Fourth Quarter 2016
What a wild 4th quarter — the Federal Reserve finally hiked rates as bond yields raced higher, and the US elected a reality TV star real estate mogul as our next President. Despite the doom and gloom expected, equities broke higher after President-elect Trump’s acceptance speech was broadly conciliatory. Thankfully, none of our managers were selling S&P Futures while they watched the election returns roll in. Following the results, bond yields raced higher on increased growth and inflation expectations. Banks and small cap stocks also jumped as investors hoped that the burdens of eight years of over-regulation would be alleviated.
With the market at all-time highs, we cannot help but focus on what could go wrong. As markets have priced in the upside of Trump tax and regulatory reform, they have also become more fragile: high yield spreads are back to multi-year lows; equity valuations are at multi-year highs; interest rates are still depressed; and even carry trades are back in vogue. According to the AAII US Investor Sentiment Survey, bullish sentiment rebounded to five-year highs after the election. The US Dollar continues to benefit from unbalanced monetary policy, as the US has started raising rates while Japan and Europe continue to push the barriers of dovish policy.
Across the world, emerging market countries continue to suffer from a drop in commodity demand. Trade imbalances in commodity exporters, such as Mexico, South Africa, Russia, and Brazil have triggered varying degrees of currency weakness, which in turn has led to inflation. Despite slow growth, some have hiked rates to protect their currency. China faces a larger problem. Confronted with highly levered banks and slowing lending growth, China is attempting to engineer a smooth devaluation to improve competitiveness and fight deflation. However, China cannot maintain a fixed exchange rate, free movement of capital, and independent monetary policy. For example, while the currency has been largely stable vs a basket of global currencies, the money market rates in China have become very volatile. Imagine the chaos if the fed funds rate in the US moved by more than 1% a day, an event that is now the norm in China.
Looking ahead, 2017 will bring renewed focus on Italian bank bailouts, Greek fiscal reform, Brexit, and other long simmering macro concerns. It is worth noting that the British pound depreciated significantly after the vote, leaving UK citizens to face higher import prices. Also, we worry that the proxy war between Iran and Saudi Arabia could get more direct, fiscal deficits brought on by low oil prices could create nightmares for the pegged currency regimes in the Middle East, and Turkey’s clamp down on political dissent following last year’s coup attempt could create further civil unrest. Increasing instability between the US, China and Russia is becoming the largest possible source of future geopolitical conflict. Finally, in Europe, additional crimes by refugees and terrorist attacks could trigger larger populist backlashes against the European Union.
In the US, we are carefully monitoring changes in US trade, tax and fiscal policy. We doubt there is a magic bullet where cutting taxes will somehow balance the budget but we do think that corporate tax reform and regulatory reform will help growth. We are also watching for any major changes in US trade policy. Trade restrictions brought on by the Smoot-Hawley Tariff Act in 1930 contributed to a 50% drop in US exports and imports, and were partially to blame for making the Great Depression worse. We hope our President surrounds himself with students of history, and targets unfair trade instead of all trade. Starting a trade war is not in the best interest of anyone.