Market Outlook: 3Q17
While the headlines of a rising market tell us the economy is improving, the internal make-up of the market—what’s working and what’s not—tells us the economy is slowing. One of them will prove wrong.
The Trump Bump
For all of 2017 there has been a strange disconnect between the “soft” and the “hard” data on the economy. By soft data we mean mostly surveys that ask for opinions. By hard data we mean reports on things that actually happened, like auto sales and construction spending.
The soft data has been very optimistic. Separate surveys of the confidence felt about the future of the economy among small business owners, among consumers, and among home builders, for example, soared after the presidential election. This reflected the widespread belief that a Trump Administration would usher in a more business-friendly regulatory environment and, working with a Republican Congress, provide stimulus to the economy through federal infrastructure spending and tax cuts to individuals and corporations.
As we pointed out in our January Outlook, even were those expectations to be met, the policy effects wouldn’t be felt in the economy until 2018 at the earliest. We, therefore, felt that confidence had gotten ahead of the economics and would meet with disappointment, even if Trump and the Republicans delivered on their promises.
And, indeed, that has been the case. Auto sales, retail sales, and hiring trends have all been weak so far this year, with first-quarter GDP growth (after-inflation economic growth) falling to an anemic 1.4%. The second quarter ending June 30 should have proved a bit stronger, but is likely to still have been fairly tepid.
This divergence between soft and hard economic data is captured best by Citigroup’s US Economic Surprise Index, which tracks how the hard (actual) data compared to the soft (expectation) data. Starting earlier this year, the chart that depicts this relationship shows a line going straight down, with the actual data consistently disappointing (surprising to the downside) widespread expectations.
Headlines vs. Internals
A similar divergence has characterized the stock market so far in 2017. For the first half of 2017, the S&P 500 returned a stellar 9.34%. President Trump has trumpeted this “headline” return as proof of the effectiveness of his presidency and of the better times ahead for the economy. Generally speaking, the stock market is a good (but not perfect) leading indicator of the economy, as we’ve remarked many times. We’ve also remarked repeatedly that the market’s direction is largely determined by whether investors believe economic prospects are improving or deteriorating.
So far in 2017, investor expectations as expressed in the stock market’s upward direction align with the expectations expressed in the other confidence surveys mentioned above: They expect better times ahead.
When you look under the hood of the market, however, it appears investors are simultaneously sending a very different signal. If investors anticipate an improving, i.e., accelerating, economy, you would expect them to favor stocks of companies that benefited most from an upswing in the economy. That is, stocks of companies whose earnings are more cyclical. Energy, material, and industrial stocks are the textbook examples.
In 2016, as the economy was indeed improving, energy stocks were the top performers for the year. Why? Because as the economy accelerates, demand for energy rises and energy prices along with it. Energy stocks tend to follow energy prices very closely.
This year, however, energy stocks are dead last in the market. Through June 30 of this year, energy stocks in aggregate were actually down 14% from the start of the year. Why? Because energy prices are declining due to falling demand from a slowing economy. So, while investors are bidding up the market, they’re not bidding up its most cyclical sector. (This weakness in the energy sector has provided quite a tailwind for our fossil-fuel-free equity strategies.)
What are investors betting on? Healthcare stocks are some of the least cyclical in the market and they’re up 15% in the first half of the year. In 2016 they came in dead last as investors favored cyclicality and shunned more steady, non-cyclical sectors.
What we see here is a complete reversal of investors’ sector preferences from 2016 to 2017. Energy was best in 2016 and worst so far in 2017. Healthcare was worst last year and one of the best sectors this year. Investors may be bidding up the market, but they’re also bidding up its less cyclical sectors.
There has been a similar flip-flop in other ways that investors express their economic outlook. Last year small company stocks led the way as they tend to get the most boost from an accelerating economy. This year, they’re dead last as investors favor stocks of the very largest companies, which typically weather a slowdown in the economy much better while small companies take the bigger hit.
Our point here is that while the headlines of a rising market tell us the economy is improving, the internal make-up of the market is telling us the economy is slowing. One of them will prove wrong. The historical pattern is that the market’s internals begin to fade before the market headlines follow. That’s what we expect to happen as the rest of the year unfolds.
Convergence
So, we expect the soft data to converge to the downside with the hard data. And we expect the stock market headlines to converge to the downside with the stock market’s internals.
We believe this convergence to the downside will continue at least into the middle of 2018. This should pressure stocks and, somewhere along the line, provoke a meaningful decline in the market—and by meaningful we mean in the neighborhood of 15%. Whether the decline turns into something more dramatic—a full-blown bear market (20%+ decline)—depends in part on the extent of the slowdown in the US economy.
If the economy slows but doesn’t slip into recession, we expect a correction (10%+ decline), but not a bear market. At this point, our base case is that the economy will avoid recession.
Tail Risk
Compounding the above fundamental risks are the “tail risks” that are heightened due to a Trump presidency. By tail risk we mean those unlikely events—a trade war with China, a shooting war with North Korea—that fall far out on the left and right tails of a normal bell-shaped distribution curve of likely outcomes.
It is simply a fact that Trump has injected a degree of unpredictability and uncertainty into world affairs that we haven’t seen in decades. This is a signature of Trump’s negotiating style, which he believes gives him an advantage when bargaining. And that may be. But he’s no longer negotiating real estate deals. He’s working on a global stage as the most powerful single person on the planet. This, we believe, has obliged us to lower the baseline risk tolerance of our clients across the board. And that means an incrementally reduced exposure to risk assets.
What we're doing
As our readers know, we’ve maintained a negative outlook on the economy and the market in 2017 since late last year. That, combined with heightened tail risks, led us to assume a defensive position in client portfolios. Specifically, we reduced our exposure to the public equity markets as a way of limiting the impact of a potential broad market decline on overall portfolio values. Put differently, we’ve lowered our sails (stocks) and put more ballast (bonds) in the hold of our ship.
As noted last quarter, we obviously were early in taking these defensive measures and wish we had the means to more accurately predict the timing of an expected decline. But we don’t. What we do have is the ongoing confirmation of our thesis by the hard data and by market internals. Were those reading differently, we’d reconsider our call. As they’re not, we’re remaining defensively positioned.
Farnum Brown, Chief Strategist
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. This is not a recommendation to buy or sell a particular security. 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.
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