Everyone’s Optimistic About the Markets. Is It Time to Worry?The consensus is that the positive things that Trump has promised for investors will come to pass in . But will they?
Brother, can you paradigm?
The Bank for International Settlements, the central bank for central banks, posed the question “A paradigm shift in markets?” in the title of its latest quarterly report. One infers that it was not meant to be rhetorical, even though it was not answered directly, as might be expected from typically elliptical central bankers.
Clearly, the U.S. election results have produced marked changes in asset markets, with stocks, bond yields, and the dollar all higher. Those moves have been based on expectations of strong growth in the economy and corporate profits, along with higher inflation. But as for an actual change in paradigm in terms of how the economic and financial world works, that’s still in the future.
Even so, the expectations are so strong as to border on certainty that the platforms on which Donald J. Trump campaigned for the presidency will be enacted as he presented them, and promptly. To be sure, after his inauguration on Jan. 20, odds favor the Republican-controlled Senate and House of Representatives approving the Trump program—that is, assuming there are no weird upsets in the Electoral College count Monday. But there is no sure thing, no matter the odds, as this bizarre year has proved dramatically.
Those expectations are encapsulated in the forecasts for the economy and markets for the coming year, a sample of which appears in our Outlook 2017 section. After dutifully perusing the deluge of predictions that land in email in-boxes this time of year, we find a similarity that calls to mind Dorothy Parker’s acid review of Katharine Hepburn, who she said “runs the gamut of human emotion from A to B.”
The range of projections seem about as narrow, with most forecasts of gross domestic product clustering around 2% growth, after inflation. Interest rates, as represented by the 10-year Treasury note, could move somewhat higher, perhaps to 3% from 2.59%. U.S. stocks should provide returns in the mid-single-digit percentage range, with a modal estimate for the Standard & Poor’s 500 index of 2400 by New Year’s Eve 2017, from 2258 on Friday.
More From Barron’s
Eli Lilly on Sale With 3% Yield, Cheap Valuation
Bessemer’s 2017 Outlook for Stocks and Bonds
Exxon’s Shares Lagged Under CEO Rex Tillerson
This tight consensus, envisioning such benign outcomes, recently moved not one, but two sage market observers—David Rosenberg, Gluskin Sheff chief economist and strategist, and Doug Kass, head of Seabreeze Partners—to invoke Rule No. 9 of Bob Farrell, Merrill Lynch’s legendary former market guru: “When all the forecasters and experts agree, something else is going to happen.”
After a year that featured not one, but two electoral shocks—Brexit and Trump—both of which stunned the markets and initially sent them sprawling, such certainty seems surprising, at the very least.
What’s especially striking is the absence of uncertainty evident in various risk measures. The CBOE Volatility Index, or VIX, which measures premiums on S&P 500 options, hovers near the year’s lows around 12; that indicates buyers of put options, which hedge against price declines, are loath to pay up for downside insurance.
That serene confidence also is evident in the high-yield bond market, where investors are settling for 4.2 percentage points in extra yield over Treasuries as compensation for the risk they bear, according to the Bank of America Merrill Lynch Master II High Yield Index. That’s less than half the 8.64 percentage points they demanded last February amid the slide in energy and other commodity prices, which imperiled the balance sheets of many highly leveraged producers of oil and metals, and the least since September 2014.
The consensus also assumes a President Trump will follow through on some of his plans on Day One of his administration, at least those that don’t need congressional approval. Among them is to declare China a currency manipulator for allegedly pushing down the yuan to gain an advantage for exports.
The Chinese currency has been weakening steadily, nearing the psychologically important mark of seven to the greenback. In that regard, the yuan is hardly alone in losing ground to the surging dollar, which has gotten a further boost from the Federal Reserve’s one-quarter percentage-point interest-rate hike last week and its announced expectation of three more such moves in 2017. Compared to the currencies of its other trading partners, however, China’s yuan has been relatively stable.
China also hasn’t fulfilled all of the U.S.’s four criteria to be declared a currency manipulator: at least $55 billion in trade with the U.S. a year, a $20 billion trade surplus with the U.S., a current-account surplus equal to 3% or more of GDP, and purchases of foreign assets equal to more than 2% of GDP. On the latter score, China has been dumping its foreign-currency assets, notably U.S. Treasury securities. According to the most recent Treasury Department data released last week, Japan has supplanted China as the largest foreign holder of Treasuries.
