The S&P 500 has rallied 10.65% through February 24th since Donald Trump won the Presidency. The rally has been led by financial service stocks & other economically-sensitive sectors. The strength and relentless nature of the rally has surprised many investors. NPP thinks that part of the rally can be attributed to the positive reaction to Trump’s tax plans and the push to ease regulation. However, part of the rationale behind the rally is undoubtedly due to factors outside of President Trump’s control.
It is easy to speculate in hindsight that equities would have experienced a relief rally once the uncertainty of the Presidential election passed. In the weeks prior to the election, it appeared investors feared committing money to equities with such a big unknown on the horizon. With that in mind, NPP believed that the equity markets would have rallied regardless of who won the Presidency. Different sectors would likely have led the rally and the strength of the rally would likely have differed had Secretary Clinton been elected President. But there were economic forces in place at the time of the election that contributed to the equity market rally.
In the U.S. and abroad, economic data has firmed over the last couple of months. Stronger payrolls and rising global PMIs indicate accelerating global economic growth. Inflation has been increasing cyclically and more importantly, the threat of deflation in many economies around the world has been waning in the short-term. The deflationary environment was generating declining profits. The end of deflation has led to sales growth of 4.62% and earnings growth of 4.73% for the fourth quarter of 2016 through February 24th. Moreover, the October to May period is historically the strongest part of the year.
NPP does feel President Trump’s election has been a significant contributing factor to the back-up in bond yields. Trump emphasized infrastructure investments and tax cuts while not being concerned about deficits during his campaign. Additionally, Trump also stated that he felt that interest rates were too low. The combination of Trump's election, the unwinding of the risk aversion trade and improving global economic data has led to the strong increase in sovereign bond yields.
The speed and pace of the rally has been breathtaking, but investors may be ignoring potential market risks. While we don’t feel a ten percent correction is imminent, there are several risks that we are monitoring. The belief that there will be tax reform, regulatory relief, and an infrastructure package in 2017 has contributed to the market rally. A delay in tax reform or rolling back regulations could lead to a sell-off. Additionally, nobody knows what the final tax reform bill will look like. When people finally see the details, it may be a case of buy the rumor, sell the news. In addition, the Federal Reserve will continue raising interest rates barring unforeseen events. At some point, higher interest rates may cause an aging investor-class to move back into bonds. Looking overseas, there are several European elections later in 2017 including elections in Germany, France, and Italy that markets may view as unfavorable.
The markets have rallied hard and fast as earnings have picked up. The hope for lower tax rates amid corporate tax reform has contributed to investors forecasting higher earnings going forward. If earnings growth does not deliver, the market is likely to pull back. Another concern would be if interest rates increase too fast. If this were to occur, investors that have been starved for yield are likely to rotate back into bonds from stocks.
Despite the potential risks on the horizon, NPP is not overly cautious at the moment. There are still parts of the market that are reasonably valued. Financial service stocks underperformed for years and we think the rally in financial stocks is just getting started. Several large-cap technology stocks are still reasonably valued. More importantly, most bear markets are caused by recessions and NPP does not see a big risk of a recession occurring in the next six to twelve months. Any pullback is likely to be a buying opportunity. Nevertheless, investors should not expect the rally to continue at its current pace for the rest of 2017.