Under normal circumstances, the Chicago Cubs breaking a 108-year drought to win baseball’s world series would qualify as the biggest surprise of the quarter, if not the entire year. However, celebrity businessman Donald Trump winning the US presidential election, despite latest polls and predictions all pointing to a win by Secretary Clinton, probably would qualify for that title, at least for financial markets. US equity markets broke a nine-day losing streak to rise over the two days leading into the November 8th election. Futures markets seemed buoyant early evening on that Tuesday as initial exit polls suggested a Clinton victory. As the results kept rolling in and Mr. Trump took the lead in several swing states, equity market futures started to see wild swings. At one point Dow futures were down more than 700 points. Yet, after the results appeared to be conclusive and Secretary Clinton conceded in the early AM, futures saw a dramatic reversal. By close on Wednesday, the S&P 500 had gained more than 1% and proceeded on a steep rally over the final eight weeks of the year.
The S&P 500 index gained 4.64% between election day and year-end, closing out 2016 with a significant gain of 11.96%, as investors priced in massive fiscal stimulus by the incoming Trump administration as well as easing of regulations. This was supported by the fact that the post-election rally was driven by Financial and Industrial sectors, which were up 16.80% and 7.53%, respectively, during this period.
At the same time, the likelihood of inflation rising faster than expected and the prospect of the Federal Reserve normalizing interest rates at a quicker pace in the face of fiscal stimulus drove bond yields sharply higher. The yield on ten-year US treasury bonds jumped 57 basis points during the post-election period, finishing the year at 2.45.
The risk-on sentiment did not carry over to the rest of the globe at the same pace. The big reason was the US dollar rising to its highest level in fourteen years, thanks to the incoming administration’s “America First” policy proposals (especially on trade) and a potentially more hawkish Federal Reserve. The US dollar index, which had fallen 0.78% over the first eleven months of the year (through election day), jumped 4.45% in the post-election period. The MSCI EAFE Index (net, in USD terms) had fallen 1.09% from January through election day but recovered post-election to finish the year up 1.00%. However, emerging markets, which would be more affected by a rising dollar, gave up some of their gains after the election. The MSCI Emerging Markets Index (net, in USD terms) was up 15.98% through election day, but pulled back over the last eight weeks of the year to finish with an annual gain of 11.19%, under-performing the S&P 500 index.
The Spouting Rock/Convex Global Macro Fund (Institutional and Advisor Classes) (CVXIX and CVXAX) gained 1.13% and 1.17%, respectively, in the fourth quarter of 2016, compared to a return of 0.09% for its benchmark, the Bank of America Merrill Lynch 3-Month Treasury Bill Index. As of 12/31/16, the Spouting Rock Global Macro Fund average annual returns since the fund’s inception on 11/24/14 were 1.20% for CVXIX and 0.96% for CVXAX, compared to 0.18% for its benchmark. The returns for the one-year period ending 12/31/16 are 4.46% for CVXIX and 4.28% for CVXAX, compared to 0.33% for its benchmark.
A solid economy awaits Trump
The US economy was already growing at a steady pace before Donald Trump’s election raised the likelihood of increased fiscal spending. The unemployment rate ended the year at 4.7% and the fourth quarter saw job creation running at an average 165,000 per month. This was lower than the 212,000 net monthly job creation averaged in the third quarter. The slower pace of net job creation, combined with the fact that wages are growing at their fastest pace since May 2009 (2.9% annual growth rate as of December), is indicative of a tight labor market.
With wages rising in the face of headline inflation that is still running below 2 percent, the US consumer remains the driving force behind the economy. Personal consumption expenditures grew at an annual rate of 2.8% in November. Auto sales posted a new annual record year in December – though light vehicle sales edged up only 0.4% from a year ago, suggesting that sales might be leveling off. New home sales, which pulled back in the third quarter after a surge in July, rose strongly in November to post a 16.5% year-over-year gain. Home prices also continue to rise steadily at a rate of 5.6% in October, according to the latest Case-Shiller National Home Price Index. This is a new high for the index in nominal terms but still about 15% below the bubble peak in real terms.
The post-election period also saw consumers in an optimistic mood, perhaps anticipating a boost in economic growth and potential tax cuts as part of a fiscal package, not to mention a rising stock market. The University of Michigan consumer sentiment index surged to 98.2 in December, the highest level since 2007.
