Navigating Optimism and Uncertainty
“It is a mistake to try to look too far ahead. The chain of destiny can only be grasped one link at a time.” — Winston Churchill
The early days of the Trump era find the pulse of the business community in an unusual place—the co-existence of both historically high optimism and uncertainty (Figure 1). Comparisons have been made between Presidents Trump and Reagan. After all, both were Washington outsiders favoring tax cuts and less regulation, but there are differences. Inflation, interest rates, and unemployment were all much higher in 1981 than they are today, and the economic cycle was at an earlier stage, with more slack resources to draw upon. As shown below, optimism and uncertainty were also lower in early 1981 than they are today.
Figure 1: The Business Community Remains Optimistic, but with High Levels of Uncertainty, This Can Create a Dampening Effect on Growth
Sources: National Federation of Independent Business (NFIB), Bloomberg L.P. Data, 1/31/17.
A rising stock market and an uptick in the pace of economic growth help account for the surge in optimism. Companies are on track to report 5% year-over-year fourth-quarter growth in S&P 500 earnings per share, and initial unemployment claims recently reached their lowest level since the early 1970s. A commitment to business-friendly policies by President Trump helps explain matters, too. Executive orders to move forward on the Keystone XL and Dakota Access pipelines have been issued, and plans for tax reform, infrastructure spending, and deregulation lie ahead. On February 23, The Wall Street Journal reported that Treasury Secretary Steven Mnuchin is targeting an overhaul of the tax code by Congress’s August recess.
Still, uncertainty abounds. In the U.S., trade relations, diplomacy, the details and economic impact of future fiscal policy actions, and their impact on the trajectory of U.S. monetary policy all raise questions. Of note, Federal Reserve speakers have said monetary tightening could come “fairly soon” if the economy continued to improve and fiscal stimulus altered the inflation calculus.
Outside the U.S.
The UK Brexit process of separating from the European Union (EU) will start by the end of March, with no historical precedent for comparison. The March 15 Dutch election should provide early 2017 color, as to the nationalist mood in Europe. Soon after, the first round of the French election takes place on April 23 (second round on May 7), with the defining issue being France’s membership in the EU. The latest polls show far-right leader Marine Le Pen as the favorite to win the first round of France’s presidential election, but she is expected to lose the second round to either the center-right’s Francois Fillon or centrist Emmanuel Macron, according to Reuters. Other elections in Europe are set to follow, with Germans going to the polls on September 24— the top issues being the refugee crisis and the fate of fiscal austerity.
Key Themes for 2017
- Uptick in inflation – The U.S. Consumer Price Index (CPI) has risen 2.5% in the year ended January—its largest gain in four years—as energy and other commodity prices moved higher in response to a pick-up in global demand. For concerned investors, diversifying with natural resources and commodities can help address the impact of rising inflation.
- Rising rate environment – The Fed’s expectation of three rate hikes in 2017 looks more plausible, following recent signs of stronger growth and higher inflation. Rising interest rates should be accretive to floating rate loan coupons, as three-month LIBOR, at over 1%, now tops nearly all floating rate loan floors. Short-duration high-yield bonds represent another avenue for investors to side with opportunities in credit, and the asset class has historically performed well during periods of rising interest rates.
- Volatile, single-digit return environment – The stock market is off to a good start. But, it’s only March, and the S&P 500 Index has averaged three 5% pullbacks a year since 1926 (one reaching 10%). Convertible bonds have performed well since the election, based on asset class performance represented by the BofA/Merrill Lynch U.S. Convertibles Index. In a volatile, single-digit return environment, if suitable, investors may also wish to seek out stocks with strong cash flow growth and a disciplined capital allocation process, as well as high-liquidity, low-risk high-yield bonds. Liquid alternatives can add diversification to a portfolio of traditional stocks and bonds, too.
Figure 2: Investment Opportunities for 20171
|Uptick in Inflation||Commodities||Commodities are attractively priced by historical standards versus consumer prices. The beneficiaries of relatively cheap and abundant energy in the U.S., including downstream users of hydrocarbons, may also do well, as inflation rises.|
|Rising Rate Environment||Floating Rate||Floating rate loans should bode well in a rising rate environment, as
their coupon rises in tandem with interest rates.
|Short-Duration High Yield||Both short-duration and high-yield securities are less sensitive to rising rates by nature. While past performance is not indicative of future results, the asset class has historically performed well in recent rising rate environments.2|
|Volatile, Single-Digit Return Environment||Convertible Bonds||Convertibles provide decent upside market participation, while Bond-like features provide some protection in down markets. With a wide range of outcomes possible in 2017 given a new administration in the U.S. and political uncertainty in Europe, this hybrid feature of convertible bonds is attractive.|
|Liquid Alternatives||We believe liquid alternatives can help diversify a classic stockbond portfolio, given their low correlations. Hedged strategies, such as risk arbitrage, have lower betas (market sensitivity) than the market at large.|
|Equities||Equity strategies that seek out cash flow growth and efficient capital allocation may be better positioned than a singular focus on high dividend yields.|
|Flexible Strategies||These strategies can lock onto the most persistent trends in credit and yield curve movements to help manage against potential blind spots. Focusing on high-yield/low-volatility bonds with greater liquidity and lower risk could help reduce volatility and exposure to defaults.|
1. Source: MainStay Investments, Strategic Asset Allocation and Solutions Group, 2/28/17. Past performance is no guarantee of future results.
2. Sources: Morningstar, MainStay Investments, as of 2/28/17, using periods from 1998–2000, 2004–2006, 2009–2010, and 2012–2013. In those periods, short-duration high yield performed well, relative to other fixed-income securities.
Investing in a period of high optimism and uncertainty poses a unique set of challenges. A growing economy and a robust opportunity set for constructing portfolios may afford thoughtful investors with the wherewithal they need to address them.
- We expect the Fed to raise rates three times in 2017.
- Treasury yields are near five-week lows, but fiscal stimulus and Fed tightening could ultimately send them higher.
- Opportunities in credit are preferred over developed country sovereign debt.
- S&P 500 earnings per share rose 5% in 4Q16 versus 4Q15 and should advance further, according to FactSet.
- We believe profit growth will be the primary driver of equity returns in the quarters ahead, rather than changes in valuation.
- The U.S. and global economies are poised to grow faster in 2017 than they did in 2016, in our view.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
To help you conveniently locate additional Internet resources of interest, this post may contain links to third-party web sites that MainStay Investments does not operate or control. The existence of such links does not indicate any approval or endorsement of, or any association with, the linked web sites. Neither MainStay Investments nor any of its affiliated web sites is responsible for the content or operation of any linked web site. By clicking on any of the third-party web site links, you agree to access and use the linked site at your own risk and according to its terms and conditions.
All investments are subject to market risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.
For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.
Commodities are investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments, or other factors) could have an adverse impact on those companies.
Floating rate loans are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity.
Alternative investments are speculative, not suitable for all clients, and intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment.
High-yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. Bonds are subject to interest rate risk and can lose principal value when interest rates rise.
Bonds are also subject to interest-rate risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down, as interest rates rise.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union.
The Consumer Price Index is calculated by Bloomberg. Data is provided monthly. The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, and is one of the most frequently used statistics for identifying periods of inflation or deflation.
The London Interbank Offered Rate (LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
The S&P 500 Index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Past performance is no guarantee of future results. An investment cannot be made in an index.
The BofA Merrill Lynch U.S. Convertibles Bond Index consists of convertible bonds traded in the U.S. dollar-denominated investment-grade and non-investment-grade convertible securities sold into the U.S. market and publicly traded in the United States.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the mutual fund.