Market Review: Progress for Progress’ Sake
December kicked off with a rise in the dollar that was triggered by increasing treasury yields and stock futures as President Trump’s tax reform plan progressed. A 25-bps interest rate increase by the Federal Reserve and a 5-bps hike by the People’s Bank of China revealed a shift toward tighter global monetary policy. However, the adjustments were either well telegraphed or too small to affect barely a ripple across the financial markets. Stocks soared to new records and the dollar rallied as the US GOP senators bargained for bill provisions, but inevitably agreed to vote for a US tax overhaul.
Bond holders showed little fear of inflation as the treasury curve’s five to thirty year spread sunk to 52 basis points and hit the flattest levels since October 2007. Federal Reserve Chairwoman Janet Yellen downplayed the significance of this ominous trend, harking a “this time is different” tone, which bore an earie resemblance to speeches given by both Greenspan and Bernanke ahead of past recessions.
On a more offbeat topic, the world’s largest exchange hopped on the Bitcoin train, as Bitcoin futures started trading on the CME Group’s venue on December 17th. This news came just a week after CBOE Global Markets Inc. presented similar derivatives. CME Group is much larger in the futures world, leading investors to believe it will have a much larger impact in the newly engineered space. We see bitcoin as a tragedy in the making.
President Trump formally declared Jerusalem to be Israel’s capital, mandating the U.S. move its embassy to Jerusalem from Tel Aviv, which is a historic shift in U.S. policy that inflamed key allies. Further, Senate Republicans passed the most extensive rewrite of the U.S. tax code in more than 30 years, delivering a bill that mandates deep, permanent tax cuts for corporations and shorter-term relief for wealthy individuals. The tax bill gives President Trump his first major legislative victory, despite a final product that carries considerable potential for unintended consequences.
The Bank of Japan retained its unprecedented monetary stimulus in its final 2017 meeting, as it awaits an increase in persistently low inflation. Although inflation has lagged behind growth in Japan, it is moving in the right direction, leaving little pressure on the Bank to increase rates now. Japan’s Topix index hit its highest close since November 1991 on Christmas Day on thin trading in most global markets. The rise was primarily driven by technology stocks.
German Chancellor Angela Merkel continued her struggle to forge a united government. She sparked up numerous talks with the Social Democratic Party of Germany, seeking to coax the group into an alliance; however, the Social Democrats remained skeptical. Business confidence weakened unexpectedly by month’s end as intolerance over the government’s inability to form a united alliance broadened.
The Italian economic expansion was revised downward in the third quarter, while exports and domestic consumption both showed improvement as the region seeks a stronger foundation for recovery. Consumer confidence rose to a two year high as campaigning accelerated for next year’s elections.
The United Kingdom and the European Union reached a deal to begin breakup talks, with the UK landing in a very weak bargaining position. The European Union said it had given ground in the deal despite Prime Minister Theresa May conceding on all major issues. The Pound rose as a result of the deal.
Chinese investors shied away from risk early in the month and rotated out of small caps and into large cap stocks, as policy makers revealed that monetary policy will be “prudent and neutral” next year, while fiscal policy will be proactive. China began policy change talks to protect against the new US tax bill dragging down the value of its currency. Their talks included suggestions of tighter capital controls, higher interest rates, and more intervention to support the nation’s currency. Despite their worries, the yuan is poised for its best year against the dollar in six years, as US yields have hurt the dollar.
Going Forward: Unintended Consequences
2017 wound down with a rush to pronounce progress for progress’ sake, without actually making much progress. Brexit talks progressed with little hope of a positive outcome. The US tax bill was rushed into action with seemingly very little true evaluation of its complexities and potential consequences. Iraq claimed the war on ISIS is over. Protests erupted in Iran, while Saudi Arabia continued its push for progress ahead of the Saudi Aramco IPO. Meanwhile, North Korea’s dictator, Kim Jong-un continued to sabre rattle with an itchy finger on the nuclear button. Welcome to 2018.
Given the significant degree of change in December, now is a perfect time to consider how to reposition the portfolio based on US tax regulation winners and losers, inflation, the dollar, European integration versus populism and world trade.
