Signal & Noise
It’s tempting to read the past year in US markets as driven by political events. The markets swooned in January in response to the Chinese government tightening monetary policy. In June our markets sold off following the Brexit vote. And in the final weeks of the year US stocks rallied following the presidential election.
In our opinion, most of this was noise that masked the underlying drivers of the markets’ near-term trends. Those drivers, the true signals, were (per usual) the economic prospects for the coming six-to-twelve months, give or take. From early in 2016 through the rest of the year those prospects were improving, and doing so despite all the political fireworks. This is why we predicted the stock market’s direction would be up for the year and why, in fact, the S&P 500 returned 12% for 2016. Economic prospects were improving.
A Political Reading
Many have taken the market’s post-election ebullience to reflect three fundamental policy expectations: a reduction in corporate regulatory risks and costs; lower personal and corporate income-tax rates; and generally a more laissez-faire environment for conducting business. We believe each of these expectations, for better or worse, is realistic.
Similar expectations were raised by Ronald Reagan’s election in November of 1980. While stocks rose after his election, by July of 1981 the US stock market was down almost 20% as the economy slowed and sank into recession.
We see a similar script unfolding for President-elect Trump. Why? Not because of much he or the new Congress will or can do. Like every president, including Reagan, when Trump takes office he will inherit a set of economic trends for 2017 that are not of his making and over which he has very little control. Those fundamental trends, in our opinion, are set to cause the prospects for the US economy to dim.
Two of Three Reasons
As we’ve argued many times, the US business cycle is driven primarily by two factors: trends in both interest rates and in inflation, particularly energy inflation. In 2016 the US economy enjoyed the benefit of a tailwind driven by two years’ worth of falling energy prices and interest rates. With a lag, each of these declining price trends—the price of money and the price of oil—provided a widespread stimulus to the US economy in 2016.
However, interest rates and oil prices both bottomed in 2016 and then turned up. From their lows both the price of oil and interest rates have roughly doubled. The yield on the 10-year US Treasury Note has gone from 1.36% to 2.54% and the price of West Texas crude oil has risen from $26 to $54 a barrel.
While rates and oil prices are still arguably low by historical standards, for the economy it’s the change that matters. And sharply rising interest rates and oil prices will have a chilling effect on the US economy.
First, higher interest rates mean higher mortgage rates and this means fewer home purchases and a slower housing sector. Housing accounts for about 15% of the US economy. Higher interest rates also spell fewer mortgage refinancings and less of the consumer spending refi’s generate. And higher interest rates yield less incremental borrowing in general and thus less spending.
Higher oil prices, as we’ve explained many times, capture more US consumer dollars at the pump, leaving fewer for domestic discretionary spending. With consumer spending representing about 70% of all US economic activity, higher interest rates and higher oil prices have a very broad, cooling impact on the overall economy.
A third headwind for the US economy is being generated by the sharply rising US dollar—a move that accelerated after Trump’s election. A rising dollar means US exports become more expensive, which leads to fewer exports and a slower manufacturing sector. Manufacturing accounts for about 12% of the US economy.
So, with housing at 15% of the US economy, manufacturing at 12%, and personal consumption at 70%, and with all facing expected headwinds, it seems reasonable to expect the US economy to slow. Which we do. Whether an actual recession develops remains to be seen. But a slowing of the already fairly slow-growing US economy looks to be in the cards.
If we’re right and a slowdown in the US economy is on the horizon, we should expect the stock market to sniff that out and lose its luster. We expect a decline in double-digit percentages—at least a correction (-10%) and possibly a bear market (-20%). How deep a decline depends on the depth of the slowdown—whether we’re facing a recession in the US—as well as on the knock-on risks of a foreign financial crisis brought on by slowing global growth.
The US economy is one of the healthier in the world as well as being the largest. So if the US economy slows, so will other economies. And when global growth slows, the odds of a foreign financial crisis rise. Where, of course, nobody knows. China is certainly a candidate as that country just posted the biggest decline in its annual exports since the 2009 crisis. But there are plenty of other potential trouble spots around the globe.
Speaking of exports, one area where our new president can have immediate effects is on trade, where the Executive Branch of our government has a lot of unchecked power over policy. While it’s very hard to know what Trump’s actual trade policies will be, his broadly protectionist rhetoric has been taken very seriously by the currency markets. Since his election, the US dollar has risen sharply against the currencies of many of our trading partners, like Mexico. Put conversely, emerging economy currencies have fallen off a cliff relative to the US dollar.
As noted above, a strengthening US dollar weakens US exports and the US manufacturing sector. It also raises the risks of a foreign financial crisis as emerging economies have built up a massive amount of debt denominated in US dollars. A stronger dollar makes interest payments on that debt more expensive. This has the same effect as raising the debt’s interest rate, which raises default risk. Add that into an environment where interest rates are also rising, and you have the makings of a foreign debt crisis.
With trade now representing nearly 60% of total global economic activity, the interjection of President-elect Trump into US trade policy must be viewed as a source of great uncertainty and a risk factor in itself. This is not a partisan observation as both Republicans and Democrats are confused by Trump’s mixed messages.
What We’re Doing
We said for most of last year that we saw dark clouds gathering in 2017. We felt that way before the election for reasons that have nothing to do with presidential politics. With the election now behind us, we continue to expect 2017 to be a difficult year for stock investors with the election having added new elements of risk to the mix.
We think of our portfolios as diversified across four quadrants of investing: public-market equity (stocks), public-market debt (bonds), private-market equity (funds) and private-market debt (funds). In any given market environment, we shift our portfolios’ allocations among these four quadrants based upon where see the best risk/reward trade-offs.
Our current posture reduces public equity exposure, i.e., the stock market, to a defensive level relative to each client’s normal exposure. As a corollary, we have increased exposure to both public and private debt, i.e., bonds and our Income & Impact Fund. In this move out of equity and into debt, our intent is to dial back the risk in our overall portfolios and dial up safety of principal and predictability of return.
We’re maintaining our relatively small existing private-equity exposure to our own Private Market Impact Fund as well as to other private-equity offerings. These private-equity investments are so long-term in nature that a negative outlook for 2017 has little relevance.
A slowdown in the US economy could very likely bring hardship to US stock investors this year. But it would also sow the seeds of a US recovery by lowering interest rates and energy prices, as demand for borrowing and energy falls off in a slowdown. This would, in turn and with a lag, re-stimulate the US economy and the stock market. This is the natural cycle of things. If we’re correct in our outlook, we’ll have an opportunity in the coming months to increase exposure to the stock market at more attractive prices.
Farnum Brown, Chief Strategist
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This material is not financial advice, an offer to sell, or a solicitation of an offer to purchase any fund managed by Arjuna Capital, LLC (“Arjuna Capital”). Such an offer will be made only by a Confidential Private Placement Memorandum, a copy of which is available to qualifying potential investors upon request.
The opinions expressed herein are those of Arjuna Capital and are subject to change without notice. This material is not financial advice or an offer to sell any product. Arjuna Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions Arjuna Capital makes in the future will be profitable or equal the performance of the securities discussed herein.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of share outstanding), with each stock’s weight in the Index proportionate to its market value. The S&P 500 is one of the most widely used benchmarks of US equity performance.
Arjuna Capital is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Arjuna Capital, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.
The opinions expressed herein are those of Arjuna Capital, LLC (“Arjuna Capital”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. Arjuna Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Arjuna Capital is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Arjuna Capital including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request. AJC -17-02