Making equities great again

Jean-Philippe Bry's picture

Global markets continue to grind higher thanks to an improving global economy and easy financial conditions. Many believe that the Trump election is the underlying reasons for the new highs in U.S. stock markets, and certainly the proposed fiscal policies and deregulation designed to stimulate the economy are creating more confidence in the business and finance communities.  Nevertheless it is also clear that Trump is the beneficiary of a good U.S. economy that continues to grow at a time when the global economy is re-accelerating.

In hindsight, 2016 turned out to be a classic mid-cycle slowdown in the U.S., where inventories were drawn down, impacting commodities and economic activity. Oil weakness created an added headwind, especially for oil exploration related capital expenditures.  Europe is earlier in the cycle and felt the impact while Asia was impacted more by the slowdown in China whose economy recovered over the course of 2016 with fiscal stimulus.

Now that we are in a synchronized global recovery what are the implications?

The most pertinent is a continuation of normalization in financial markets.  What this means is that the historically low interest rates are likely to continue to rise over the course of the year. This was one of the major calls by Signature in the fall of 2016 when we declared the end of the 35 year bond bull market.

The Fed is scheduled to raise rates 2-3 times in 2017 and unlike the rate rise in late 2015, future rate rises are likely to be absorbed by the economy and the rest of the world without the violent negative reaction witnessed in early 2016 thanks to the revival of economic activity. Inflation is also rising from depressed levels, as oil prices recover and wage growth accelerates, particularly in the U.S. where unemployment is at multi-year lows. Our Rates team believes real interest rates, the difference between interest rates and inflation, will stay low as the Fed will remain on the more dovish side so as to ensure they do not snuff out a recovery.

Recent history of raising rates too early and too aggressively in a post deflationary environment by Japan and Europe can be disastrous, as appeared to be the case when the Fed raised rates in late 2015. There are no guarantees but our premise is that the Fed will stay behind the proverbial inflation curve to maintain good financial conditions all the while prudently raising interest rates. Our bet is on two rate hikes and not three over the year.

Meanwhile longer rates will grind higher and the yield curve will steepen, to the benefit of cyclical sectors and financials.

Our Macro team believes government bonds globally will likely underperform, reinforcing our negative call from last fall.

Our High Yield and Investment Grade teams see those markets favourably with continued performance given the positive economic backdrop and the possibility supply might become an issue should certain U.S. tax changes being contemplated are passed.

Our FX specialist’s view of the U.S. dollar is that it is poised to continue to rise as prospects of Trump policies favour higher interest rates over time. The fact the U.S. is further advanced in the cycle, compared to Europe and much of the rest of the world, means the interest rate differential between the U.S. and the rest of the world will remain high – favouring investment flows to the U.S. which is USD bullish. 

For now the world can absorb the higher USD without materially negative impact because the recovery in commodities and oil are fuelling a profit recovery in many companies with large U.S. denominated debt. However, if the dollar were to accelerate upwards meaningfully and rapidly, our current positive market could rapidly change.

This global backdrop clearly favours equities over bonds, something we have been advocating since last fall at Signature.

We have continued to reduce our government bond exposures as well as our cash positions to overweight equity exposures in our balanced funds.

What are the risks to the positive outlook?  Beyond comments on the USD made above, the Trump presidency presents many unknowns. The biggest is the extent to which his rhetoric is a negotiating tactic to extract better conditions for the U.S., particularly with respect to trade. Given the sanguine nature of markets when Trump suggest a unilateral 20% border tax on Mexico suggest this is precisely what investors believe.  Relations with China are rapidly deteriorating thanks to Trump’s comments and are also seen for now as negotiating tactics. Naturally reality and market perception can rapidly change.

Another risk is that Trump will have difficulty passing the multitude of policies through Congress. Some are relatively simple like looser environmental standards or a watering down of financial regulation where there is general agreement between Trump and the Republicans. However on more complex issues like tax reform or a replacement of Obamacare, the opinions are extremely divided meaning it will take a long time, delaying much anticipated legislation that is expected to add stimulus to the economy.

That may not be as big a risk for 2017 because the economy is already strong and reaching some limits in capacity, especially on the employment side. Anecdotal evidence suggests many companies are finding it difficult to find workers.

So the bigger short term risk appears to be more around trade, which for now is being dismissed as a negotiating tactic.  Sentiment and confidence in markets is currently high and a short term pull back is a possibility which we would view as a further buying opportunity.

Disclaimer
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This report may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Comments

Jean-Philippe Bry's picture
Submitted by Jean-Philippe Bry on

While I agree that markets have gotten ahead of themselves, and a pullback feels inevitable, the timing is uncertain. The critical question is whether such a pullback would represent a buying opportunity or herald the beginning of a bear market. We believe it would present a buying opportunity, given the strength of the world economy and prospects for stimulative policy from the Trump administration.

Holding some cash in anticipation of a correction might seem wise only if markets can keep rising before such a correction occurs.

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