The industrial sector continues its status as the economy’s weak link. The industrial production index recorded its fifteenth straight month of contraction in November, decreasing by 0.6% year-over-year. The glass half full take here is that the index is now contracting at its slowest rate in over a year, while manufacturing PMI has climbed to 54.7 in December, up from a low of 49.4 in August. Exports also appear to have finally turned the corner, growing at an annual rate of 0.76% in the third quarter, the first positive reading since the fourth quarter of 2014. The stabilization of the dollar over the first three quarters of the year certainly helped the export sector, but it is an open question whether the dollar’s renewed post-election surge will crimp exports once again.
Positive economic news during the fourth quarter, and the possibility of massive fiscal spending in 2017, minimized the uncertainty over Federal Reserve (Fed) policy at their December meeting. As was widely expected, the Fed raised interest rates by 25 basis points at this meeting. The Fed has been looking for reasons to raise rates for a while, in the essential belief that monetary policy is abnormally loose and it should utilize any credible excuse to tighten. Interestingly, policy makers expect three rate hikes in 2017. A tight monetary policy would most likely cohere with a large fiscal expansion as promised by the new Trump administration but the uncertainty as to the size and effectiveness of such a package potentially risks a premature and accelerated pace of tightening based on over interpreted data. At present, with inflation having undershot the target for so long and bleak evidence of wage spiraling in the near future, there is no compelling case to raise the cost of borrowing rapidly, especially given the market’s response to the anticipated fiscal stimulus – higher long-term rates and a stronger dollar, the fallout of a tight monetary policy.
Convex’s proprietary leading economic index (CPLEI) risk rating for the US rose from Hold at the beginning of the quarter to Hold-Buy in November and December. However, domestic equity allocation was reduced from 66% in October to 59% after the presidential election due to uncertainty over the incoming administration’s policies. Equity allocation was further reduced to 55% a day prior to the Italian referendum (on December 5th) to reduce exposure to known-unknown risks, especially in the financial sector. The portfolio’s exposure to domestic equities contributed 2.71 percentage points to the fund’s fourth quarter return.
Monetary policy stymied while populism rises
The European central bank (ECB) voted to extend their bond-buying program through to the end of 2017 at their December meeting. However, they will taper the amount of purchases from the current 80 million euros to 60 million euros from March 2017. In a sign that European monetary authorities have reached an impasse, the ECB urged countries with more fiscal space to increase fiscal expenditure so as to bring additional growth to the bloc. This echoed calls for fiscal stimulus by the European Commission in November, amid persistently low inflation and a negative output gap despite record low interest rates.
On a more positive note, a cyclical recovery may be in sight, at least in certain parts of Europe. Northern European countries like Germany, Netherlands and Sweden saw momentum in the manufacturing and construction sectors. Manufacturing PMI has also been rising in Spain since August, hitting 55.3 in December, even as the unemployment rate trends lower and political uncertainty abated.
Headline Eurozone inflation came in at 1.1 percent in December, which is the highest since September 2009, but well below the central bank’s target of 2 percent. The euro also appears to be racing towards parity with the dollar, falling 6.1% over the fourth quarter to 1.055. In theory this should help exports but the reality is that most Eurozone exports lie within the common currency area.
At the same time, political uncertainty creates a large dark cloud over Europe and could very well throw a spanner into any recovery. The populist angst that gave rise to Brexit continues to spread across the continent, with Italy the latest to experience political upheaval. The Italian referendum that took place on December 5th, which on the face of it was about constitutional reforms and not related to European Union (EU) membership, resulted in a loss for the Prime Minister Renzi’s ruling party and a nominal ‘win’ for the anti-EU, populist party. This created renewed uncertainty about the status of a bailout package that Renzi was working on for rescuing Italian banks, which are amongst the most troubled in Europe. While the new government has approved a bailout package for 20 billion euros, the rescue bill only seems to be growing larger as each day passes and it is not certain whether the approved funds will be enough. It is an open question as to whether the new government will even make it all the way to the next general election (scheduled in 2018), making it likely that populist parties could gain further ground if interim elections are held.
