The Fed raised rates again in March with the target Fed Funds rate now at 0.75-1.0%. It is anticipated that this rate hike will be the first of a few this year but as we have come to learn, the plan Fed policymakers present in one quarter can be significantly different from the actual changes in the policy rate in subsequent quarters. If inflation continues to take hold, it can be expected that the Fed will respond with another hike or two this year. However, there are no shortage of external factors that could put additional rate hikes on hold in 2017. No matter what happens the rest of the year regarding monetary policy, we have already witnessed something this year that had not happened since before the financial crisis: increases in the Fed Funds rate in consecutive quarters.
Despite the strong start to the year in US and global equity markets, the torrid pace slowed down in March. The S&P 500 returned 0.12% in the final month of the quarter while the MSCI All Country World Index rose 1.22%. US markets continued to rise in the quarter following the inauguration of President Trump. Similar to the post-election stock market rally at the end of 2016, the performance in US markets is largely attributable to the new administration’s pro-business rhetoric: tax cuts, regulatory reform and infrastructure spending. Some have said the pro-business talk has revived the “animal spirits” in the US. While it certainly seems like markets have become increasingly confident in the future business environment backed by strong hiring numbers and consumer confidence surveys, we are a little more skeptical. In our view, the post-election rally that continued into the first quarter of this year “priced to perfection” the anticipated pro-growth policies that Trump would pursue with the help of a Republican-controlled House and Senate.
In a way, March was a wakeup call for markets as investors seemed to realize that talking about major tax overhaul and spending plans is much different than implementing such legislation. The discrepancy between campaign rhetoric and legislative change was highlighted by the House’s plan on repealing the Affordable Care Act. The infighting that surrounded the bill in the House, combined with Senators proclaiming the bill would be dead on arrival and an ambivalent President, made clear that any legislative changes would be challenging to accomplish. Even in a best-case scenario, legislative change takes time. The health care debate showed that large-scale overhauls not only will take time, but may not come to fruition at all, or be much smaller in scale that Trump campaigned on.
Tax reform is another big-ticket item that Republicans want to tackle early on, but even if Trump is more personally invested in tax reform than he has been with health care reform, the task is still monumental. Even if some Democrats are convinced to support a tax reform bill because of middle class tax cuts for example, they are unlikely to provide the bipartisan support needed before the 2018 midterm elections to minimize the chance Trump gets a big “win” in the first part of his term. This supports our belief that stock markets, already sitting at high valuations, got ahead of themselves early in the quarter and this was followed by a slight pullback at the end March. In sum, while we are hopeful for a pro-growth corporate tax reform bill, we are not anticipating a major change just yet—although any progress towards one in Congress might be enough to guide equity markets even higher.
On the short-term horizon, increased market volatility may be in store for the second quarter of 2017 for a number of reasons. First, if the Fed raises rates again investors may be enticed to move money out of equities and into higher-yielding US Treasuries. Additionally, if economic growth in Europe continues to pick up, European debt may begin to look more attractive relative to yields over the last year, which could also draw money out of stock markets.
On the flipside of positive economic growth in Europe however lies the potential for destabilizing effects if Marine Le Pen wins the French presidential election. Her anti-Euro, pro-nationalism platform could serve as a knockout punch to the European Union. Based on current polling Le Pen has been gaining momentum recently, although she is still likely to lose to Emmanuel Macron. The French election, set to begin later this month, may be the biggest event with serious market-moving potential on the calendar for both the quarter and the entire year. If 2016 taught us anything, though, it is that unexpected outcomes in political events may send markets down in the short-term but that they have yet to derail the US equity bull market. The French election may prove to be different, but US equity markets have been resilient over the last 5 years. The escalation of conflict in Syria may also provide a case study in geopolitical driven volatility in the short-run that is outweighed by stronger market fundamentals over the course of the year.
Constructing durable asset allocations remains our primary focus, given all of the various economic and political puts and takes. We will also continue to take advantage of market dislocations during periods of uncertainty when we believe compelling opportunities present themselves.
Carl Hall, CFA
Chief Investment Officer
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