Here is a small excerpt of the weekly market update from Advisor Cheat Sheet. The S&P 500 was virtually unchanged last week as holiday-light trading conditions combined with a relative dearth of any important news caused markets to drift sideways for most of the week.
Terrorism reared its head on Monday and Friday in three separate instances (Russian Ambassador shooting, Berlin Christmas market, Tunisian airline hijacking), but smaller-scale terrorism simply hasn’t been a market influence in 2016, and that continued last week.
The most notable and potentially market-moving event of last week actually had to do with trade. Potential trade conflicts with China is an underappreciated risk for markets in 2017, and that risk rose last week.
First, Trump appointed Peter Navarro, author of the book Death by China, to head a new National Trade Council. Second, the Trump transition team announced it was exploring the possibility of enacting import tariffs via executive order (as opposed to going through Congress). Both headlines were ignored given the holidays, but the China trade relationship is an important macro risk to watch in early 2017.
Last week, the internals largely confirmed that this rally has paused during the final weeks of 2016, as the cyclicals that led stocks higher post election (small caps, banks, industrials, energy) lagged while defensives (utilities, consumer staples, healthcare) outperformed.
Yields were slightly lower last week, but the movement in rates wasn’t behind the sector trade last week. Instead, it was just profit taking and short covering given the enormity of the moves post election. From a sector standpoint, the only notable underperformance came from retailers, as they are starting to face a headwind thanks to the potential corporate tax changes that Trump/Republicans are proposing. Specifically, if the tax laws change and the US starts taxing imports, retailers are some of the biggest losers as that will further shrink margins. The tax outlook isn’t enough to become outright negative on retailers, but a potential headwind is building on that sector.
For the remaining four trading days of 2016, and the first week or two of 2017, the set up for stocks remains the same: The upside momentum has stalled as investors move past the post-election, pro-growth euphoria. For stocks to grind materially higher near term we’re going to have to see some actual proof that these pro-growth policies will be enacted relatively soon, and not be too diluted by the Washington sausage-making process.
That said, the path of least resistance remains higher, and while it may make sense to take some profits (perhaps in banks, energy, or infrastructure names) I certainly wouldn’t be reducing core holdings despite high valuations. Given the general optimism spreading across Wall Street and the economy, as we end 2016 and begin 2017 it’s important for us to consider what could go wrong. While there are always a lot of answers to that question, today I want to focus on the most likely answer… policy errors.
As Mohamed El-Erian put it last week, right now the market is pricing in no policy errors from Trump and the Republicans or from the Fed. While I hope we don’t see any policy errors, I’m afraid my experience has taught me to not be so optimistic.
From a fiscal policy standpoint (meaning Trump/Republican pro-growth tax cuts and deregulation) there are two specific risks I’m worried about in 2017: Underperformance and trade.
Potential Fiscal Policy Error #1: Underperformance vs. Expectations. Expectations for a corporate tax cut in the first half of 2017 are pretty high, as are material changes to Obamacare and other deregulation. If these initiatives get bogged down in the Washington swamp and don’t get delivered, then this market is easily 5% overvalued.
Potential Fiscal Policy Error #2: Trade. Easily the most important events in the market over the past few weeks have been the apparent hard line Trump will take with China. If there is a trade policy blunder (meaning we start moving towards import tariffs or a trade war) that will hit markets.
From a monetary policy standpoint, the policy risks are equally clear, if the Fed hikes rates too fast and stunts growth, or the Fed leaves rates too low and inflation accelerates.
Potential Monetary Policy Error #1: Rates rise too quickly. The Fed raises rates too fast and stunts economic growth (remember, no one knows how this economy, which has become accustomed to 0% interest rates over the past seven years, will react to sharply higher rates).
Potential Monetary Policy Error #2: The Fed Doesn’t Raise Rates Fast Enough. Conversely, if Trump and the Republicans do push through pro-growth policies, it could ignite inflation, because there is still ample liquidity floating around the US economy (i.e. the supply of money is still historically very, very high, so the potential for a sharp increase in inflation is there). Now, longer term, this outcome may not be bad for stocks (they are an inflation hedge) but proper tactical positioning will be critical to outperforming in Q1 2017, and beyond.
Bottom line, our positioning remains the same: Due to caution on this rally, we are not materially moving to cyclicals yet, and we will await some confirmation of actual pro-growth policies. Tactically, we still like sectors and ideas that are highly correlated to higher inflation and higher interest rates (so banks, although near term some profit taking may be warranted—but longer term the sector is still attractive).
Finally, Europe remains interesting to us, especially European banks in light of the added clarity from the Monti dei Paschi bailout last week, and the settlements by DB and Credit Suisse. ETF’s Provided To Subscribers.
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