Market Update November 2017 – Congress makes further progress on tax reform
Congress makes further progress on tax reform. By passing the budget through the reconciliation process, the House of Representatives can simply adopt the Senate budget version, which currently calls for $1.5 trillion in tax cuts. Despite this move, we remain skeptical that budget neutrality will be reached, which is a requirement for tax reform to pass by a simple majority though this means. Although there are ways Congress can seek to truncate the time allowed for scoring, we are doubtful that will be enough to hide the gaping holes in the budget as currently presented. That being said—it seems that the only predictable thing about politics today–is its unpredictability.
Populism is not dead in Europe. Austria, Spain and Italy serve as a reminder that there are still risks to populism in Europe. However, we remain constructive on the sustainability of the European recovery for now.
Emerging markets earnings continue to improve. While multiples have quickly made up for the last three years of undervaluation, earnings still have more room to expand. Sales growth is strong, but earnings growth is still recovering. Inflation has been muted and creates a supportive environment for continuing equity recovery.
Market Review: Two Steps Forward, Three Steps Back
The House of Representatives passed a $4.1 trillion budget legislation in early October, taking a critical step toward implementing a tax-cut plan later this year. In mid-month, the Trump tax-cut plan gained momentum after the US budget vote, as the Senate approved the budget measure and the House passed a measure to adopt the Senate budget through reconciliation. That said, reconciliation will still require that the budget is balanced, which it still is not. Moreover, at the end of the month, the tax cut process was dealt a serious blow when Robert Mueller issued the first indictments of high level Trump associates in the Russia investigation. Though nothing has linked the Russian election medaling with the Trump administration per se, the indictments and ongoing hearings over the next weeks and months could certainly present a distraction for Congress.
The International Monetary Fund raised its outlook for the global economy, indicating the current broad-based global economic recovery will likely continue through this year end and into next year, driven by a pickup in trade, investment, and consumer confidence. By month end, the Catalan Parliament approved a declaration of independence from Spain, taking Spain’s political crisis to a possibly dangerous level. However, at month end, the Spanish government took control of Catalonia, replacing the Catalan President as means of reiterating the unconstitutional nature of the declaration. This could lead to further protests as more than 150 ministers will be replaced.
Adding to geopolitical tensions, Bahrain has imposed visas on Qataris in the continuing Qatari crisis as the GCC frowns on Qatari support of Iran. In addition, Saudi Arabian Crown Prince Mohammed Bin Salman backed the extension of OPEC production cuts beyond March 2018. While the cuts are supportive for oil prices, they inflame Middle East tensions with Iran, who are determined to continue to increase their own share of global supply in the face of OPEC cuts.
Consistent with analyst expectations in September, the Fed voted to keep interest rates unchanged at the most recent meeting, while projecting another increase before the end of the year. Analysts continue to maintain expectations for two rate hikes in 2018, on the basis that recent low inflation will eventually hit the two percent target with healthy growth.
The US economy grew at a solid pace in the third quarter despite the impact of hurricanes, reflected in economic momentum remaining steady around 2%. The dollar strengthened further in October and US stocks led the S&P 500 higher as a result of strong economic data and expectations for a Fed interest rate hike in December. Hurricanes took only a modest toll on home sales, as existing home sales increased last month. The US labor market continued to tighten as well after recent hurricane-related disruptions, as the numbers of American filings for unemployment benefits increased less than expected.
The European Central Bank announced their long expected plan to reduce in its bond-buying scheme, as the euro zone long-term inflation expectation hit a seven-month high, gradually withdrawing extraordinary monetary stimulus. According to IMF, economic growth in the euro zone was revised upward on the back of strong domestic demand and export growth resulting from accommodative financial conditions. However, the fund also cautioned that euro zone growth would remain under pressure due to weak productivity and high debt in some countries.
China’s economic growth eased slightly to 6.8% in the third quarter, though still above the government’s full-year target, as exports and investment lost pace while consumption growth remained relatively stable. Despite solid economic growth, analysts warn that the economy this year benefited from the lagging impact of significant monetary and fiscal stimulus through debt-fueled investment in 2016.
Japan’s sentiment improved across the board in the third quarter due to solid growth in exports and industrial activity. According to Oxford Economics, business sentiment continued to improve across most Japanese industries in the third quarter, and is expected to be optimistic over the next three months. The rise in business confidence is consistent with PMI manufacturing survey readings over the past year.
