The first half of 2017 saw several notable changes compared to last year, as growth stocks and large caps outperformed value stocks and small caps. However, some things stayed the same, such as the market’s continued march higher. Looking forward, the broad tenets of our “Regime Change” operative scenario laid out at the beginning of the year remain intact, with the caveat that it is going to take a while.
One of the main regime changes we highlighted, the normalization of monetary policy, continued as the Federal Reserve (the Fed) hiked interest rates in March and June after doing so last December. Their most recent commentary suggests that if the trend of better economic data persists, the Fed would move to gradually reduce the size of their balance sheet. Taken together, the shift away from crisis-era monetary policy of the last eight years marks one of the most important regime changes we have identified in the markets. Although the pace will remain very gradual, the ultimate impact to the investing landscape will come as the “rising tide” that lifted all assets recedes, and earnings growth becomes the driver of the market going forward.
The rest of the world has also seen improvement in their fundamental backdrop, opening the door for other global central banks to follow a similar normalization of their post Great Financial Crisis (GFC) monetary policies. Europe, for instance, appears to be experiencing an improvement in economic activity though at a slow pace. The European Central Bank (ECB) has added considerable monetary stimulus into the continent’s economy over the last eight years, similar to the Fed. As economic indicators continue to recover across the region, they too, could begin the process to remove the monetary stimulus.
Also unchanged this year is the daily deluge of headlines coming from Washington, as the U.S. presidential “regime change” officially took place in January. The hope of fiscal policies shifting from being a modest drag on growth to being a positive tailwind remains; however, expectations have tempered as to the magnitude of the positive impact. Increased spending in areas like defense remain potential positives, while developments, such as changes to the Affordable Care Act, appear challenged by the dysfunction in D.C. Perhaps the most impactful to corporations, and investors, would be progress on reforming taxes. Any would likely require an offset elsewhere to ensure a revenue-neutral result. Nonetheless, tax relief could still serve as a potential catalyst for corporate profits. While expectations were more elevated coming into the year, investors are now looking much farther into the future for the ultimate passage and associated impact. One aspect of fiscal policy already underway is reducing regulatory burdens across various industries, many of which do not require legislative changes. As a result, the likelihood — and speed — of those benefits for affected businesses is dramatically increased. Companies have faced increasing expenses over the past several years toward understanding and complying with regulatory requirements. They now hope that regulatory spending can plateau or even decline on the margin moving forward.
While macroeconomic winds continue to shift, our focus remains on the implications for companies and industries as the second longest bull market in history continues. An important distinction is that market cycles do not die from old age; rather, the corporate profit cycle determines their life expectancy. Corporations have faced a challenging period since the GFC as limited topline growth has forced management teams to find efficiencies in expense controls and reduced capital investments. The digital transformation of traditional business models, dubbed the “Amazon Effect,” is having a profound impact on businesses. Whether due to an increase in confidence or fear of being the next victim, firms will need to increase their capital spending, especially in areas of technology and automation. The resulting productivity gains are a key component to maintaining profit margins, as a tight labor market could drive wages higher going forward.
We continue to look for regime change to play out in the coming years. While investors wrestle with the specifics, fiscal policy has replaced monetary policy as the primary form of economic stimulus. This may favor active management over passive management; the changing landscape with higher interest rates and policy shifts should create greater dispersion among different stocks. The “rising tide” effect of monetary policy that lifted all stocks, regardless of their underlying merits, is receding. While the ultimate timing and details are uncertain, the “tide going out” will help separate high-quality businesses with strong earnings and growth prospects from those without. Higher levels of inflation and interest rates should further help to reduce correlations within the equity markets as nominal growth increases back to more historical levels at or above 4%. At that level of nominal GDP, the market has historically enjoyed earnings growth in the range of 8 to 12% as nominal growth serves as a proxy for revenue growth of corporations. In contrast, one of the most challenging aspects of the last eight years has been the lack of topline to leverage through efficiencies and overhead into profit growth. Fundamentally, investors continue to forecast strong earnings growth; the 2Q17 earnings season for the S&P 500 is expected to be the fourth consecutive quarter of year-over-year improvement after a streak of four declines prior.
Looking forward, the equity markets remain at all-time highs while companies are seeing improvements in their fundamental prospects, even as political uncertainty remains elevated.
Volatility remains at historical lows, not just for equities. Should the global economy embrace the regime changes underway here in the U.S., there would be even more upside to corporate profits. Alternatively, rhetoric could converge with reality as political gridlock and dysfunction within the party in power overwhelm the optimism. At Westwood, we remain focused on identifying high-quality businesses with undervalued earnings and growth prospects. Our focus on absolute risk has historically provided strong downside protection as our higher quality companies have served us well in protecting clients should volatility increase from here.