Broker Check

Electing For A Cautious Investment Stance

| October 28, 2016
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Rounding the corner into the final quarter of 2016, there appear to be two dominant preoccupations on investor’s minds – the election and the Federal Reserve’s next move.  Each of these items clearly have implications on how 2017 and beyond will shape up.  Internally, we believe that the stock market has been cooperative over the past eight months but now are currently transitioning to a more cautious investment stance.  This means that we are taking profits and protecting accounts from excess risk exposure through various measures, including long put options, short call options, cash, and inverse ETFs.  In our view, it would be unwise to be cavalier about risk within the framework of a skittish market, high valuations, and the uncertain outcome of the political events.  In their 10th annual report measuring stress, The American Psychological Association noted that 52% of Americans polled stated the election “is a very or somewhat significant source of stress in their lives.”  Similar to previous elections, it is likely that volatility will pick up ahead of the US Presidential election in November and continue to rise in the first 60 days of the Presidential term.  We do not want your investment portfolio to be another source of stress and concede that there are certainly reasons to be cautious in this environment.   We are taking the steps to keep the long-term investment plan in place by lessening any short-term market gyrations driven by sentiment.

It seems that the monetary policy tailwind produced by the Fed and other central banks may be fading.  Since 2009, the Fed has been extremely accommodative in their policies which has resulted in record low interest rates as well as an artificially stimulated economy and market.  It has been clear that we have been under a Federal Reserve controlled market, meaning that any shift or change in policy stance should get the attention of investors.  The Fed has leaned in to a rate hike several times this year, only to pull back for a variety of reasons, leaving the Fed Funds rate unchanged since the December 2015 hike.  According to Fed Chairwoman Janet Yellen at a recent Fed speech, “The case for an increase in the fed funds rate has strengthened.”  Most economists believe the Fed would be quite reluctant to act so close to an election, for fear of being accused of playing politics.  However, some suggest the possibility of some “reverse psychology” - hiking prior to the election to “prove” they aren’t political.  Just like last year, if they do not raise rates by December, they will lose credibility.  Therefore, there is the real potential that a shift toward a slightly more hawkish Fed may be beginning. 

There are positive and negative implications to this move for governments and individuals.  Additionally, monetary policy normalization could also change how companies manage their cash.  In the low interest rate world, instead of investing in long-term capital spending projects that would be to the betterment of the economy, corporations have been taking the proceeds of that debt and buying back their own stock - which has been great from a stock market perspective, but certainly less so for the economy.  We believe the Federal Reserve rate hikes will be gradual, but favor industries that have a positive response to increasing interest rates.  Nevertheless, monetary policy is becoming less effective in boosting economic growth.  As monetary policy reaches its limits, some major economies appear on the verge of relying more on fiscal policy to boost growth, such as with major infrastructure spending.  Following the next hike, the Fed will want to wait four to six months in order to assess their impact on the economy and closely monitor whether GDP growth can remain above 2%, inflation surpasses the target of 2%, and if the dollar can avoid further gains.

We have found that this election cycle has left investors on edge.  In BlackRock’s latest Investor Pulse survey, 75% of respondents believe the 2016 election will be more consequential to their personal finances than the 2008 election - one which took place in the midst of the largest market crisis since the Great Depression.  While political opinions are diverse, historical studies show that the president’s ability to change national policy on his or her own is limited.  Ultimately, it is Congress that will make the decisions on most of these issues.  We continue to believe that Congress - particularly the Senate - will remain narrowly divided in 2017, and that this will act as a significant impediment to rapid, market-moving policy changes.  This tends to work best for investors, as equity markets tend to react more positively to divided government.  The Senate appears up for grabs, which makes the House of Representatives key.  Such events (of a one-sided representation) would likely trigger additional economic and market uncertainty.  It is important for investors to recognize that political compromise will likely temper the most radical proposals of either party.  Regardless of the outcome, it is paramount to remember though that this country has shown a remarkable ability to survive and thrive in all kinds of political environments, and we remain optimistic that it will continue to do so.  Neither the Great Depression, Great Recession, two world wars, nor political crises of all types have long detained the stock market’s upward climb.  Over time, one truism has held constant: markets are resilient.  More worrisome from an investment perspective than near-term political outcomes is the shifting populist environment in many countries toward a more domestically-focused, anti-globalization stance.  With free trade and cross-border flows of capital and labor coming under political fire in many advanced economies, the US Presidential elections and future policy direction with affect risks to the market-oriented global order.  If this triggers a protectionist spiral that causes new trade barriers, we think it would be a detriment to corporate profits, global economic activity, and financial markets.

While recession risk in the US is currently low, the nation has slowly been shifting to the latter stages of the business cycle.  The jobs market has remained on track and incomes are rising, which should boost consumer spending.  In addition, more people are entering the workforce.  However, productivity growth has started to falter amid rising wages, which may cause further pressures on profit margins.  Poor pricing power conditions and rising labor costs will likely complicate an already difficult earnings environment, leading to uneven profits and earnings trends that make the need for investment selectivity critically important.  While valuations at the index level remain fair to fairly-full, bargains remain underneath.  The tightening of monetary policy and election related volatility in stocks will unleash the benefits of active management and we will remain willing to re-deploy capital as situations present themselves.

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