Quality is King
Perhaps the main take away from tax reform is that quality will be king. On the positive side, the permanent reduction in corporate taxes will be a boon for corporates, particularly corporations with strong balance sheets and cash flow generation. On the other hand, a major provision of the tax overhaul limits the deductibility of interest expense to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) and 30% of EBIT after 2021 using a 12 month look back basis. This provision will severely impact highly indebted companies with little to no earnings, as well as certain segments of the equity markets that use leverage to finance dividends and share buybacks. We see a coming chasm between stable EBITDA companies and highly speculative plays, both in the equity and corporate debt markets. While we don’t see this as a broad opportunity to underweight high yield indices, we do recommend a bias towards higher quality earnings in the sector.
While the biggest winner for taxes should be small caps who should feel the impact of reduced corporate taxes more than large caps, it is worth noting that debt levels for small caps have risen to levels not seen since the mid 1990’s. The outlook for earnings, however, is very positive and we would anticipate that this outlook will likely not be shared broadly across the index, but will be based on quality of earnings and cash flow. Therefore, we see idiosyncratic opportunity as markets fail to differentiate.
US Versus the World
Large cap equities currently trade at rich multiples. Taking a very long-term view to the 1950’s, it is worth noting that ex- the dot-com bubble, these levels are near all-time highs. However, these highs are arguably late in the economic cycle, consistent with the delayed recovery after the last debt-led recession. With the boost of optimism around tax reform, we could see continued support for these elevated multiples, despite a slowing earnings cycle going into 2018. In addition, the most likely outcome of the tax repatriation holiday is continued buybacks and dividends if history is any guide.
That said, investors in multi-national corporates with earnings parked overseas will likely benefit across the capital structure from the new repatriation clauses in the tax reform bill. The nearly $1.2 trillion in cash held overseas by large corporates can now be repatriated at preferential tax rates (15.5% for foreign retained earnings held in cash and 8% for foreign earnings retained in excess of current cash). Corporations can avoid the tax altogether by repatriating foreign earnings as dividends or by reinvesting the cash into operations overseas. This provision provides less incentive for companies to issue bonds to finance dividends and buybacks, which lends a potential boon to investors in multi-national dividend payers and could result in a serious decline in corporate bond issuance. The decrease in bond supply bodes well for investment grade corporate bond holders.
On the other hand, global trade is still showing signs of continued expansion. The US continues to throw up barriers to participation in this global trade recovery with little to no progress on the renegotiation of NAFTA and refusal to participate in other free trade agreements.. With Europe mired in the battle against populism, emerging markets stand as the biggest beneficiary of the global trade theme.
Inflation, Yields and Dollar
Despite the persistence of low inflation, we see inflationary pressures bubbling. With US breakeven inflation rates at 1.98%, there is broad scope for continued pressure to build. The tax bill as a start, could very well herald in increased wage inflation as corporations pass through minimum wage hikes to end prices and the possibility of infrastructure spending could add to those inflationary pressures. Tax reform’s provision of allowing 100% immediate deductibility of tangible asset expenses with a sunset provision in 2023 could actually translate into near term manufacturing expansion that could boost inflation as capacity already remains abundant and growth may be slow to materialize. Meanwhile, the yield curve continues to flatten, while the Fed expects three rate hikes in 2018 and three more in 2019. We see a general softening in nominal treasury demand at auction and higher demand for TIPs. We expect interest markets overall will likely be a loser in 2018, after years of anticipation. While this should be positive for the dollar relative to interest rates around the world, strong GDP growth from emerging markets as trade expands will likely keep the dollar subdued in 2018 as well.
Going into 2018,we maintain our current allocation within the US equity markets, but expect to reduce exposure to US and increase exposure to international equities. Within international equities we will begin increasing our position to emerging markets at the expense of developed markets. In fixed income, we move we are increasing exposure to higher quality BBB/BB corporates and an reducing exposure to High Yield in general to CCC and below. As the yield curve continues to flatten we expect to continue to increase quality and get longer duration.