A Boost to Normalization
“Change is the law of life and those who look only to the past or present are certain to miss the future.”
John F. Kennedy
The stock market has reacted favorably to the election of Donald Trump. The opinions of Clinton voters and those who did not vote do not matter. A program of infrastructure renewal, lower taxes, deregulation, and better healthcare has “Trumped” protectionism for now. Presidential honeymoons do not last long and it will be imperative for definitive plans to quickly replace speculation. Already most economic forecasts have been revised upward for 2017, and interest rates have risen in anticipation of the Fed meeting in December. It is the bond market where the bleeding is happening. As mentioned in our last Compass, it is too early to declare the “Great Rotation” from bonds into stocks, but when the yield of the 10-Year Treasury rises 67% from mid-July, every economist should take notice. The increase in overall rates since the election has precipitated a shift out of fixed-income Mutual Funds and bond ETFs. More than $1 billion has flowed out since the election as rates rose 50-basis points for the 10-Year Treasury. For many investors the full effect will not be apparent until they receive their November or December statements.
Before the election it was a widely held belief that a Clinton victory was assured and investment managers accepted a continuation of the status quo. A large federal government positing overregulation, higher taxes, and rising healthcare and education costs was deemed a manageable investment climate. The 2% economy had prevailed since 2010 and the stock and bond markets remained in bull mode. All of this is changed. The economy has the opportunity to be better, inflation will return and interest rates will rise as fiscal policy accelerates to normalization. Rotation in the stock market away from Utilities, REIT’s, and Consumer Staples into Financial and Industrials was immediate on the day after the election. Some adjustments have been made, the move into drugs has been tempered after realizing that responsibility for rising prices were market forces rather than potential broad-based price regulation. Industrials are falling victim to a rising dollar, lowering foreign earnings offsetting the positives of the effects of an infrastructure buildout. This is all occurring in an economic environment that has many of the characteristics of a market bottom as compared to a market top. Consumers and corporations have deleveraged, US productivity is at a post-War record lows, and unused capacity is plentiful.
Even prior to the pro-growth mindset the economy was showing consistent improvement in concert with our forecast of longer-term consumer-led economic growth accompanied by low rising interest rates and moderate inflation. With the election this outlook received a substantial boost, now the magnitude and duration of the bull market has much more potential.
The Consumer: The consumer and the housing market are poised to continue their growth in 2017. Household formations are growing about one million annually, a trend that is expected to continue as more Millennials (87 million) settle down to family life. The major problem for housing has been the inconsistency in sales due to low inventory. The most recent October 2016 Existing Home Sales from the National Association of Realtors were 5.6 million, up 5.9% above year-ago levels and the highest since February 2007. The median existing home price is $232,000 a 6.0% increase from October 2015, and the 56th consecutive monthly year-over-year price increase. Unsold inventory is at an historically low level of 4.3 month supply. A large number of lower-end single family homes and condos were purchased by investors following the financial crisis. Many of these were converted to rental units. At year-end 2015 there were 17.5 million renter occupied single family homes, compared with 10.7 million in 2000. With rising rents and price appreciation, investors are holding these longer, but eventually most will be sold adding to supply. Also, more Baby Boomers are aging in place and downsizing at a much later age. This has created a surge in home improvement spending, but lessens the supply of existing homes. New Home Sales were 560,000 in October 2016, lower than the estimate of 590,000, but up 17.8% year-over-year, and the best October since 2007. Supply remains low at 5.3 months.
The impending Fed increase in interest rates should only have a marginal impact on real Disposable Personal Income. Consumers balance sheets, unlike in other periods of rising rates, are more countercyclical. Almost 75% of outstanding household debt is in fixed-rate mortgages with roughly 90% at an average 3.8% rate. Other fixed-rate instruments (including auto debt) account for an additional 15% of household debt, leaving less than 10% of debt at a variable rate. The November 2016 University of Michigan’s Index of Consumer Sentiment, sharply increased following the election. The overall Index rose 6.6 points to 93.8, the largest month-over-month gain in three years. Notable is the 8.4 point rise in the sub-Index of Consumer Expectations. This trend was confirmed by Holiday sales over Black Friday through Cyber Monday. Housing and real Personal Disposable Income should be positively impacted as the low unemployment rate and slower job growth result in rising wages and salaries.
Forgotten over the past two weeks is the positive for corporate earnings from an expansive fiscal policy. Initially, infrastructure spending will benefit a select group of companies and should have a multiplier effect on consumer spending. Tax cuts will take longer to pass, if for no other reason than government moves at government speed. The unwinding of Obama Executive Orders will have a positive short-term impact on costs for many small companies, banks, and the energy sector. JP Morgan estimates a $15 increase in 2017 S&P 500 earnings and most other estimates fall in the $10-$12 range. These estimates would bring the 2017 consensus earnings P/E of 17.0X down to a range of 15.0X-15.5X. Corporations will have more freedom to control their destiny, that in itself should add to earnings.
Our investment policy remains optimistic. Transitioning to a new Administration may increase volatility short term, but should not interfere with long-term investment strategy. A more dominant consumeroriented economy is evolving, but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.