Waiting for Washington: Policy Disappoints, But Global Growth Delivers

06.19.2017 - Ronald J. Sanchez, CFA

  • Focus on fundamentals. The economy drives long-term market appreciation 
  • Look overseas. Consider increasing your allocation to equity markets outside the US where economic growth is robust and valuations are attractive. 
  • Keep politics in perspective. Expect market disruptions as budget negotiations, debt ceiling debates and other political agendas surface in Washington. 
  • Go global. Within the S&P, multinational companies with strong balance sheets and broad international exposure may have an advantage over US-centric companies.

After a remarkable post-election surge in the US equity market, investors hit the pause button in early March as expectations for President Trump’s pro-growth economic policies came back down to earth.

On March 1, the S&P 500 Index stood 12.4% higher than it was on Election Day and essentially remained at that level through the end of May—as trading was confined within an extremely narrow range (CHART 1). In fact, volatility expectations collapsed to lows not seen in almost 25 years, as reflected by the market’s fear gauge, the CBOE Volatility Index (the VIX). Actual market volatility also evaporated. Through the end of May, there were only four days in which the S&P moved 1% or more in either direction, compared to 17 days during the fourth quarter of 2016.

Confidence in the Economy

This unusual level of tranquility on the surface of the US equity market may seem surprising given the geopolitical environment, uncertainty over US fiscal policy, a surprise rate hike in March and an abundance of political drama in Washington, DC. In our view, this steadiness is a direct result of the dramatic improvement we have seen in global economic conditions. Risks moderated over the past year as the IMF raised its global GDP forecasts, deflationary pressures faded and central banks cautiously backed away from their super-accommodative monetary policies.

These material improvements in global economic conditions were strong enough to more than offset disappointment over the lack of fiscal stimulus. The market’s growth trajectory was put on hold, policy expectations were reset and sector preferences reshuffled, but investors appear to have taken a measure of comfort in global economic growth and better-than-expected corporate earnings in the US and abroad.

Resynchronization Continues

In Europe, PMI data surpassed expectations, indicating that the economy grew at its fastest pace in six years, and France’s election of a moderate president reduced political risk. These improvements inspired a slightly more hawkish tone from the ECB and nudged investors away from “safe haven” bonds toward riskier, growth-oriented assets. As European economic growth moved into closer alignment with the US, so did government bond yields (CHART 2). Japan, which was caught in a deflationary spiral for 20 years, posted its fifth consecutive quarter of economic growth.

The US economy also grew modestly in the first quarter of 2017. Corporate earnings grew at their fastest pace in five years, employment improved, borrowing costs remained near historic lows and inflation expectations for the next five years eased meaningfully, falling from 2% to 1.7%. Lower inflation could relieve some of the pressure on the Fed to raise rates, supporting growth among US businesses and perhaps giving the US economy’s slow and steady growth cycle more room to run.

The corollary to this improving global landscape is that non-US equity markets are beginning to outperform the S&P—in some cases, by a sizeable margin. European stocks outperformed the US market in two of the last three quarters and appear to be on track to outperform again in the second quarter of 2017.

This terrain may seem unfamiliar to investors who are accustomed to seeing the S&P as the center of the investing universe. But we have been adjusting to this new reality by gradually increasing our exposure to international equity markets.

Policy Expectations Reset

The S&P could be described as a sideways market for the past three months, closing at 2395 on March 1 and 2413 on May 30.

But this tranquility belies the sharp rotations that appeared below the surface, driven by uncertainty about US fiscal policy. As post-election euphoria faded, investors moved away from market sectors and individual companies that were considered most likely to benefit from pro-growth policies such as tax reform (CHART 3).

In essence, expectations for swift and significant change in Washington were dampened by the reality of the US legislative process; which is complicated, time-consuming and often contentious. The last time US lawmakers passed a comprehensive tax reform package, for example, negotiations took more than two years from start to finish. That was more than 30 years ago.

Investors appear to be constantly reassessing the prospects of new legislation in Washington. For example, the Mexican peso sank to record lows versus the dollar when trade restrictions appeared likely, but strengthened again as the Trump administration appeared to soften its tone.

But despite shifting policy expectations, the S&P held on to its gains. This is not surprising. As we pointed out in last quarter’s Perspective, policy uncertainty can be uncomfortable, but is unlikely to derail economic growth or spark a full-blown market correction. Fiscal policy can influence the market, especially at the sector level, but it is not a primary driver of economic growth.

The Universe Expands

In broad terms, we remain confident that pro-growth policies will be implemented in some form or fashion in the US. They might not take effect as quickly as anticipated and are unlikely to be as potent or as powerful as the markets expected after Election Day. But the specifics don’t change our fundamental view of the US economy’s stability. We expect the US market to remain fairly resilient to policy shortcomings, with resynchronized global economic growth offering a helping hand.

That said, we would not be surprised to see additional market disruptions as we move through budget negotiations, debt ceiling debates and other political agendas in Washington. And earnings will have to continue improving in order to justify the full valuations we see across US large-cap stocks.

The brightest prospects for price appreciation appear to be in Europe, Japan and other developed markets that have moved past the most formidable challenges to economic growth (a theme explored in more detail by Carin Pai in this quarter’s Equities Overview). Risks remain, but there is no question in our minds that the universe of growth opportunities is expanding.

This communication is intended solely to provide general information. The information and opinions stated are as of June 19, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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