Since the U.S. election, we have seen strong performance in stocks and weakness in bonds as the long awaited increase in interest rates has finally begun. Considering the magnitude of these moves, it is fair to ask if prices have moved too far too fast or if both stock and bond prices will continue to move.
While we do think it is reasonable to expect some pullback after the recent uptick, HCM believes the intermediate outlook is positive and worthy of overweight equity risk exposure.
From an economic perspective, it is tough to say whether the proposed policy changes will be good or not. There is always risk that we may see too much fiscal stimulus at a time when the federal budget cannot afford it and the economy does not need it. The result could be an overheated economy, creating the risk of an eventual recession that would push stock prices down and bond prices up as investors run for cover. Or the American economy could respond providing more capacity, stronger economic growth and continued low inflation.
While there is uncertainty about the economic implications of the proposed policy shift, the odds seem very good that next year will likely see corporate tax cuts, spending increases and Federal Reserve rate hikes. HCM believes that the change in policy favors stocks over bonds.
A lower corporate tax rate will increase 2017 earnings per share causing a reduction in price earnings multiples, moving stocks from being relatively expensive back into a fairly valued range. These improved fundamentals, along with a lack of attractive investment options, suggest to us that stocks have additional upside potential from here. This is why HCM is maintaining a modest overweight allocation to equities and is hoping to add to our allocation if we see a pullback in prices.
We believe that bonds will continue to be challenged as the Fed moves to gradually normalize monetary policy with a rate hike later this week, followed by more next year. Also, we believe the anticipated changes in fiscal and monetary policy will push long-term interest rates higher and bond prices lower. This is why we are maintaining more than half of our fixed income allocation in alternative bond strategies.
History suggests that the first few rate hikes are unlikely to slow the economy in any meaningful way. Consequently, we believe the net impact of a policy shift to easier fiscal policy and tighter monetary policy should be expansionary. Spending increases and tax cuts will likely boost economic growth far more than the next few interest rate hikes will slow it.
Stocks returned to their post elections rally mode last week with the Russell 3000 (IWV) gaining about 3.36% while developed foreign markets (EFA) gained about 2.91%. Emerging markets (EEM) gained about 2.90% for the week. Bonds (AGG), resumed their slow grind down as they lost about .27% for the week. (Note: performance is based on the change in net asset value.)