November underscored that the consensus can be wrong, very wrong. A month ago, there were two widely accepted opinions: One, Hillary Clinton would win the US presidential election… Wrong! And two, if Donald Trump were to win the election, stock markets would decline or fall dramatically… Right for a few hours, but then another big Wrong! Throughout November, US stocks pushed upwards on expectations of lower taxes, increased spending, less regulation and higher economic growth. For the month, the S&P500 advanced a solid +3.7% and the Dow Jones surged even higher, +5.9%, as both indices achieved new record highs. Upheaval underlined the advances in US indices. The biggest winners were the Financials sector and small cap stocks, both up over +12%. In contrast, the biggest losers were defensive stocks including the Consumer Staples and Utilities sectors, both retreating more than - 4%.
Beyond US equities, massive upheaval across investment asset classes. When consensus views shift rapidly and radically about a new political world order with economic impacts (fiscal and monetary), there are bound to be further disruptions across different financial markets:
• US Dollar surged to its highest levels since 2003 on prospects of higher economic growth, higher interest rates and uncertainties overseas. With an unusually strong gain of 3%, USD appreciated against the Euro, Japanese Yen and most Emerging Markets currencies.
• International equities suffered from the strong Dollar and fears of a protectionist Trump administration. The MSCI international equity index retreated -2.3% with Emerging Markets declining -4.4%. The worst region was Latin America, down -9% in November, but year-to-date remains above +30%.
• As interest rates jumped, bond prices fell. The yield on 10-year US bonds pushed from 1.8% to 2.4%, a move reminiscent of the May 2013 “taper tantrum”. The result was major sell-off in bonds, a big monthly decline with the most negative impact on long-duration bonds, especially with maturities beyond 10 years.
• Oil rose on OPEC agreement. At the end of the month, members of the Organization of the Petroleum Exporting Countries agreed to their first production cut in eight years. This is significant as it required the alliance of rivals Saudi Arabia and Iran with intervention by Russia. Oil prices reached nearly $50/barrel, a surge from its lows of $26 in February.
• Metals gone wild. Copper surged +20% with expectations of increased US infrastructure spending and stable demand in China. In contrast, gold prices fell more than -9% during November to 10-month lows.
REGIME CHANGES BEYOND U.S. ELECTION
November’s turmoil fits with the narrative of massive political shifts this year. Both the UK Brexit referendum in June and the US presidential election exemplify rising populist and nationalist movements mixed with anti-immigration and anti-globalization campaigns. But major changes have not been limited to English speaking democracies. In mid-October, the world’s longest reigning monarch (for over 70 years), Thailand’s much beloved King Bhumibol Adulyadej passed away. Another recent death was the controversial Cuban leader Fidel Castro who made a strong imprint on the 20th Century for his decades-long defiance of the US. As we write this note, Italy’s centrist Prime Minister lost a referendum vote for political reform and South Korea’s leader is on the verge of impeachment due to a widening political scandal, capping a very uncertain and unexpected year for some of the world’s larger economies.
Looking to the US Dollar and interest rates In the short/near-term, it is very reasonable that recent trends from the election may continue, supported by seasonality and limited news flow into year-end. Moreover, the anticipation of higher US economic growth does not face reality until late-January when the incoming administration and Congress begin their terms. Aside from political expectations, two metrics we are closely watching are the US Dollar and US interest rates. Both are mere headwinds at present, but if extended too far or too fast, these intertwined factors could have broader and serious implications across the global financial system.
US Dollar strength is a threat to Emerging Markets where several countries have raised interest rates ahead of the US Fed to protect their currencies. Moreover, the level of Dollar-denominated borrowing has grown in Emerging Markets to over $3trn and debt-servicing costs could become straining. Back in the US, the stronger Dollar will again pressure S&P500 earnings as companies report lower overseas profits, as seen in late-2014/early-2015.
Higher interest rates are a double-edged sword. While rising rates are usually the sign of a healthy economy, the sudden rise since the election has been jarring. The upward movement in rates is welcomed by banks and savers, but sparked a sharp sell-off in bonds. Inevitably, higher rates soften economic growth, whether on credit cards or real estate, one of the strongest recent areas of the economy. For home mortgages, 30-year rates have already spiked above 4%, their highest rate in nearly two years. Looking to December 14, we expect the US Federal Reserve will raise its Fed Funds rate, but the bigger question is the pace of further interest rates moves in 2017 and beyond.
OUR INVESTMENT STRATEGIES
In our Intelligent Investing for Intelligent People approach, we manage investments across:
1. Broad Portfolio Allocations, and
2. Two distinct Proprietary International Equity Strategies, appropriate for select clients Broad Portfolio Allocations:
For most of our clients, a diversified portfolio is generally most appropriate for their investments. Together, we will determine investment objectives and risk tolerances and then construct portfolios incorporating an optimal asset allocation and security selection.
• Equities: US equities remain the cornerstone of our investment approach for broad portfolio allocations, a positive for most clients’ diversified portfolios. New changes sparked from the US election generally favor US over international equities. We still believe there is a reasonable place for international stocks, but note while Developed Markets such as Europe and Japan can benefit from a weaker currency there could be more challenges for Emerging Markets.
• Income: As highlighted above, the new regime of fiscal spending and potential monetary policy has implications for income-generating investments. While some may argue the ultra-low interest rate environment is over, we still find enough international fragility to believe that interest rates should remain low. We will maintain positions in bonds for diversification, but can still find sources of income generation in areas including REITs, preferred shares and dividend-paying equities with sustainable growth.
Proprietary International Equity Strategies:
Our Country Selection strategy was slightly ahead of the international equities index in November. Clearly, exposure to Emerging Markets weighed down the performance of the strategy – including positions in Brazil, Mexico and Turkey, where country funds were down between -11% and -15% in November. Nevertheless, the strategy was helped by currency-hedged positions in Japan and Europe and in countries where the currency impact was muted, such as Canada, China and Australia.
Eric Uchida Henderson, CFA
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