Winds of Change

by Shawn Narancich, CFA
Executive Vice President of Research

Volatility on the Back Burner

What has become known as the Trump Trade has delivered strong equity returns since election day last fall, with the benchmark S&P 500 rising by 6.5 percent over this period. More remarkable is the fact that the blue chip index hasn’t experienced a 1 percent or greater loss since October 11, 2016. This lack of downside volatility is unusual, and as the nation transitions to a new presidency, we can’t help but wonder whether the delivery of business deregulation, tax reform and infrastructure spending will meet the expectations that investors have built into stock prices. Indeed, as we note in our 2017 Outlook presentation, government policy poses a key risk to our call for modest equity returns in 2017. With equity index valuations at 18x expected earnings, the margin for error has shrunk. We believe that for stock prices to make forward progress this year, earnings must grow.

Early Innings

And on that note, investors are beginning to digest an increasing number of fourth quarter earnings reports, which in the aggregate are expected to show low single-digit growth similar to what corporate America delivered the last time around. To date, the regional and money center banks have reported respectable numbers, but the reaction to earnings has been muted. The likes of Citigroup, Goldman Sachs and US Bancorp all beat expectations this week, but shares didn’t do much afterward in the wake of substantial gains already realized since the election. Whether it be short rates levered to the Fed’s interest rate policy or the longer end of the curve, higher interest rates are a key positive for banks, allowing for better net interest margins and more fruitful investment of excess reserves. As we reconcile our outlook for modestly higher interest rates this year with the low rate comparisons of 2016, we foresee relatively attractive earnings visibility for the financials sector in 2017.

Base Effects

Which brings us to a key underlying determinant of interest rates. Investors digested news this week that headline inflation is now up to a two-and-a-half year high of 2.1 percent, certainly not a shocking number per se, but notable because of its attribution to the rebound in oil. Gasoline prices a year ago reflected oil below $30 per barrel, a level that would prove to be transitory, but is nevertheless creating difficult base period comparisons for the consumer price index. As these “base effects” work their way through the numbers over the next couple months, headline inflation numbers appear headed for the 3 percent level. We don’t think this causes the Fed any undue consternation given their understanding of the underlying factors in play, but with unemployment well below 5 percent and wage increases gaining traction in the broader economy, investors should be prepared for at least another couple of rate hikes this year.

Ushering in a New Era

What impact Trump tax reform and trade policy might have remains to be seen, but the border adjustable tax plan (taxing corporate profits at a lower rate, but broadening the tax base by taxing imports and making exports tax free) being promoted by the House of Representatives could, if implemented, have untoward consequences for both inflation and economic growth. The risk to both stocks and bonds is that border adjustability is seen by other nations as an import tariff in disguise, resulting in retaliatory trade policy and the potential for a damaging trade war. President Trump disavowed the proposed new tax policy this past weekend, but what tax reform ultimately emanates from D.C. is difficult to discern at this point.

Our Takeaways from the Week

  • Inauguration week in the U.S. heralded modestly lower stock prices amid continued low volatility
  • Tax reform and trade policy loom large as Donald Trump assumes the U.S. presidency