✔ Stock valuations are up, in part in anticipation of tax relief.
✔ International stocks may offer lower valuations and an improving business cycle.
✔ The Fed appears poised to raise rates and inflation risks exist, but bonds still play a key role for investors.
Stocks moved sharply higher in the weeks following the November presidential election. The surprise sweep of the White House and Congress by Republicans caused investors to anticipate pro-business, pro-growth policies, from corporate tax cuts to regulatory reform. But more recently, markets have seemed to reassess the timing and likelihood of those policy changes. The appointment of an independent investigator on May 17 raised additional questions about the outlook for policy, and led to a sharp drop in stocks and a pickup in expected volatility.
This May’s Viewpoints Inside/Out event, hosted by Fidelity Senior Vice President Chris McDermott, brought together investment professionals from Fidelity, BlackRock, and Capital Group to discuss possible policy changes in Washington, their potential to move markets, and the broader market and economic context. Here we present some of their thoughts on the post-election stock market rally, the potential impact of issues such as tax reform and infrastructure spending, and where they’re finding opportunities in the U.S. and abroad.
- Matt Miller, policy and communications advisor at the Capital Group
- Jean Park, U.S. equity portfolio manager of Fidelity Growth Strategies Fund
- Cormac Cullen, co-manager of Fidelity Municipal Income Fund
- Russ Koesterich, CFA, JD, managing director and portfolio manager of BlackRock’s Global Allocation Fund
Since November, stocks have gained more than 11% and Treasury bond prices are down slightly, with the 7-10-year Treasury Bond Index down about 2.5%. What fueled the stock market rally, and is it sustainable? Our experts say investors were excited by the prospect of pro-growth policies from the new leaders in Washington, but the panelists question whether economic reality justifies investors’ enthusiasm.
Matt Miller: When the dust settled, there was an instant sense that the election results could lead to policies like stimulus spending and tax cuts.
Jean Park: It seemed very clear that the outlook and opportunities for stocks improved considerably. I saw more widespread opportunities for companies to grow earnings, whether through organic growth, stimulus, or tax reform. A lot of stocks started pricing in the “what if?” factor.
Cormac Cullen: In the municipal bond market, shareholder fears spiked after the election. Investors were concerned, first and foremost, about tax reform being a more realistic possibility under single-party rule, and what that reform might mean for tax-exempt products such as muni bonds.
Russ Koesterich: The prospect for a lot of stimulus out of Washington drove a lot of the market action at the end of 2016, and investors came into 2017 with relatively high hopes. Cyclical companies were doing well at the end of last year, rates were going up, the dollar was gaining, and risky assets, like small caps, were beating relatively less-risky assets, like large caps. This year there’s been a partial reversal of most of those themes.
There are several reasons for the reversal; it’s not all about Washington. Investors’ optimism hasn’t been matched by their behavior in the economy. In other words, that optimism has yet to translate into people spending more, businesses increasing their capital spending or a real acceleration in manufacturing. So the big question that we are focused on is whether the hard data—the actual economic activity—catches up with the soft data—the sentiment, or if investors just got a little too euphoric about how much Washington was going to help growth in 2017.
Cormac Cullen: In 2017, we have seen a reversal in the municipal bond market. Some of the selling in late 2016 began to abate and issuers sat on their hands, improving the technical picture. It has been incrementally positive, month by month in 2017, and it’s not clear this will be a bad year.
Efforts to pass health care reform have proven complicated, and questions remain about the timelines for other policy priorities, including tax reform, regulatory reform, infrastructure spending, and trade. Our experts discuss the potential for tax reform to deliver a tailwind to U.S. stocks, and the ways public/private infrastructure projects could offer interesting opportunities for savvy investors.
Matt Miller: There’s always noise in politics. And given the dynamics of President Trump and the media, the noise level is even higher than usual. That’s why it’s important to focus on key policy areas that affect asset values, such as taxes, trade, and regulations.
On taxes, I don’t see how the Republicans would give up the opportunity to pass some kind of a significant tax cut. But I think expectations are ahead of where the actual tax reform measures—whether corporate tax cuts or repatriation schemes—are probably going to end up. I think there’s a very low probability that we’ll see a border adjustment tax, because it would end up raising prices in sectors with high imports, like retail and energy. And we can’t be sure that tax reform will even happen this year.
Russ Koesterich: Corporate tax reform would be very important to the financial markets. Coming into 2017, earnings estimates were aggressive, and those estimates were justified by the idea that a big cut to corporate taxes would be a tailwind for S&P 500 earnings. Now the prospects for getting corporate tax reform in 2017 appear to have diminished, which means investors may have to turn their attention to 2018 and ask whether any tax reform that comes will deliver the same kind of expected earnings growth boost for U.S. companies.
Cormac Cullen: If there is tax reform, I think it will be deficit-financed tax reform, not deficit-neutral. With the unemployment rate at 4.4% there isn’t much slack left in the economy, so a deficit-financed fiscal stimulus could lead to faster inflation. This could cause interest rates to rise and bond prices to fall. On the other hand, if nothing happens with tax reform or other major policies, we’ll be in an environment that is very similar to where we’ve been—where the economy is doing okay, but inflation and GDP aren’t growing significantly. In that event, investors probably will reach for yields in the municipal market, and that will lead to some ill-advised risk-taking.
