The market in context
The most important event for equity investors in 2016 hasn’t been about Brexit or Trump, but about the reversal in the multi-year downward trend in government bond yields off their abnormal lows set in early July. This is effectively a market vote of confidence in the outlook for inflation (and growth) based largely on the steady US economic recovery. The surprise election of Donald Trump didn’t trigger rising bond yields, but did accelerate it. Trump’s economic agenda offers a plausible route to stronger US, and potentially global growth.
The yield party isn’t over, but the bubble is deflating
Investors have enjoyed several years of outperformance in high yield and defensive stocks benefiting from their relative appeal to falling long term government bonds yields. Think property trusts, utilities and some industrials. These are now being sold down as the marginal dollar shifts either: a) back into bonds, for their improving returns, or b) into cyclical laggards leveraged to higher economic growth such as commodity stocks and cyclical industrials. Notable industrial performers include difficult-to-forecast cyclicals in chemicals, manufacturing and insurance providing a headache for investors as they offer far less earnings certainty than defensives.
Has the market got ahead of itself? On our preliminary analysis, Trump’s economic plan would add 0.4pc to US growth, both in 2018 and 2019 which is clearly positive for corporate earnings and share prices. However we think the market’s relative moves since the election are overdone, given risks attached to the legislative passage, financing, execution and impact of Trump’s plan and the fact that its full effect wouldn’t be felt until 2018-19. Our Research Sector specialists can form sensible arguments showing that high yield, defensive stocks are now oversold (too cheap) and that some commodities and cyclicals are overbought (too expensive), as they are similarly discounting risks to a recovery. This isn’t the first, nor will it be the last time that markets overshoot fundamentals.
Cyclicals to Trump defensives… albeit slowly
The ongoing recovery of cyclical industrials in line with a reflationary economy is a theme that we expect to continue to play out in coming years. However progress is likely to be slow, and interspersed with periods where the markets may lose or gain confidence in the timing of its trajectory, not to mention likely macro shocks. Similarly, we expect interest rate settings to remain at historically low levels providing investors opportunities to accumulate high yielders which get oversold in the market over exuberance.
Adapting our equity strategy
We have consistently flagged that the path to the normalisation of global monetary policy is going to be slow and bumpy. It’s paramount that investors appreciate that after years of debate around the trajectory of interest rates that the economic environment has now begun to shift. Therefore equity sector allocations that performed best in the past five years are unlikely to be those that deliver outperformance in the years ahead. Investors need to adapt with the market.
- Justin Still, Investment Adviser (Authorised Representative: 000279726), Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410