“It’s the economy, stupid”

The stock market has been caught up in a political roller coaster ride in recent months, rising and falling on the likelihood of President Trump delivering the fiscal stimulus he promised on the campaign trail.  While financial markets seem obsessed with reading the political tea leaves, it is the de facto slogan for Bill Clinton’s 1992 campaign that is worth remembering at times like this: “it’s the economy, stupid.”

While potential fiscal stimulus (e.g. tax cuts and infrastructure spending) has added fuel to the fire, it’s important to remember that current trends in financial markets were well underway on the evening of November 8th.   For example, while interest rates leapt after the election, the benchmark 10-year treasury yield had already increased from a low of 1.36% in July to 1.86% on the eve of the election.  With that same treasury yielding 2.34% today, we can observe that more than half of the rise in interest rates occurred before the election.  The same is true of many economic indicators and stock market indices, which also began their ascent well before the election.

While it can be difficult, we have been attempting to ignore the political noise and focus on the underlying fundamentals that have been driving financial markets for the past 9 months.  Here are some of the areas we’re watching right now:

• The economy and corporate profits have reaccelerated late in the business cycle and in nearly synchronized fashion across the globe.  This is unusual but not unprecedented; a similar event occurred in the late 90s.  This eventually ended badly, partly because the Federal Reserve (the Fed) was too slow to increase interest rates in front of the Y2K specter.
• The Fed has met its dual mandate of “price stability and maximum employment,” and has successfully begun to raise interest rates without creating upheaval in financial markets.  We expect the Fed to continue gradually raising rates throughout 2017.  The path of the interest rates will become increasingly politicized and uncertain towards the end of the year, when the focus shifts to the potential reappointment of Janet Yellen (the chair of the Fed).
• Financial markets have taken rising interest rates and political uncertainty in stride so far. That said, we expect economic and political news to drive increased market volatility during the year as the administration attempts to turn its proposals into policies.
• Even if a fiscal stimulus deal is struck, it may only help the economy in the short term – and could come at a cost. With low unemployment and flat productivity, faster economic growth could create meaningful inflation for the first time in many years.
• Valuations across almost all asset classes is worrisome. Whether we look at interest rates (on bonds), capitalization rates (on real estate), or price-to-earnings ratios (of stocks), most assets seem expensive relative to their fundamental characteristics. International stocks may be one exception, but they come with their own set of risks.

It is frustrating that politics have become so entangled in the outlook for financial markets. We take comfort in the fact that the recent rally in stocks has some fundamental support – and is not entirely predicated on political changes.  More importantly, the fundamental underpinnings of recent market activity point to a shift in some well-established trends (e.g. low inflation and interest rates) that may require investors to consider their investments in a new light.  We believe that maintaining our focus on fundamental research, tactical portfolio construction, and risk management will be critical to driving successful investment outcomes in this rapidly evolving political, economic and market environment.