China, in fact, has been liquidating foreign assets at a rapid pace to stabilize the yuan, or at least slow its descent—precisely the opposite of accusations that Beijing is pushing it lower. The Chinese monetary authorities are fighting capital flight, as individuals try to get their legal $50,000 a year out of the country and businesses make acquisitions, in no small part also to move money abroad. The result has been akin to a bank run, with Chinese government bonds crashing last week, forcing a halt in bond futures trading, amid the slide in the yuan.
China also puts great symbolic importance in the yuan’s being added to the International Monetary Fund’s Special Drawing Right, which officially took place on Oct. 1. With its currency reeling despite its support, being accused by Washington of manipulating it in the opposite direction would be an affront to Beijing.
At a gathering of some high-powered investment minds last week, one in attendance suggested such a scenario could provoke a confrontation in the South China Sea to test the new Trump administration. Events on Friday seemed to overtake such speculation after a Chinese warship seized an underwater survey drone used there by a U.S. Navy oceanographic survey ship.
Such geopolitical disturbances aren’t discounted by the serenely confident markets. They also assume that Trump’s fiscal plans will sail through Congress almost immediately, especially his tax cuts, which have substantial support among Republicans, who control both houses. The possibility of opposition from staunch deficit hawks to either tax cuts or an increase in the federal debt ceiling, which will be needed in a few months, falls outside the consensus.
Another possibility raised at our gathering: Some GOP stalwarts may push a Supreme Court nomination to fill the vacancy left by the late Justice Antonin Scalia as a first priority. That could delay any fiscal action, which might mean no stimulus would be felt until perhaps 2018, and doesn’t figure into the 2017 relatively rosy outlook.
One other possible skunk that could ruin the bulls’ picnic could be a renewed swoon in oil prices. A year ago, as noted, crude prices were in near free fall, which threatened the solvency of much of the junk-bond market and other lenders to the energy sector. Since oil has returned to the $50-a-barrel range, the stock and high-yield bond markets have recovered, with equities hitting records and the Dow Jones Industrial Average nearing the 20,000 mark.
Saudi Arabia’s agreement to produce just over 10 million barrels a day, from a peak of 10.7 million in July, has been key. One motivation might be to bolster oil stocks, as the Saudis prepare their initial public offering of shares in Aramco, which could be the biggest IPO in history. Whether the Saudis would continue to curb output—and with it, much needed revenue—once the IPO is placed is another question raised at this salon. As the past couple of years have shown, as goes crude, so goes the stock market.
None of these developments qualify as black swans, to be sure. But looking ahead to 2017, there seems to be heady anticipation that the positives promised from November’s elections will come to pass, and quickly. Yet the record of 2016 is that what was expected didn’t happen, and what couldn’t happen, did. That suggests risks ahead—and opportunities for those ready to pounce on them and having the cash to do so.
ANOTHER POSSIBLE SURPRISE: The tax exemption of municipal bonds could be targeted as an offset to the cost of the Trump tax cuts, according to a public-finance lobbyist at a recent conference quoted by Bloomberg. Munis’ tax exemption is projected to cost the Treasury about $420 billion between 2017 and 2026, relatively small change in Uncle Sam’s couch cushions.
Munis have fared poorly in the bond selloff, since tax cuts would reduce the appeal of tax-free income. That has gone too far, as colleague Amey Stone quotes John Mousseau, head of fixed-income investing at Cumberland Advisors in Sarasota, Fla., in Barrons.com’s Income Investing blog. Long-term munis with double- and single-A ratings are yielding 4% to 4.25%, more than comparable Treasuries, even without the tax advantage. “These yield levels need to be embraced,” Mousseau writes rather passionately. Muni yields also tend to fall, relative to those of taxable bonds, in a rising-rate environment, he adds.
Much of the rise has been due to bond-fund redemptions, which probably also has been spurred by tax-loss selling. Even harder hit have been closed-end muni funds, which Amey also reported were upgraded last week by Stifel Nicolaus analyst Alexander Reiss, who presciently downgraded a bunch last August near their peak prices. Sell high, buy low—a concept that could catch on in 2017?