for about 12 hours. Overnight, as the results started coming in DOW futures fell into the Abyss down over 900 points. Calm seemed to return in the morning as investors scooped up shares of stocks that could benefit most from the new administration.
Financials were a no brainer as the rollback of regulatory overreach could go a long way toward boosting the bottom line. Industrials and materials were also direct beneficiaries with an infrastructure spend getting bi-partisan support. The sector performance chart post the election shows the massive rotation of money out of defensive into cyclical stocks.
Junk was one of the few fixed income investments that ended the year on a high note pointing to confidence in the economy seeing little chance of a recession in 2017.
Looking at the U.S. in a vacuum it’s easy to see why strategists are tripping over themselves to raise targets for the benchmarks. While it makes for great conversation and we certainly have several positives as we head into the New Year, like Mike Tyson says; “everyone has a plan till they get punched in the mouth.”
Putin – Trump – Xi
Given the fact that we face geo-political challenges in nearly every corner of the planet I think it’s safe to say at some point we’re going to have to respond to an event that throws the market off balance.
Kim Jong Un
Military conflict in the South China Seas, North Korea nuclear ambitions, terrorist threats here at home and abroad are just a few of the potential headlines that we could wake up to with little warning.
While I fully support many of the pro-growth economic proposals I’ve heard from the President Elect I’ll repeat what I’ve penned in previous posts. There’s a huge economic divide between rhetoric and policy and political compromise has been with us since the dawn of the Republic.
Tax reform, repatriation of corporate funds held captive offshore, infrastructure spend and rollback of some regulations are all market friendly potential outcomes we could see in the years ahead but most require at least two of the three branches of government to be in sync and every now and then the third as well.
The White House
Washington will play an important role for investors in the coming year but it would be a mistake to focus exclusively on Pennsylvania Avenue.
Recent economic data has been promising. Estimate revisions to the upside, jobs, GDP, auto sales and consumer confidence all point to an economic outlook friendly for U.S. stock investors. On the dark side, continued struggles in Europe and their currency, the flight of capital from China and the economic challenge of a rising U.S. dollar for emerging markets could all trickle back to the U.S.
The challenges and opportunities facing investors in 2017 is a conversation we could carry on until next New Years’ Eve. Some investors will choose a subjective bottoms up approach and others like yours truly will make quantitative rules based decisions. Both can deliver excellent long term returns.
The only guaranteed losing strategy is the emotional response to an economic or geo-political event.
Welcome to 2017!
*At the time of this publication funds managed by David Nelson were long (JPM) & (SPY)