There are clear reasons why the markets have performed strongly this year, as the market commentary below lays out. But one can't help feel that there is an element of levitation above the tide, especially when the net inflows of hundreds of billions of dollars to passive funds in effect place a positive bet on every industry and company out there. This market may allow politicians to enable Trump to run the country like he has run his businesses - running a fine line between optimism and bankruptcy.
Tax reform may provide a boost to earnings, but how much will that really trickle down when the big issues remain off the table? We need our politicians to work together on the tough challenges, to have the courage to agree on long term solutions to both our national debt and the societal issues of inequality and education, to better tackle the modern economy.
Which of the below could tip negative first? With tax reform now going live, I think it's likely we have another year or two of upside as most of the themes below hold. But deflationary pressures from the hyper growth of technology across our economy likely depress growth and raise the pressure of the debt.
- Synchronized global growth:
- A synchronized upswing in global growth, which came
into focus even before the 2016 election, was one of the most widely
cited drivers of equity strength. The WSJ pointed out that all 45 countries monitored by
the OECD are on track to grow in 2017, with 33 of them
set to accelerate from the prior year. This is the first time since 2007
that all are growing and the most countries in acceleration since 2010.
The OECD said that the global economy will grow at its fastest pace since
2011 this year, and will continue in 2018 with all economies
contributing.
- Earnings recovery continues:
- According to FactSet’s Earnings Insight report, the estimated growth
for S&P 500 earnings in 2017 is 9.6%. It noted that if this growth
rate stands, it will be the highest since 2011. S&P 500 earnings
posted back-to-back quarters of double-digit growth in Q1 and Q2 for the
first time since 2011. This followed the first back-to-back quarters of
earnings growth in 2H16 since Q4 2014 and Q1 2015. While Q3 earnings were
adversely impacted by the hurricanes, the Street is looking for a return
to double-digit growth in Q4 and for that trend to continue throughout
2018.
- Earnings themes largely upbeat:
- Corporate executives noted throughout the year that
sentiment and growth expectations were optimistic. In its quarterly Beige
Book publication, Goldman Sachs noted that in Q3, such optimism
started to translate into better demand. Despite the uncertainty
surrounding the details (at least for most of the year), Washington
seemed to be a relative bright spot on earnings conference calls this
year with taxes and deregulation the key areas of focus. However,
executives also highlighted rising labor costs as a headwind on profit
margins.
- Fed tightens, but monetary policy still supportive and
financial conditions ease:
- Despite the traction behind the Fed’s tightening cycle
this year, still-easy global monetary policy was cited as a key tailwind
for risk assets. BofA Merrill Lynch noted in late November that the BoJ
and ECB have purchased ~$2.0T of assets this year. Financial conditions also
eased throughout the year. Following the Fed’s third rate hike in
December, the Goldman Sachs US Financial Conditions Index was at the
lowest level (loosest financial conditions) in over three years on the
back of record equity levels, tight credit spreads and low yields.
- Low volatility:
- Low volatility was one of the most notable
characteristics of this year’s rally. Credit Suisse pointed out that
market experienced zero 2% moves and only eight 1% moves in 2017.
JPMorgan noted that the average VIX level of ~11 was ~10 points below its
historical average. While there were some concerns about investor
complacency, Morgan Stanley discussed how the low market volatility
environment is largely a function of fundamental factors such as low
economic and earnings volatility. It added that it is also a natural
outcome of the QE era and secular stagnation.
- Low inflation:
- Fed Chair Yellen said low inflation was the “biggest
surprise” in the US economy this year. The combination of low inflation
and a tight labor market generated a lot of debate about the extent of
transitory, cyclical and structural influences. From an equity market
perspective, the sluggish inflation trend was largely seen as a positive
by helping to keep long-term bond yields low (and financial conditions
loose) in the face of Fed tightening and expectations for global central
banks to be very cautious in removing policy accommodation.
- Republicans pass tax bill:
- Republicans defied the policy skepticism that
prevailed throughout much of the year and passed a $1.5T tax overhaul in
December. The legislation was particularly favorable for business,
lowering the corporate tax rate from 35% to 21%. Sell-side strategists
estimated that the corporate tax cut could boost S&P 500 earnings by
7-10% in 2018 (Reuters). However, there was a lot of debate about
what may be now priced in, along with uncertainty surrounding what
companies what will do with the tax savings (bigger buybacks and
dividends, increased capex, M&A, price investments).
- Animal spirits:
- The animal spirits dynamic seen as supportive for
equities in 2017 was partly evidenced by elevated consumer and business
confidence levels. One that attracted attention was the NFIB index of
small business confidence. It recorded its biggest monthly increase in
December 2016 just following the election. This November, it touched a
34-year high, hitting its second-best level in the history of the index.
The release highlighted the “change in the management
team in Washington” as the key driver behind improved expectations.
- No spillover from geopolitical tensions:
- Geopolitical tensions failed to have any meaningful
impact on risk sentiment this year. Despite the increased sophistication
of North Korea’s nuclear program and President Trump’s rhetoric, there
were thoughts that this year’s flare-ups really did not deviate much from
prior periods of tension, with a lack of “good” military options for
either side keeping the focus on strategies of deterrence. There was also
a lot of discussion about the equity market’s historical track record of
ignoring geopolitical tensions and investors using related dips as buying
opportunities (NY Times, WSJ).
- No spillover from Trump controversies:
- The market consistently demonstrated a lack of
interest in the controversies surrounding President Trump. This included
the backlash that stemmed from his reaction to the violence in
Charlottesville and repeated attacks on Republicans in Congress and even
those in his own administration. Special Counsel Mueller’s probe into
Russian interference in the 2016 election, which has ensnared several
Trump campaign officials and reportedly is also looking into whether
Trump may have obstructed justice, was another non-issue for markets.
- Passive vs. Active:
- The heightened momentum behind the shift from active
to passive investing was cited as helping to keep the path of least
resistance higher for the market given the indiscriminate nature of the
(broad-based) buying. Reuters noted in mid-December that according to
Lipper, equity mutual funds have seen net outflows of $141B this year
while equity ETFs are on track for $265B of inflows. In October, the WSJ noted that investors plowed nearly $300B into
Vanguard Group in the first nine months of 2017, nearly matching flows
into the firm for all of 2016.
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