The Political Angle
The market continued rolling right along in the 1st quarter as corporate earnings growth and the prospect of tax and regulation reform kept investors in a good mood. For the quarter, the Dow Jones Industrial Average was up 4.6%, the S&P 500 added 5.5% and the Nasdaq Composite gained a remarkable 9.8%. Smaller companies, which had outperformed large caps by a significant margin in 2016, became laggards in 2017. The S&P 400 MidCap Index was up 3.6% while the S&P 600 SmallCap Index added just 0.6%.
Despite the optimism-fueled rally on reforms, President Trump’s primary campaign platforms – immigration and healthcare – have hit major roadblocks. The travel ban has been blocked in the courts twice while the American Health Care Act never even made it to the House floor for a vote due to a lack of support. The Trump administration has said it’s moving on to tax reform but even that is looking uncertain.
The president’s ability to push through tax reform may have been weakened in light of the healthcare reform failure. Even House Speaker Paul Ryan has gone on record saying that tax reform could take longer than healthcare reform. The bottom line: Washington may be the catalyst that moves the markets for the remainder of 2017.
Continued Strong Earnings and Growth
Washington politics aside, the economy continues to do well, with solid earnings and revenue growth returning strong. After an earnings recession that resulted in five consecutive quarters of negative year-over-year earnings growth, things are again looking positive for corporate earnings. Analysts are forecasting 6.4% earnings growth in Q1 on roughly 6% growth in revenues. Consumer confidence readings are at levels we haven’t seen in some 15 years. Unemployment rates are still hovering just below 5% while the core inflation rate has remained steady at around 2.2%.
Record Low Financial Guidance
Looking forward we aren’t seeing much in the way of guidance for Q1, as a record-low number of companies are giving financial guidance as large banks are set to kick off reporting next week. In the past month, only 83 have published profit guidance of any variety. The silence adds to the air of mystery in U.S. equities, where valuations are high and volatility nonexistent as prices again lock themselves into a range after the four-month Trump bump. While tight lips contrast with the voluble optimism expressed in fourth-quarter conference calls, it may also signify confidence. The general rule of thumb is bad news gets announced early rather than good. The assumption we extrapolate from this is that assume is that nothing has significantly changed from the trend of improving earnings.
The Technology Sector
The technology sector was the big winner in the 1st quarter as the Nasdaq continues to set new highs. We have been participating in that rally, with our Nasdaq call position being our largest weighting. Additionally, we have also taken steps to align ourselves with what we see as a global recovery taking hold. We now have solid exposure to both developing and developed markets across the globe, in anticipation of a European-driven recovery gaining steam. Bolstering our view acre comments from Blackrock’s Larry Fink, who said the U.S. may be the slowest-growing economy in the first quarter among the G-7 nations. Japan, Canada and Europe are expanding faster than anticipated six months ago while the U.S. is lagging expectations. Additionally, without tax reform and deregulation, he says, our markets could suffer setbacks.
Infrastructure Plans
We’ve also taken some positions to capitalize on the new administration’s infrastructure plays, with small bets placed on a growth in the steel and industrials sectors. Looking forward, energy and building materials also could see a boost the economic cycle continues to mature, and we will move into those sectors as opportunities arise.
The Fed
On the fixed income front, the Fed’s move to boost rates higher by a quarter point in March as was widely expected as job growth remained strong and unemployment low. The wording and forecast in Janet Yellen’s statement following the move was remarkably similar to comments made in the previous quarter suggesting the Fed has seen little evidence to change their current way of thinking. The ubiquitous “Dot Plot” indicated the Fed could still be compelled to lift rates again in 2017, maybe more than once.
Not everyone, however, is convinced it’s the right path. Skeptics point to wage growth, which is still low and in real terms may actually be declining. In a low unemployment rate environment, workers typically have more leverage in demanding higher wages, but thus far, we haven’t seen much evidence that this is happening. If rising rates make loans and mortgages more expensive while working families don’t see a corresponding rise in earnings, it could threaten a return to recession. That being said, we still should see at least one more rate hike in 2017.
Conclusion
The market seems to want to keep moving higher and the Fed has little interest in rocking the boat, but I think investors should consider taking a bit of a defensive posture. I think the trend is still up and Q1 earnings should help fuel some of that rise but the markets might be underestimating some of the potential risks at play currently.
While it’s not yet time to necessarily make radical adjustments to asset allocations, it’s important to consider that valuations are still high, and the Fed could ultimately take too heavy a hand in trying to control the growth/inflation balance. Also, political uncertainties from a number of corners of the globe could change conditions at a moment’s notice.
To that end, we think gold and silver make attractive defensive hedges at current levels, and have some room to run. Historically, gold has performed well in rising rate cycles, which it looks like we might have in 2017. The prospect of any number of political events – elections in France, Germany and Iran, the start of Brexit, North Korea – could result in a flight to quality that causes Treasury and gold prices to move even higher. One good shock to the global system and gold could be above $1,300 in relatively short order.