Jean Park: I think there was a view that we were going to have more financial regulatory reform under a Hillary Clinton administration. Before the election, a lot of financial stocks—especially bank stocks—were pricing in that possibility. Bank stocks had been left for dead, because it’s so difficult to operate in a low-interest-rate environment.
Now it looks like we have a backdrop of rising rates and a potential overhaul of financial regulations. All of a sudden, you can see several positive catalysts. After the election there were a bunch of really cheap, discounted stocks, so that was the first place I went—I knew bank stocks were going to be a beneficiary coming out of the election.
Matt Miller: On infrastructure spending, there’s a push by the Trump administration for more public/private partnerships. Some of these could turn into toll-able projects for which consumers pay for ongoing use.That’s something we’re trying to get smarter on. We’re working to learn more about the nature of the potential projects and the types of companies that could move quickly and be successful if Washington pursues that type of a plan.
Cormac Cullen: Health care reform could have a sizable impact on certain areas of the muni market. In fact, there’s a great deal of uncertainty around the insurance market, including what the administration will do with regard to subsidies and other payments to individuals on the health care exchanges. If those subsidies and payments are curtailed, insurance coverage could fall, which could hurt hospital bonds.
Which sectors and styles stand to benefit from policy changes, and where is value being overlooked? Our experts see opportunities among mid-cap stocks, non-U.S. dividend payers, and select general-obligation municipal bonds.
Jean Park: If all of the positive pro-growth policies come to pass, today’s stock prices would look cheap. And I see some very attractive upside if just some of them come through. I’ve been focusing on the companies that will be the beneficiaries from higher interest rates, potential tax reform, regulatory reform, and government stimulus. This is a checklist that I’ve kept on my wall as I look for opportunities for the fund.
For instance, let’s look at tax cuts. If there are tax cuts, you need to look at the P&L for individual companies to see who will benefit. In general, I think mid-caps should benefit more from a tax cut than larger-cap companies. The kinds of companies that would benefit most from a cut in corporate tax rates are those with a U.S.-centric workforce. A lot of the mid-cap stocks in the U.S. have less foreign exposure than larger companies, which tend to be multinationals. Mid-caps also tend to have a higher percentage of their earnings in the U.S., so they will benefit more from a cut in corporate rates. More consolidated industries may also benefit, because the profit boost isn’t as likely to be competed away.
Russ Koesterich: In an environment where 10-year Treasuries are yielding 2.25%, investors are more willing to pay a premium for certain bond surrogates, such as utility stock or a REIT, that pays a big dividend. But U.S. equities are expensive by historical standards. We’ve been finding more reasonably priced dividend stocks in Europe and Japan.
Investors looking for yield have bid up U.S. dividend stocks, but we’re not seeing as much of that in Europe. And central banks in Europe and Japan haven’t followed the U.S. Federal Reserve’s tightening measures. The European and Japanese economies are earlier in their economic cycles, so growth is softer and central banks are more willing to keep their foot on the gas pedal longer. As a result, we believe monetary policy is likely to be more of a tailwind for international stocks than for U.S. stocks.
Cormac Cullen: Tax revenues have been somewhat disappointing at the state level in recent months. For this and other reasons, investors have pivoted away from general-obligation bonds and toward revenue bonds, which get their revenues from hospital patients, toll-road drivers, airports, and other sources. Anytime investors pivot away from an area, it creates the potential to find mispricing. So when sentiment swings one way, I look the opposite direction and see what’s getting left behind. If you look carefully among general obligation bonds, you can find bonds with yields that are attractive relative to the issuers’ fundamentals.
Jean Park: When it comes to infrastructure, lots of people were asking what could happen if we got all this stimulus. Sometimes I think of things in reverse, which is what would be happening with industrial companies and the stocks without that stimulus. I think that setup is still very interesting. We were in an industrial recession in 2014 and 2015. So the expectations had been so low that it almost didn't matter who was going to win the election or what that election outcome, we were likely going to see some acceleration.
What principles should individual investors keep in mind in today’s markets? Is it time to prepare for a correction? How should retirees approach investing? Our experts suggest keeping a long-term view—and remembering that today’s low-rate environment may mean branching out to find income.
Russ Koesterich: The good news is that people are living much longer. The challenge is, it’s really hard to fund a 30-year retirement. To start, the single best thing people can do to address this challenge is to extend their working lives, which allows them to save more and to draw down their retirement savings over shorter periods of time.
Investors also need to have assets in their portfolios that will give them some growth and offer protection against inflation. That often translates to holding modestly more in equities. And with rates as low as they are, investors also have to consider other sources of income such as dividend-paying stocks, preferred stocks, emerging markets debt, and high-yield bonds. Putting these together in a diversified, multi-asset-class portfolio within a flexible, risk-managed mandate will provide investors with the opportunity to cast a much wider net compared to what older generations could do decades ago, when rates were much higher.
Cormac Cullen: Right now, volatility is pretty muted. What’s tricky for any market—whether munis or other asset classes—is that volatility can come from the unpredictable thing that no one’s anticipating. No one can tell you what that catalyst will be. That’s why it’s so important to take a long-term view and to match your risk tolerance to your financial situation, goals, and priorities.
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