The market performed well through the first quarter of 2017, extending a period of low volatility. However, the longer this low volatility environment persists, the higher the probability volatility will increase as time passes. We enter the second quarter cautious, especially with the current proposed tax and health care reform measures having the potential to inject uncertainty into investors’ minds.
Top Factors Impacting Markets
Coming into 2017, there was a lot of uncertainty about the agenda the new White House administration would pursue and the subsequent reaction from Congress. Health care, immigration, and tax reforms were central issues during the campaign, but there was uncertainty regarding the priority sequence. Despite the Republicans holding a majority in both houses of Congress, along with the White House, swift reform on any of these major issues hasn’t happened yet.
The markets were already expecting an acceleration of global growth during the course of this year, but President Donald Trump’s victory and the prospect of lower taxes swiftly pushed the markets higher beyond expectations during the first quarter of 2017.
Potential Tax Reform
The result of the positive market reaction to President Trump’s ascendency to the White House has stretched equity market valuations in the United States relative to any historical metric. The market’s current overvaluation is somewhat mitigated if the new administration’s proposed corporate tax cuts are passed by Congress and implemented.
President Trump’s campaign promise to lower taxes combined with a Republican controlled Congress gave rise to the notion that tax reform was likely to materialize sooner rather than later, and investors concentrated on it. However, it became clear early on the priority of the administration was health care reform, which failed to pass through Congress in March 2017. The ongoing negotiations needed to repeal and replace the Affordable Care Act (ACA) doesn’t appear to be materializing as quickly as the White House may have anticipated, which could have a knock-on effect and delay the passage of tax reform through Congress.
As time elapses, an increasing number of market participants may conclude it is unlikely health care reform and the most comprehensive tax reform in history will occur within the same year. The decreasing likelihood of tax reform occurring in 2017 could be a catalyst for a rise in volatility. If delays to tax reform become apparent, the question is when, not if, the market will react.
Tax cuts would directly add to company earnings without increasing sales or reducing expenses, because more profit is realized by paying less tax. For example, if a company’s per share price and earnings are $10 and $1, respectively, it’s earning 10 percent per share. If a corporate tax cut boosts its earnings per share to $2, at the same price of $10 per share, then it’s now earning 20 percent per share. This simplistic example illustrates how corporate tax cuts could drive future economic growth.
The House Republicans’ tax reform proposal contains an underappreciated, but meaningful change with the potential to accelerate economic growth: the ability to expense capital expenditures. This change incentivizes companies to invest in the growth of their business, rather than simply buying back shares or issuing special dividends as firms have been wont to do with their extra cash in recent years. Those activities do not have lasting economic value.
Capital expenditures—such as purchasing buildings, equipment, or upgrading technology— have been on the decline for several years, and is a significant contributor to the anemic pace of growth experienced since the financial crisis. The paradigm among the leaders of corporate America changed after the crisis. No longer have investments in their businesses been made in anticipation of future demand; rather, demand has to be sustainable before investments are made.
The ability to deduct capital expenditures from taxable income, rather than recoup the cost over a number of years through depreciation and amortization, is potentially a strong enough incentive to change the new paradigm and drive economic growth higher. Increasing capital expenditures also has the potential to drive wage growth, leading to sustainably higher inflation, which is the result of stronger demand and greater pricing power for firms.
Global Growth Acceleration
As the world economy accelerates, data suggests that European companies are more operationally leveraged than their US counterparts and, as a result, are poised to benefit more. Among European firms, 46 percent of revenue is derived outside European borders, according to the April 2017 Goldman Sachs research report, Europe versus the US: Act II. For S&P 500 companies in the United States, only 30 percent of revenue originates outside of the country.
The policy shift at the European Central Bank away from negative interest rates is likely to be a driver of growth as well. As yields rise on European sovereign bonds, bank profitability should increase, leading to more credit lending. Credit is the grease that keeps the economic engine functioning smoothly, and it also levers growth. As a result, when banks are expanding credit, it generally leads to higher economic growth. Financials also comprise a higher percentage of the European equity market than in the United States, which argues that increases in credit lending and bank earnings boosts European growth even more so than in the United States.
