Market Outlook

The U.S. elections, OPEC negotiations and Federal Reserve policy all impacted market returns last quarter, with broad equity benchmark returns ranging from +1.2% to +3.8%. Prior to the election on November 8, investors had largely priced expectations for more of the same regarding governmental policy and its effects on the financial markets. When the polls closed, the results ushered in a changing of the guard.

Unlike the past eight years, investors now believe the coming year will bring some combination of fiscal policy, higher inflation, faster economic growth, reduced regulation and tax cuts. It helps tremendously that economic growth has already resumed with 3rd quarter GDP increasing by 3.5% with similar expectations for the 4th quarter. This rate of economic expansion represents a stark departure from the prior three quarters of 1% growth, and 3rd quarter also was the first in the last seven to show positive earnings growth. Against this backdrop investors will shift their focus to companies with stronger earnings acceleration, proprietary advantages and solid balance sheets, and away from slower growing, higher yielding companies.

We expect 2017 equity returns to be in the 8-10% range, driven by financial, industrial, energy and technology sectors. Earnings will grow in the middle single digits and accelerate into 2018 as infrastructure spending, tax reform and economic growth pick up. Infrastructure stocks should do well as the market anticipates spending in the late 3rd and 4th quarters. Regulation and tax reductions will help domestically oriented companies, led by the banking industry. Technology revenue and earnings will continue to grow as corporations invest to become more efficient in an inflationary and competitive environment. And Energy will see an advocate in Washington that allows and encourages them to produce abundant energy here at home.

Higher interest rates will cause the interest sensitive sectors to underperform. We expect the utility, consumer staple, housing and telecom sectors to struggle as rates move back to normal levels. Healthcare will also be disrupted by potential changes to Obamacare and continued focus on pharmaceutical pricing. With the run up in the equity markets since the election, two interrelated questions should be asked and answered: is the market overvalued, and is it sustainable.

We are enthusiastic for the equity markets in 2017, and subscribe to the positive outlook, but prefer to let the numbers tell the story.  As the first table shows, the S&P 500 Index is currently trading at 16.7x 2017 earnings per share.  While that does look a bit rich compared to past periods, we assign greater value to earnings growth and subsequently, the PEG ratio, which is the P/E divided by earnings growth.  An improvement on P/E alone, PEG ratios bring future earnings into consideration, allowing one to compare relative valuations across different industries, styles or indices that may have different historical P/E ranges.

Employment growth has also been an indicator for the overall market and it remains healthy.  Continued economic expansion, an increase in infrastructure, healthcare and technology spending will keep total employment growing.

The second table pulls the same data points for each of the MCM strategies. These low PEG ratios indicate opportunities are still present because, while P/E’s are slightly higher, the earnings growth rates are much greater than the market.

As we have done for nearly thirty years, we build equity portfolios made of companies that meet our fundamental requirements and in whose future success we wish to participate. We seek business characteristics we think will reward shareholders in the long run.  We cannot say when, or how, markets will reflect and prize strong earnings growth, good operating performance, sound management practices and the like, but we continue to believe it is the only way to invest for our clients, rather than try and predict the behavioral vicissitudes of the investing public from period to period.

The FOMC raised rates for only the second time this cycle, after first doing so in December, 2015, moving another quarter of a percentage point.  However, the upward move in rates had been ongoing since July 8 when the U.S Treasury 10-year note touched its low of 1.37%.  The only surprise came in the form of the projections released by the FOMC which suggested three raises in 2017 rather than the previously expected two.  Interest rates barely reacted to the news, having already pushed their way upward long in advance due to the change in expectations referenced above.

But the bigger story for 2017 is the changing composition of the FOMC itself.  Recall the FOMC is made up of twelve members: the seven appointed Board Governors, the president of the New York Fed, and a rotating cast of four from the remaining eleven Reserve Bank presidents.   There are currently two board seats that have been vacant since 2014, leaving only ten voting members.

We expect nominees for these two empty seats will hold policy views that believe monetary policy has been too easy for too long.  This will give more weight to the hawks on the committee, countering those who might still like to leave rates low.  Further, we expect that once these names are approved by the Senate, a third Board member will resign, providing an opening for yet another like-minded voter to be added.  This would allow the new Administration to have an unusually heavy impact on the Federal Reserve and the FOMC well in advance of the 2018 term expiry of the Board Chair, Janet Yellen.

The U.S. Treasury 10-year note started the quarter at 1.59% and ended the quarter at 2.44%, touching 2.59% along the way.  Following such a dramatic move, most investment grade fixed income indices were heavily negative for the quarter, with returns ranging from-2.1% to -2.6%., weighing down any balanced allocations.  GDP is accelerating, unemployment is bottoming, inflation is moving toward the 2% target and the FOMC nominations will tilt the composition hawkish, so the upward direction in rates will continue, but probably not with such speed.

We have been waiting awhile for this outcome to transpire.  And policy took a far longer route than anyone envisioned.  The election didn’t start the rate rise, but it did provide effective fuel with a more growth-minded candidate.  Fixed income portfolios that have thrived on longer durations felt the pain in the fourth quarter and will see more in the coming year.  We are excited to finally see the economic conditions required to get interest rates back toward something resembling normalcy.  For investors who count on their fixed income allocations to play the traditional roles of income and safety, their prudent choice will be with a shorter duration portfolio, made up of well selected investment grade issuers.