Despite a strong start to 2017, questions remain

Stock markets reacted very positively to Trump’s election, with a strong rally that pushed the S&P 500 upward by 4.6% between the Nov. 8, 2016, election and yearend. The broader Dow Jones industrial average (DJI) rose by 7.8% and the small- and mid-capitalization Russell 2000 index rose by 13.6%.

Bond yields rose as well, with 10-year treasuries’ increasing to 2.48% by Dec. 13 from 1.86% on Nov. 8, locking in an increase in the U.S. Federal Reserve Board’s overnight rate to 50 basis points (bps) from 25 bps at the Fed’s Dec. 14 meeting.

The trade-weighted U.S. dollar (US$), which already was at a very high level, also rose in value – by 4.9%. This put the US$ more than 25% above its mid-2014 levels.

In line with prospects of higher growth, there has been a massive rotation out of defensive equities and into stocks that will benefit from economic growth and higher interest rates – specifically, resources, industrials and financials.

“The markets are assuming that we’re undergoing a regime change to inflationary growth from cyclical stagnation, and that [this change] will drive a re-rating of all asset classes,” says Jurrien Timmer, director of global macro at Fidelity Institutional Asset Management in Boston.

Dan Chornous, CIO at RBC Global Asset Management Inc. in Toronto, agrees: “There’s an emerging sense that we have passed a regime change, signalling a move away from very low interest rates to a more market forces-driven approach. We could get surprisingly more growth, as all corporations would tend to benefit from a shift in direction, speed and expectations.”

The key to Trump’s strategy is renewed optimism on the part of companies that have been discouraged from investing in new plants, machinery, equipment and processes in the U.S. by too much regulation. François Bourdon, chief investment solutions officer at Fiera Capital Corp. in Montreal, calls the previously ever-increasing regulation the “choke factor,” and he thinks that companies will respond with enthusiasm. Bourdon anticipates that growth in the U.S.’s real gross domestic product (GDP) could be 3% this year, almost double 2016’s estimated 1.6% and significantly stronger than the 2%-2.5% that most of the global investment experts interviewed for this report say they expect.

Stronger GDP growth in the U.S. may be good for some other regions as well, assuming Trump doesn’t introduce a lot of protectionist measures. The big risk is his threat to put high tariffs on imports from countries that he thinks are unfairly competing in the U.S. market. China may be a major target, for example. If China retaliates – which is highly likely – there could be a trade war, with unpredictable and potentially destabilizing results that could range from steep job losses in the U.S. to rising security tensions in Asia.

So far, Trump is using pressure tactics on the trade front by sending out tweets threatening high tariffs on companies that are moving their production to lower-wage jurisdictions or selling goods made in those jurisdictions in the U.S. The investment experts interviewed for this report assume that Trump will stay with that strategy, along with renegotiating trade deals such as the North American Free Trade Agreement. Renegotiation is less of a risk than high tariffs because the process is lengthy and the changes would likely be implemented gradually.

Nevertheless, the threat of U.S. protectionism is likely to hang over financial markets for some time. “Emerging markets are particularly vulnerable,” says Charles Burbeck, managing director for global equities at UBS Global Asset Management (U.K.) Ltd. in London, U.K. He notes that the markets already are struggling with large amounts of US$-denominated debt, which will become harder and harder to pay back if the greenback continues to climb.

The consensus is that the US$ won’t rise much further, although a significant drop also is unlikely. With U.S. interest rates rising, investors will favour US$-denominated investments, keeping the demand for the US$ strong.

Furthermore, some improvement in emerging markets’ GDP growth is anticipated, including in Brazil and Russia, both of which are expected to have positive growth after years of recession.

Europe’s and Japan’s GDPs also are expected to grow, albeit modestly. Both countries are struggling with declining populations, which limits their GDP growth potential. However, their central banks still are engaged in quantitative easing (QE) aimed at encouraging more consumer and business borrowing – and the rise in the US$ makes their exports more competitive.

That leaves the risk factor of China. And it is a major risk, says Peter O’Reilly, head of global equities for I.G. Investment Management Ltd. in Dublin. As the world’s second- biggest economy, China is a major determinant of global economic growth in general and of resources prices specifically, he notes. At the same time, China is trying to shift to a more consumption-driven economy rather than remaining exports- and infrastructure-reliant – a change that the country is not finding easy.

For example, a year ago, there were fears that China was going into a hard economic landing because indicators of industrial production turned very negative. This caused a large outflow of foreign capital and a weakening of China’s currency, which the government was not able to stop, says O’Reilly. That led to a sell-off of equities around the world and helped to push oil and base metal prices to very low levels. China’s government responded with a big infrastructure program that got the economy growing again at the targeted 6.5% and prices of both equities and commodities recovered.

The same thing could happen this year, says O’Reilly, and although another big fiscal stimulus package could keep the economy growing, that won’t solve the underlying problem: China needs a lot of money deposits to remain in the country to finance the transition to more consumer spending.

Here’s a look at global investment opportunities for this year:

– The U.S. Stock valuations are high, with a price/earnings (P/E) ratio close to 20 for the DJI. Timmer, for one, expect P/E rations to drop: “If earnings go up by 10%, there might only be a 5% appreciation in share prices.”

However, Chornous believes there could be further increases in multiples: “If all falls into place, U.S. returns could be in the high single digits.”

Cooper thinks U.S. earnings could rise by 6%-7% and doesn’t think share prices have fully priced in an increase of that scale.