As estimates for bank earnings have improved, earnings revisions in Europe turned positive after years of consistently negative revisions. Resultant to the factors mentioned, institutions are leading the inflow of capital back to the European equity markets. Institutions tend to be patient and invest in areas of relative value with the expectation of realizing that value over market cycles. Sustainable capital inflows usually correspond with higher market prices.
Lastly, while valuations in the United States are stretched, Europe is relatively attractive in comparison. With the prospect for positive earnings surprises seemingly better in Europe, the valuation could further be mitigated, increasing the expected return from the region.
Similar to Europe, profit growth in Japan is occurring at a fairly rapid rate. The Bank of Japan also appears to be moving away from negative interest rates, which should help Japanese banks and provide similar results that were detailed for Europe. Lastly, exports are a significant contributor to Japanese economic growth, and the weaker yen is boosting exports— so this should help the country’s future economic gains.
Article 50 was enacted and is now irreversible with negotiations taking place between the United Kingdom and the European Union over the next two years. In the meantime, it appears Brexit has already economically benefited the UK in at least one area. As a result of the referendum, the pound fell, making UK manufactured goods more competitive.
Historically, a strengthening dollar usually has a very negative impact on emerging markets’ securities, debt, and equity. However, the impact of dollar strength may diminish for two reasons:
- Investors’ increasing desensitization to similar events
- Emerging markets’ debt issuance is increasingly denominated in local currency rather than US dollar-denominated
The demand for US Treasuries continues to be strong—in part, because they’re yielding higher than European and Japanese bonds while being viewed as a better credit risk. As European and Japanese bonds’ yields rise, it will be interesting to see when and if they compete with US Treasuries for investor capital.
Since the crisis, it has become increasingly apparent that the Federal Reserve’s policy has been dependent on asset price reflation rather than traditional economic metrics. With the equity markets faring well, and the markets anticipating interest rate increases by the Federal Open Market Committee (FOMC), we anticipate a total of three interest rate hikes in 2017. On March 15, 2017, after a two-day session, the FOMC increased the overnight lending rate 25 basis points to a range of 0.75% to 1.0%. This has only been the third interest rate increase since the Great Recession. We anticipate two more increases by the FOMC —likely in June and then again in fall, either in September or October.
Looking Ahead to 2018
Next year is going to be more consequential for the markets than 2017 for three main reasons:
- Janet Yellen’s term as Federal Reserve chair will be up February 2018.
- The 13th National Congress in China will be elected from October 2017 to February 2018 and will be in session from 2018 to 2023.
- There will be 38 governors up for reelection across the country between 2017 and 2018.
The French presidential election on May 7 resulted in a victory for Emmanuel Macron over National Front far-right candidate Marine Le Pen. Macron’s win allays fears that France would exit from the European Union. The outcome, 66 percent of the French people voting for centrist Macron compared to 34 percent for Le Pen, demonstrated a stronger victory than most polls predicted. The decisive result for Macron rejected the notion that Le Pen and her party might be gaining enough strength to surprise with an outlier victory, like the vote favoring Brexit in the United Kingdom and the win by President Donald Trump in the United States.
Macron, at 39, becomes the youngest President in France’s history, but the lack of strong backing by any major political party has pundits keeping a watchful eye on the Parliamentary elections next month for clues about the country’s future direction and the young president’s ability to shape policy. Macron’s victory marks the third straight defeat for far-right populist parties in Europe, following losses in the Netherlands in March and in Austria last December.
There’s an upcoming election in Germany too, September 24, 2017, but the German outcome isn’t likely to have as consequential of an impact on the capital markets as the French election result.
If there’s a correction in the marketplace, there’s no reason to panic. Even a strong, positive year like 2016 saw a 12 percent correction. With the Japanese and European markets growing, this is a good opportunity to rebalance your portfolio to reflect markets outside of the United States.
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To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams wealth advisor.