Even as the ECB seems to have reached their limit of possibilities, the Bank of Japan (BoJ) appears to be trying anything and everything within the realm of monetary easing to try and get Japanese inflation off the zero mark. The BoJ’s new framework of yield curve control, announced at their September meeting, includes purchases of Japanese government bonds (starting in January 2017) and a commitment to even overshoot their target inflation rate of 2 percent. At the same time, the central bank continues its equity ETF buying program (which it doubled in July), and is now on track to become the largest shareholder in 55 companies within the Nikkei 225 Stock Average, making the third largest equity market in the world a rather strange place.
The CPLEI risk rating for Germany, Netherlands and Sweden rose to Hold during the fourth quarter, but the overall regional rating remained at Caution-Hold thanks to a negative outlook for France, Switzerland, United Kingdom, Ireland and Italy. With Japan also rated as Caution-Hold and higher volatility in Japanese equity markets, the fund portfolio had no exposure to developed International markets throughout the fourth quarter.
The portfolio had a small exposure to selective emerging markets that were rated Hold up until the US presidential election, namely, India and Taiwan (South Korea position was offloaded at the end of October), adding up to a 5.5% allocation. These exposures were reduced to zero after the US election due to concerns over the impact of a rising dollar and new trade policies on emerging countries. Other Emerging Markets, including China and South America, were rated as Caution or Caution-Hold throughout the fourth quarter. Emerging Market allocations during the pre-election period dragged the portfolio return down by 0.57 percentage points.
The overall risk rating for the world rose from Caution-Hold in October to Hold in November and December, mostly on the back of positive US economic news. However, the fund’s exposure to fixed income was reduced from 22.5% in October to 4% after the election, over concerns of yield curve steepening in the face of potential Fed tightening and reaction of fiscal stimulus. The entire fixed income exposure during the post-election period came from high yield bonds. Together with the reduction in equity exposure during this period, the portfolio had a cash allocation of 40% post-election. Fixed income allocation dragged the fund’s fourth quarter return down by 0.80 percentage points.
The immediate question on everybody’s mind is what happens next with respect to policies pursued by the incoming Trump administration, not to mention the impact of these, including the reaction function of the Federal Reserve and other countries. Whether China can manage its transition to a consumption-based economy while fighting capital outflows remains a key risk. Also, as we mentioned earlier, heavy clouds of political uncertainty hang over Europe just as several countries in the region appear to be making a cyclical recovery.
While we stay away from making forecasts and predictions, we are closely watching and seeking answers to the following ten questions as 2017 gets underway:
1. Will fiscal spending by the Trump administration meet expectations?
Equity markets, and bond markets, are clearly pricing in significant fiscal stimulus from the incoming Trump administration, including major changes to the tax code (corporate and personal), regulatory upheaval, infrastructure and defense spending. However, the Trump rally is currently based on conjecture. The President-elect’s policy proposals remain opaque and the reality is that all of these policies will have to go through Congress. Even with a Republican Congress, any significant tax reform package is unlikely to pass before the summer, especially if they try to make the package revenue-neutral (which would remove any stimulus impact). Deficit-hawks in Congress have also begun to pour cold water on any major infrastructure-spending bill. It is an open question as to how much pressure the Trump administration can put on Congress to get its way. There is always the possibility that the final package could surprise to the upside, but with Congress’ role in crafting the various pieces of legislation, we are more than likely to see the opposite.
2. Will America look inward and reverse decades-long trade policies, perhaps leading to a trade-war?
Trade policy has been an area where President-Elect Trump has stood firm on throughout the campaign, and after. The fact that he is serious about trade is reflected in his appointees to set trade policy, including the Commerce Secretary, the US Trade Representative, and the head of a newly created White House office that will oversee American trade and industrial policy – all of whom are highly critical of the US-China trade relationship as it stands today, let alone globalization. The question is how the new administration will go about restructuring America’s existing trade relationships and upend decades-long policies that both parties in Washington have acquiesced to, and whether this will be done in concert with a Republican Congress that has traditionally been very pro-trade. Will they institute something like import tariffs – the President-elect’s team has floated a 10% tariff aimed at promoting American manufacturing – or remove expensing of import costs while restructuring the tax code, which are essentially tariffs? While the Trump team’s goal is to raise GDP growth by reducing imports, it is not quite as simple since imports actually rise as the economy grows with higher consumption, resulting in more trade deficit. So it will not be easy to cut the trade deficit for an import-dependent country like the US while also expecting it to grow above average. Of course, none of this can be done unilaterally and we have to assume that other countries will retaliate as well. We could then be looking at significant consequences for companies in the US that rely on global supply chains, and ultimately consumer prices. Not to mention the impact on countries, especially those in Asia, that play a critical role in these global supply chain routes.