Bourdon, with his 3% U.S. GDP growth assumption, favours U.S. small and mid-sized stocks, which will benefit the most from deregulation. He says these stocks’ prices could rise by 10%-15%, while U.S. large-caps’s prices could rise by 5%.

However, O’Reilly is unenthusiastic. He had been overweighted in the U.S., but is now trimming his holdings. He says there isn’t any evidence that Trump’s policies will work and also notes that global earnings still are dropping.

Wendell Perkins, senior portfolio manager at Manulife Asset Management (U.S.) LLC in Chicago, is even more pessimistic. He believes the recent rally pushed stocks to unreasonable levels and that there could be a 10%-15% correction. Perkins admits that “a brighter outlook is a very plausible scenario,” but adds that “brighter” does not necessarily mean “bright.” He points out that the U.S. economy remains weak, global GDP growth is weak and inflation is weak. Where, he asks, will the demand come from to improve economic activity in a meaningful way? “Governments can’t spend enough and you don’t have China growing fast,” he says.

Perkins is not alone. Timmer also wonders where additional GDP growth will come from: “The U.S. is already at full employment, so any growth shock will be inflationary.” He notes that inflationary expectations have risen to around 2% from 1.3%.

Burbeck is concerned that Trump’s policies could result in more inflation rather than additional GDP growth. “Economic growth is determined by productivity growth plus population growth,” he says. Productivity growth has been weak in recent years because businesses haven’t been investing. He says that unless that is reversed, GDP growth is unlikely to rise.

Nevertheless, Burbeck notes that with interest rates on the rise – the Fed is expected to raise its rate at least twice this year – heavy sell-offs of fixed-income investments in the next 18 to 24 months are likely. A good deal of that capital is likely to flow into equities. Burbeck favours domestically oriented U.S.-based companies because protectionist measures could dampen prospects for exporters.

The most pessimistic of the money managers interviewed for this report is Nandu Narayanan, CIO at Trident Investment Management LLC in New York and manager of several of funds sponsored by CI Investments Inc. “The global economy is a lot weaker than people think,” he says. “It’s slowing dramatically and there’s a high likelihood of global recession.” He admits the U.S. may not go into recession immediately, given Trump’s stimulative policies. However, he warns that whatever growth the U.S. achieves this year will be front-loaded and dwindle thereafter.

– Europe. Stephen Lingard, senior vice president and portfolio manager, Franklin Templeton Solutions, part of Fiduciary Trust Co. of Canada, a subsidiary of Franklin Templeton Investments Corp. in Toronto, thinks Europe is a wild card. If the political situation there, particularly support for populist parties, settles down, he believes that equities in the region could do well. Valuations are cheap and the economy is picking up.

The political risk is real. There are a number of important elections this year in European countries – in France, Germany and the Netherlands – with Italy also a possibility after a 2016 referendum rejected proposed constitutional reforms. There are fears that populist parties could do well, potentially setting the stage for referendums on withdrawing from the European Union (EU), as the U.K. voted to do in the Brexit referendum.

The big question is whether the euro will survive, says Cooper. He doesn’t expect an answer in 2017 but says this year’s election results “could be central to the debate.”

The European Central Bank is continuing its QE program, which may lock in positive GDP growth. Bourdon is expecting Europe, including the U.K., to grow by 1.25%-1.5%. The weak euro will help this growth.

The pound sterling (£) has dropped in value relative to the US$ – but because of the vote to leave the EU rather than Trump’s election. The £ ended 2016 at 21% below its level on June 23, the date of the Brexit referendum. Shares of U.K.-based domestically oriented companies also dropped, leaving prices “very cheap,” according to Perkins. He is less enthusiastic about European equities. Bourdon also doesn’t expect much from Europe, saying returns are likely to be 0%-5% this year.

However, Burbeck expects European shares to outperform, saying they are cheaper than U.S. stocks and also are more leveraged to global GDP growth.

– Japan. This economy – with the country’s declining population, huge amounts of government debt and corporations with little interest in shareholders – has been stagnating for years. Prime Minister Shinzo Abe has been trying to kickstart GDP growth with fiscal stimulus, reforms and large amounts of liquidity through the central bank’s QE program. So far, the results are not exciting.

Few of the money managers interviewed for this report are overweighted in Japanese equities, although Perkins says the stocks are “really cheap” and Burbeck expects them to outperform U.S. equities.

– Emerging markets. There isn’t a lot of enthusiasm for these equities because of their vulnerability to both the high US$ and to potential U.S. protectionism. However, Bourdon believes emerging markets’ equities prices could rise by an average of 10%-15%.

– Resources. The general expectation for oil prices is they will remain in the US$50-US$60-a-barrel range. A sustained price above US$60 would result in a surge in U.S. shale-oil production that could force the price back down. Most producers make money at US$50, although that’s insufficient to cover the cost of major projects, such as those in Canada’s oilsands.

Base metals producers also are making money at current prices. Supply is tight for zinc and metallurgical coal, but sufficient for most other base metals.

Gold is not attracting much interest because financial markets are assuming economic growth will increase, with little need for insurance against falling asset values. The price of gold is expected to be range-bound at US$1,100-US$1,300 an ounce.

– Financials. Financials are overweighted in general. Rising interest rates are positive for banks, as that increases their net interest margin. With rising rates in the U.S., banks there are favoured. There also are opportunities in Europe and some opportunities in emerging markets’ banks.

– Other sectors. There’s little interest in utilities and telecommunications stocks because they tend to underperform in an environment of rising interest rates. Consumer staples are also unexciting.

However, there are considerable opportunities in consumer discretionary and infrastructure-related stocks.

© 2017 Investment Executive. All rights reserved.