Quarterly Review January 2017

Markets Play Trump Card

With pomp, splendor, and much uncertainty, our country inaugurated a new President this past week. Our country remains divided nearly evenly between those celebrating the election and those who are texting "OMG". While President Trump pushes for change, many within his own party are feeling that their political dynasty-thinking and their sense of control over the political process is being threatened. With the sealing of the process complete, let's hope for the best. At a minimum it will be interesting to see how the political circus plays out. It is sure to be quite a show.

The markets responded to the election giddily, with a remarkable surge in stock prices. Let's take a moment to review how various indices fared for the past quarter and for the year: 

​Index 4th Quarter​ For the Year 2016
​Dow Jones Industrial Average (the Dow)
​+ 7.9%
​+ 13.4%
​S&P 500 Stock Index (the S&P 500)
+ 3.3%
+ 9.5%
​NASDAQ Composite
​+ 1.3%
​+ 7.5%
​Russell 2000 (small companies)
​+ 8.4%
​+ 19.5%
​Dow Jones Global Stock Index (non-US)
- 1.9%
+ 1.8%
​10-Year Treasury Bonds
​- 6.9%
​+ 0.0%
​Commodities Index (Reuter-Jeffries CRB)
+ 6.6%
​+ 25.0%
​U.S. Dollar Index (WSJ Index)
+ 7.6%
+  3.1%

All index values come from the Wall Street Journal. Stock indices do not include dividend return..

​As the fourth quarter began, the markets were already on their way to posting a good year of gains.At that time only the U.S. dollar was in the red.All other indices were well in the black. After the election, stocks steadily surged—much to the dismay of many observers. As can be seen in the above table, the quarterly results were remarkably positive.Only bonds suffered—and they suffered mightily—not so much in response to the much-anticipated increase in short-term interest rates initiated by the Federal Reserve Bank ("the Fed"), but perhaps due more to the expectation for increased inflationary pressures.

As I thought about how to reconcile the stock market rally with the election of a President some describe as a "loose cannon", the seeming contradiction began to make some sense. While they can impact each other, there is a difference between the realms of social/political conflict and that of economics. Whereas the election result reflects a very divided country, it does not directly translate to economic catastrophe. The surge in stocks after the election reflects the expected (positive) impact on corporate business and corporate earnings.In the stock market arena, the process of buying and selling stocks does necessarily assign value judgments beyond the expected consequence on corporate profits.It may sound heartless or mindless, but that's the way it is. President Trump's election pushed to the forefront the expectation of reduced regulations on many sectors of the economy, including the financial sector and oil and natural resources, among others. While reduced regulation provides more slack to those who have behaved badly and have proven to need regulation, reduced regulations means less compliance expenses and more business opportunities--business activities previously limited or prohibited. These opportunities may return higher risk to our economy (think in terms of large banks returning to the same shenanigans and risky business ventures that created the financial crises that threatened the well being of our entire economy only 10 years ago).

Where We Are Now

Unlike President Obama, President-elect Trump has inherited a positive economy. We continue to experience a good and sustainable rate of growth. The employment picture continues to improve, with the published unemployment rate of 4.7% at the lowest rate in a decade.Interest rates have increased but not beyond expectations.Inflation has ticked up a bit but the rate is muted and is not seen as a problem. Manufacturing has experienced more growth than it has for the last two years even as the dollar has gained in value against foreign currencies (making our exports more expensive to foreign purchasers). The service sector continues to grow at a healthy pace, as it has for some time.

Looking at the markets, the post-election rally has pretty much run its course for now. We are hovering near the all-time stock market highs set in December. Valuation--measured by the current price of stocks divided by their recent 12 months earnings (the Price-to-Earnings ratio)--is high, reflecting the expectation that future increased corporate earnings will justify current stock prices.

Looking Ahead

When the Fed increased rates by .25% in December as expected, they stated that they expect to increase rates three times in 2017. Of course, this is the same Fed that predicted four rates hikes in 2016 instead of just one. The Fed's action during the year will depend on our growth rate, employment gains, and inflation. Right now, it appears the pieces of the increased-rates puzzle are in place. While this may serve to control the rate of inflation, the effects of higher interest rates vary. Lenders—like banks—benefit from increased interest rates while borrowers—like the real estate sector and consumers—pay more in borrowing costs.

Another important consequence of higher interest rates relates to the Federal budget. We have had abnormally low interest rates for the past 9 years. An increase in interest rates translates to higher interest costs on the formidable federal debt we carry. As that interest expense becomes a larger and uncontrollable part of the budget, it will get harder to engage in spending on more productive areas like infrastructure.

For now, the wild card is President Trump.It is pretty much already known that he can't do all the things he promised on the campaign trail. While some of the changes are laudable, others—as great as they sound—have fiscal disaster written all over them. For example, massive infrastructure spending would improve roads, bridges, subways, and the like, but the absence of a revenue source to pay for it can only mean one thing:deficit spending on a massive scale. Hopefully both sides of the political aisle will refuse to add such an increase to our already severely bloated debt balance. Higher taxes to pay for ambitious plans will not be popular, resulting in a return to earth from the loftiness of campaign trail rhetoric.

President Trump is an agitator for change. Being able to predict what changes will actually occur is difficult. He faces disharmony within his own party as well as with the abundance of those he has alienated. We will have to see what that change looks like.

Although it would not be surprising to see some easing in stock prices in the early part of the year, a sustained rate of economic growth should provide stability to the markets.In the absence of a shock to our economy we should be able to maintain our steady rate of growth. The source of highest risk to the markets is political risk—the risk that policies coming out of Washington could neutralize our growth rate or spread chaos within our country.

As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.

Please feel free to call with any questions or comments.

Craig S. Limoges CFA, CFP

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