3. How will the Federal Reserve react to increased fiscal spending?
Fiscal spending by the new administration will be carried out in an economy that is near full employment and is starting to see wages rise. This is clearly an environment in which the Fed believes fiscal spending is not required, as Fed Chair Janet Yellen noted after the Fed’s December meeting: “I would say at this point that fiscal policy is not obviously needed to provide stimulus to get us back to full employment”. While the Fed seems inclined to wait and see what fiscal policies will actually be implemented, they may look to normalize rates at a faster than expected pace (of three rate hikes in 2017) if inflation appears to be heading out of their comfort zone. In that event, we could see some tension between the Fed and the executive. We could also see a flattening of the yield curve if fiscal policies fail to provide the expected boost even as the Fed continues along their current trajectory of rate hikes. Note that a flattening of the yield curve by itself is not indicative of future recession (unlike an inverted yield curve). Throughout the late 1990’s, when the economy was expanding at a rapid pace, the yield curve was considerably flatter than what it is today. Is the US entering a period of political and economic uncertainty in 2017 with unclear policies from the new administration and premature monetary policy tightening?
4. Will the US dollar continue to rise?
The Fed embarking on tighter monetary policy was always likely to push the dollar higher, especially with Europe and Japan still mired in negative and near-zero rates across the curve. With the Trump administration looking to promote “America First” policies, especially with respect to trade, the dollar could see a further boost. Ironically, the rising dollar will only make it harder for American manufacturers to compete overseas, while providing ever more incentive for American companies to offshore operations. A rising dollar will also be negative for emerging markets, especially China, which we discuss below.
5. Will rising interest rates crimp US consumption spending?
Consumer spending has been the driving force behind the recovery since 2009, with housing, car sales and durable goods sales all benefiting from the low rate regime. Car sales have already begun to level off and durable goods may see a double blow if import prices also rise. Private residential investment, i.e. investment in new single and multi-family structures, home improvement and commissions, has historically been a strong contributor to GDP but has been weak during the entire recovery – a key reason behind the sluggish recovery. Residential investment slowed in 2016 and is likely to do so again in 2017 if interest rates continue to rise, putting an additional dampener on growth.
6. How will China deal with its transition while fighting capital outflows?
Equity markets cratered during the first week of 2016 after Chinese authorities fixed the yuan reference rate at a five-year low on January 6th. Concerns continued throughout the year, with China spending nearly $329 billion of its reserves, on top of $513 billion in 2015, to defend its currency amid capital outflows. This is despite an uptick in economic data – third quarter GDP growth came in on target at 6.7% but it was primarily driven by local government debt. The Chinese have made advances to transition their economy away from export-led manufacturing but the service sector still makes up about 50% of the economy. Sectors like telecom, healthcare and education continue to be tightly controlled by the state. The question is how long the Chinese can continue to provide short-term support on the back of a rising debt load that is already close to 250% of GDP. While the yuan caught a break mid-year as the dollar stabilized at a lower level, it came under renewed pressure as the dollar resumed its rise after the US election. Reserves fell to a six-year low of $3.01 trillion in December 2016 even as the country saw $82 billion of capital flows just in that month. In addition to fighting capital outflows with its foreign reserves, the Chinese also introduced stricter capital controls recently. Chinese authorities may come renewed pressure to stem outflows if the dollar continues to rise in 2017. The problem is that stricter capital controls will depress business sentiment, especially foreign direct investment. The other option is to raise interest rates, which will hurt their heavily indebted borrowers. As we wrote at the beginning of the year, the overseers of the world’s second largest economy may be forced to resolve their way out of the impossible trilemma by letting go of one of the following – low interest rates, a stable exchange rate or ending the free flow of capital – and how they go about doing this remains one of the biggest known-unknown risks.
