Market Outlook 2017
Clients of the Firm,
As the end of 2016 rapidly approaches, we look back on a volatile year in which we saw a very dynamic stock market stoked by the surprise election result and the long-awaited move higher in interest rates begin to materialize. Our forward focus remains on identifying undervalued investments in a higher price and higher rate environment and the underlying factors that drive incremental profitability in businesses we own and aspire to own.
The U.S. Election
The surprise outcome of Donald Trump in the U.S. presidential election resulted in an equally unexpected stock market rally and bond market decline. The stock rally favored banks and industrial companies as the prospect of higher interest rates and the expectation of stimulus spending on infrastructure buoyed those investments mightily. Initially, other investments lagged the rally as money came out of technology and utilities to fund those incremental investments. As the rally gained strength, money began to flow out of bonds and cash and into U.S. stocks, thus lifting the averages including the lagging sectors. Once these institutional portfolio adjustments are complete, it is likely a more rational and less unified reaction by stocks will result. Our decision-making is based largely upon the micro economic activity of the companies we invest in and less so on macro trends. Our hope here is to put some context around the recent rally to inform on some of the reasons we have seen the recent sudden move higher in stocks and lower in bonds.
The Federal Reserve
Yesterday, the Fed announced a 25 basis point increase in interest rates bringing the Fed Funds Rate to 0.50%. They also indicated their expectations are for three further rate hikes of 25 basis points in 2017. This action would bring the 2017 year-end Fed Funds Rate to 1.25%, in-line with our expectations but one hike more than consensus estimates.
The implications for equity investments continue to favor the financial services sector while being unfavorable to bond proxy investments, such as utilities and telecom. The Fed continues to be data dependent and confirmed at yesterday’s meeting they are not on a pre-set course to raise rates. Therefore, if the economy strengthens more than expected, they may raise rates further than anticipated. Conversely, if the economy weakens, they may increase rates at a slower pace or not at all.
The bond price reaction to the Fed uncertainty dovetails with which outcome prevails. Our view is that the economy will strengthen as a cocktail of tax decreases for corporations and individuals, stimulus spending through deficit and capital repatriation programs proposed by the incoming administration take shape. If this base case comes to pass, bond prices will decline especially if the Fed raises rates more than expected. Conversely, bond prices may rise if our base case of economic growth does not materialize and the Fed slows its pace. Therefore, it is our considered opinion that a short-term focused bond portfolio remains a prudent capital preservation strategy. We have found that yields have increased particularly on the 1-3 year corporate bond curve and are finding lower risk value in that part of the curve.
Capital Allocation Decisions
Strategic capital allocation in this environment continues to favor equities that will benefit from the aforementioned policies, even though valuations are richer than the recent past. Meaningful pullbacks in the current rally should be used as buying opportunities to bring equity allocations up to desired risk levels. In addition, as yield opportunities emerge on the shorter end of the bond curve, capital should be deployed to take advantage of higher shorter-term rates. Holding some cash as a proxy for long-term bonds remains a reasonable strategy in order to have available capital to make any purchases. U.S. Dollar strength will remain a headwind for multinationals as rates diverge from international monetary policy in Europe and Japan. The stronger dollar improves domestic purchasing power but weakens U.S. company’s ability to sell commodity products overseas as they become less price competitive. Should dollar strength plateau, multinationals may become compelling values.
2017 Equity Outlook
Several macro themes emerge as we look to 2017 and the likely investment implications thereof. The coming year will likely be marked by higher interest rates, less regulation, a strong dollar, lower taxes, fiscal stimulus and geo-political uncertainty. This type of environment would likely favor stocks as an asset class, as earnings of several sectors would be meaningfully improved by some of these macro trends. Financials, for example, would benefit from a steeper yield curve as net interest margins improve. Domestic industrials and defense companies would benefit from domestic spending on infrastructure or defense. Lower corporate tax rates would benefit all domestic company earnings due to a lower tax bill and therefore, more earnings per share. Deregulation would likely benefit financials and energy companies. Geo-political uncertainty will likely increase volatility and potential risk events. These events, provided extreme outcomes are not realized, would likely present buying opportunities for companies poised to benefit from the above macro backdrop.
When interest rates rise, risk assets re-price. A prudent investor uses a discounted earnings methodology to measure what value he or she should pay for a security. An input to that model is the risk-free rate. In short, investors demand more potential return from a risk asset when a risk-free asset yield moves higher. As stock investors, short-term prices tend to adjust lower to reflect higher interest rates. Historically, however, stock prices tend to rise while interest rates are rising as rates are increased to slow growth and contain inflation and imply strong economic conditions.
Our approach to investment management has been consistent for many years and is based on the analysis of valuation and the expected return on investment resultant of that analysis. This data driven approach uses the macro-economic backdrop as an insight and input to micro analysis of investments and their intrinsic values. We evaluate the price we pay for a security to try to determine an expected return on our investment. To do this, we estimate future earnings or cash flows from the investments we select and discount them to present value. This informs us of a rational price to pay for something given the assumptions we make about the investment. This rational approach allows us to make decisions based on a framework for price and expected return rather than market sentiment. As this volatile and unexpected year comes to a close, we wish to thank our clients for their confidence in our management of their funds. We look forward to serving you in the new year.
Peter C. Wernau
Wernau Asset Management
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This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.