Going Forward: One Part Global Recovery, Two Parts Political Intrigue
The world today is a fascinating mix of a globally coordinated upturn, uncoordinated monetary policy, and unpredictable political outcomes. While we can find reasons for optimism in the global recovery, we must remain vigilant. The recovery we are experiencing has come predictably late and could be truncated as a result of the elongated, stimulus-led timeline. We are now much closer to the end of this economic cycle than the beginning, but still quite far away from interest rate normality. The US and the UK are leading the path to rate normality with Europe following at a slower pace, and Japan still likely to maintain easy monetary policy. Muted inflation has given the emerging markets a boost as global trade volumes have continued to expand. However, asset price inflation is still prevalent in the form of high multiples and tight credit spreads and evidence of excess liquidity is still easily found. Nasty potential catalysts in the form of questionable political agendas, willfully ignorant economic proposals, attacks on basic democracy and increased geopolitical tensions continue to give reason for pause.
Global Economic Upturn
Evidence of a coordinated global upturn continues to mount in trade volume data and manufacturing data; however, the IMF has warned that the recovery will not last. In fact, we point out that the recovery has been the very belated result of massive post-crisis stimulus. From a cyclical perspective, we are almost certainly closer to the end of the economic cycle than the beginning; however, muted inflation continues to keep the goldilocks conditions in place. The biggest beneficiary of this has been the emerging markets. That said, we are not as keen on the overvalued Asia/technology story as we are on the trade recovery story. There are also segments of the emerging markets that have lagged the recovery, such as Latin America.
Uncoordinated Monetary Policy
While Yellen has changed her tune on rate hikes, now arguing that hikes should be taken before inflation sets in, lest they be too late (versus her previous chorus that rate hikes too early could derail a fragile recovery and would not easily be taken back), it would seem that her days are numbered. Her strong views against banking deregulation will likely be her Achilles heel. Pecking at her very competent and successful heels are: Jerome Powell, who possesses a dynamic combination of experience and policy consistency, but is open to some deregulation; Stanford economist John Taylor, who is a noted hawk and former Fed governor, though not an economist, and whose wife’s father is a long time Trump business associate and who is open to deregulation; and Gary Cohn, who is largely unqualified, but known to be an advocate of deregulation. No matter which way you slice it, rates are rising in the US, though under Powell, the front runner, they may rise more slowly. Meanwhile, the ECB is just starting to seriously talk about tapering, and in true European fashion, will go about it slowly and thoughtfully as the euro strengthens out of concern. The UK is dazed and confused and so is the British pound. But, Prime Minister Shinzo Abe’s landslide victory has all but ensured continued supportive monetary policy in Japan as well as a weaker yen. This suggests the dollar should ultimately rise against the G4’s in the short term, though in the medium term, could remain weak relative to emerging market currencies where growth differentials support a weaker dollar on a relative basis.
The push and pull continues with the Catalonian impasse turning into a Spanish constitutional crisis, and Northern Italy thumbing their noses at Southern Italy. With populist agendas still firmly in play, European politics are creeping back into the headlines. The victory of Andrea Babis, the Czech Republic’s version of Trump, puts Czech firmly in line with their fellow Central European anti-establishment, populist-led governments of Hungary and Poland, which is a notable departure for the Czech Republic. Moreover, in combination with Sebastian Kurtz’s election in Austria, it serves as a reminder that the forces at play are significant and not going away. Despite French President Emmanuel Macron’s proclamation that America’s Isolationism will catalyze further European integration, it would seem the opposite is occurring in the face of continued and growing inequality. When prosperity becomes scarce, populists rise by creating a rush towards resource hoarding by creating scapegoats often in the form of immigrants and the poor who, they claim, take underserved resources. These have been the sounding bells of every successful populist campaign. Moreover, the destabilizing forces propelling immigration and exacerbating inequality are not going away, suggesting that Europe, constantly a shining star in portfolios, could become an investment liability.
In summary, we maintain our current asset allocation to US, Developed and Emerging Markets. In Fixed Income, we remain expect to begin extending duration slightly while improving the quality of corporate credits in the portfolio in leu further tightening by the Fed which may provide a better trading environment for bonds. We remain very constructive on value add real estate equity in areas dominated by the working class, as well as debt backed by real estate.
–Your Investment Team at Lido Advisors
Past performance is not an indication of future performance. The information provided in this newsletter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. There is a risk of loss from investments in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.
The information contained herein reflects Lido’s views as of the date of this newsletter. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessary come to pass. Lido has obtained the information provided herein from various third-party sources believed to be reliable, but such information is not guaranteed. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Lido is not responsible for the consequences of any decisions or actions taken as a result of information provided in this newsletter and does not warrant or guarantee the accuracy or completeness of this information.
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The BofA Merrill Lynch US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. (Source: BofA Merrill Lynch)
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. (Source Russell)
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