7. How will China retaliate if the Trump administration starts a trade war?
This question arises if the new administration decides to act on its rhetoric and slap tariffs on imports, especially Chinese imports. It is an open question as to what retaliatory actions the Chinese will take if this occurs. China’s own problems, not to mention the fact that it runs a huge trade surplus with the US, narrow the space within which it can act. They could, however, make it difficult for US entities to do business seamlessly in China, with more taxes and investigations. Access to Chinese markets is critical to the growth trajectory of large American companies like Apple, Boeing and General Motors.
8. What will be the impact of rising anti-EU populist sentiment in Europe?
The major European countries like Germany are seeing a backlash against a core EU principle, the free movement of people across borders, in the face of refugees streaming in from a war-torn Middle East and terrorism. Furthermore, 2017 will see elections in some of Europe’s major countries, including the Netherlands in March, France in May and Germany in the fall. At this point it looks increasingly likely that the populace in these countries will move further towards parties that are antagonistic toward the union. Note that this does not imply a breakup of the common union. Instead, Europe is likely to muddle through as it has over the past seven years. However, rising populist and nationalistic sentiment will constrict the space within which EU governments can ease the ever-increasing pressures of remaining in a monetary union – like creating a fiscal union, joint debt issuance or continent-wide fiscal stimulus. Weakened leadership across the union also raises the possibility that Europe may not be able to act deftly to deal with, say a continent-wide banking crisis, which would only make the various countries even more susceptible to anti-EU populist movements.
How will the United Kingdom manage Brexit?
Prime Minister Teresa May of the United Kingdom (UK) has said that they will begin the divorce process from the EU by invoking Article 50 of the EU treaty by the end of March. The hard work of Brexit then begins. The Prime Minister has reiterated that Brexit will in fact be a “Hard Brexit” – meaning Britain will regain complete control of its immigration policies, laws and regulations, at the price of losing access to the common market. The Brexit vote in June did not sink the British economy but uncertainty will rise as negotiations begin. The big question is how the government manages the transition period while negotiations are underway, which could take years. For instance, while remaining part of the EU’s customs union, which allows free flow of goods and services across borders, the UK cannot negotiate new trade deals with other countries outside the EU. It is against EU law for a member to negotiate its own trade deals with outsiders. If they do immediately exit the customs union, the hope would be for a transition arrangement, but as of now, the remaining EU members appear unwilling to extend such accommodation. The UK government also seems to be underestimating how long it will take to negotiate bilateral trade deals once it is out of the EU. Trade negotiations take years because these deals almost always include the service sector, which is harder to sort out than the exchange of physical goods. Also, each country has a limited amount of staff that can work on these deals. In fact, the UK is even more at a disadvantage since all its existing trade agreements were done under the auspices of the EU and negotiated by teams from Brussels. This means they will have to cobble together an entirely new team of trade negotiators with the requisite skills to create its own sovereign trade regime, all in rather quick order.
10. Will crude oil prices stabilize around $50 a barrel?
Equity markets began 2016 tightly correlated with oil prices – the correlation between the S&P 500 index and oil prices hit 0.88 during the first twelve weeks of the year. However, this correlation reduced after oil prices stabilized in the latter half of 2016, even as equity markets closed the year at record levels. While the price of crude was given a significant boost after OPEC reached a deal to make production cuts beginning in 2017, there are several factors that could prevent it from going much higher. OPEC countries cheat their production quotas often and it is an open question whether Russia (a non-OPEC member) will abide by the cuts. Prices are also in contango, indicating short-term over-supply. US shale companies produced an additional 300,000 barrels per day (bpd) in 2016 and this could rise to a million bpd in 2017 as more rigs start coming online. That would make them the marginal producer – and there is no deal that requires shale companies to cut back production, except market prices. A rising US dollar could also impact worldwide demand if it makes oil, which is priced in dollars, more expensive. Demand could also slow if China continues its slowdown. The International Energy Agency projects demand to rise only 1.3 million bpd in 2017, down from 1.4 million bpd in 2016.
The Convex proprietary risk rating for the world stands at Hold as we move into 2017. We continue to monitor economic prospects of thirty different countries across five regions of the globe. We also remain vigilant about potential known-unknown risks arising from the questions mentioned above.
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