07 Feb Q1 2017 Market Commentary
Welcome to Gratus Capital’s Quarterly Market Outlook.
This quarter, Marc Heilweil, Senior Portfolio Manager, and Todd Jones, Director of Investments – weigh in on the current financial environment. They lend context to common areas of interest or concern, and hopefully spark new conversations between you and your Gratus advisor.
Here’s what Marc and Todd are talking about this quarter:
What are the reasons the market has reacted so strongly to President Trump being elected?
TJ: There are three primary reasons why the market has reacted so strongly to the recent change in our country’s leadership.
#1 – There are potential tax changes that have the ability to improve earnings by double digits. Therefore, the market is discounting in anticipation of favorable tax changes.
#2 – Anticipation of regulatory change is also adding to market discounting. For example, by reducing regulations on banks and other industries, such as energy or mining, these share prices have taken off dramatically. Some projects will likely be more accessible in the near future, such as drilling offshore near California.
#3 – The earnings recession is ending. For approximately the last 18 months S&P earnings were flat; however, we’re starting to see movement toward more positive returns.
Why are alternative investments important now in order to reduce risk in portfolios and provide a reliable return?
TJ: There are two key reasons why alternative investments are important right now. First, they offer diversification benefits that come from earning a return in a different way with no correlation to the equity or fixed income markets. Secondly, because both equity and fixed income markets are currently fairly expensive.
Bonds have been selling off post U.S. election on a global basis. Are bonds still a good investment to have in a portfolio? How is Gratus addressing the recent back up in yields?
TJ: Yes, bonds are still a good investment. They provide two critical components within a portfolio, specifically income generation and volatility dampening. Keep in mind that bonds and stocks don’t move in the same direction. Therefore, when equity markets are rapidly selling off, bonds help provide diversification.
Certainly there has been a notable move up in yields, which tends to push prices down. The way Gratus has addressed this, dating back as far as 2009, is by avoiding government bonds. They’re the most exposed to a changing interest rate environment. More recently, we’ve been gradually migrating away from fixed income investments and moving toward alternative investments in order to take advantage of lowering yields.
Will the US dollar stay strong throughout 2017 and how will this impact your investment decisions?
TJ: In the past two years, the US dollar has strengthened and has been a key macro variable in question. The reason why the dollar’s strength could be an issue is because of its impact on international earnings by U.S. companies. Specifically, the US dollar’s strength impacts foreign earnings. The degree to which earnings are impacted is the variable we’re watching closely, including how companies are adapting to the stronger dollar environment.
Keep in mind that when the dollar is strong it negatively impacts emerging markets’ currencies. This is the primary reason why we presently don’t believe in having emerging market exposure within our portfolios.
Does the rise in global populism concern you as an equity or fixed income investor?
MH: For some time now I’ve been concerned about the rise in global populism. It’s quite understandable that the rapid rate of change has caused people to question whether their governments are actually looking out for them. There’s no doubt in my mind that governments haven’t shown adequate sensitivity to this concern and it’s caused people to question whether their government could have done more to control the rate of change. In particular, I’m very guarded about the outlook for the Eurozone. The populist candidate, Geert Wilders, appears likely to get a majority in the Netherlands and he advocates withdrawing from the Eurozone.
As with many of these upsets or changes, the breakup of the Eurozone may not be as damaging in the long term as current fears would have it. Relief from the Brussels bureaucracy may provide a stimulus to European economies, similar to how President Trump has unleashed some confidence in the American business community.
Health care seems to be a bad place to be since the ACA will likely get repealed. Why would we own it?
MH: Unfortunately the demand and the need for health care will not change. Whether it’s a minor illness or a more serious heart problem, we’ll need our health care system. Whether or not the ACA gets repealed in full or merely gets modified remains to be seen. In a stock market of very high valuations, the uncertainty over health care reform has created some attractive opportunities in that space. Very high-quality health care companies are discounting negative changes that may not occur.
Pricing and competitive bidding for pharmaceuticals would have to be instituted by Congress. However, in the past they’ve shown no willingness to accomplish this. One of the benefits I’d like to see happen and is consistent with President Trump’s viewpoint is measures to ensure that other wealthy countries pay better prices for the inventive products of American pharmaceutical companies. Essentially, America has been subsidizing the research and development of medical devices and drugs while other wealthy countries, through their price controls, have not contributed. In fact, countries such as Japan and Germany drop the price of drugs on an annual basis.
President Trump and Congressional Republicans have talked a lot about lowering corporate tax rates. Has the rise in stock markets resulted from this, are companies really improving, or are we going back to “irrational exuberance”?
MH: Unquestionably the policies of the new administration are being viewed positively by the financial markets. Certainly there is a large discrepancy between the corporate taxes shown as paid for financial statement purposes versus the actual amount that is paid to the IRS. Therefore, while cleaning up the corporate tax situation is long overdue, and the lower stated rate currently thought to be 22% is a positive for small business, one must be humble in the face of the uncertainties in the current environment. Remember that when share valuations are very high the market becomes susceptible to unforeseen shocks.
What’s an investor to think about the stock market today?
MH: I think it’s important to concentrate on what can be known, and what’s knowable is analyzing businesses from the ground up. Remember that buying shares is buying a piece of an existing business. Ask yourself whether the business is well positioned within its marketplace and whether the culture and leadership are acting in the interest of all shareholders. What’s more, never forget to pay attention to the price that is paid for a share of the ownership of the business.
How can people follow up with you on these issues and any related questions?
TJ: I gladly welcome any follow-up questions or questions for next month’s commentary. Send them to firstname.lastname@example.org.
Marc Heilweil, Senior Portfolio Manager
Todd Jones, Director of Investments