Markets are in flux with eight years of unprecedented central bank intervention to stave off deflationary forces, and now a new chapter—a passing of the baton to fiscal policy. While the details of what’s to come and the ability of the new administration to effect change will only become apparent as the year progresses, change is certain.
We have been of the belief that the outlook for most asset classes is bleak, with medium to long-term expected returns far below their long-term averages. The explanation for this perspective is widely accepted at this point: 35 years of declining interest rates, higher than average valuations, unfriendly demographic trends and low productivity growth. And while all of these arguments still hold for the long run, the long run matters not for 2017. What does matter is positioning during this important transition period. Everything is relative, so the decision for 2017 comes down to a simple question, which asset class has the advantage? The answer lies within valuation, sentiment and earnings growth.
If, as expected, the Trump administration spends heavily on infrastructure and the military, simplifies the tax code and reduces the overall corporate tax burden, makes the regulatory environment more business friendly, enacts legislation that encourages manufacturers to stay put or come home, and plays hardball with our major trade partners, the impacts would be clear: higher growth, higher inflation, higher rates and a stronger dollar. A lot of “ifs” packed into that sentence to be sure, but we believe that scenario to be likely with Republicans controlling both the White House and Congress. Additionally, according to Real Clear Politics, “The GOP now controls 68 out of 98 partisan state legislative chambers—the highest number in the history of the party.” Republicans currently hold the governorship and both houses of the legislature in 23 states, while Democrats have that level of control in only 7.” In short, the Republicans have everything lined up to accomplish their goals…and nowhere to hide if they don’t.
Working on the assumption that a large portion of the outlined agenda can be accomplished at least in part, what would the probable outcome be for the major asset classes? Here’s our quick take:
- U.S. Investment Grade Debt: No surprises here, rising inflation and rising rates are clearly a negative in the short term for bonds, and fund flows could exacerbate the problem.
Key Takeaway: Generating a positive real rate of return will be difficult in 2017.
- U.S. TIPS: Unexpected increases in inflation propelling nominal rates higher (as opposed to increases in real rates) could make the asset class attractive, but remember, current prices already factor in expected inflation, and there is a lag effect to the principal adjustment when inflation does rise.
Key Takeaway: We see promise in the asset class overall, but expect low real returns.
- Foreign Investment Grade Debt: Investors here confront all of the same issues facing U.S. investment grade debt, but from an even lower starting point in terms of rates, and there is the possibility of a currency headwind should the dollar continue to rise.
Key Takeaway: We can see no reason for U.S. investors to allocate to this asset class in the near term.
- Emerging Market Debt: Meaningfully higher yields and improving fundamentals make this an interesting asset class, but a rising dollar could hurt in a number of ways. Dollar-denominated debt becomes more expensive for issuers to repay, and U.S. investors in local currency debt will have their returns eroded by the currency translation. Throw into the mix the potential for trade wars and the fundamental picture gets murkier.
Key Takeaway: We’re cautiously optimistic here, but risk is real.
- High Yield Debt: Stronger growth certainly bodes well for high yield issuers, as it should forestall defaults, but spreads declined by approximately 270 basis points in 2016, and now stand about 160 basis points below their long-term average.
Key Takeaway: There isn’t much upside in our opinion.
- Commodities (ex-Gold): Stronger growth and higher inflation are clearly beneficial here, but the negative roll from the futures curves can eat up returns. The equities of commodity producers are likely a better bet.
Key Takeaway: Don’t tango with Contango.
- Gold: Is gold an inflation hedge or an alternative currency? Truly long-term data (think hundreds of years) puts the former into question, and if it is a currency, a stronger dollar won’t be kind to investors in this sparkly metal. Add in the fact that higher rates make this non-yielding asset less and less attractive.
Key Takeaway: No yield means no luster.
- Emerging Market Equities: As with emerging market debt, valuations and fundamentals are indeed compelling, and stronger U.S. growth should likewise be beneficial here, but currency headwinds and the threat of trade wars make this an uneasy bet.
Key Takeaway: Invest for the long run, but strap in.
- Foreign Developed Equities: Valuations look good and European Central Bank (ECB) support is strong, but with a number of key elections forthcoming (i.e., France and Germany), the impact of Brexit unclear, and continued dollar strength possible, U.S. dollar-based investors may not fare as well as they might expect.
Key Takeaway: With great uncertainty comes great opportunity…and volatility.
- U.S. Large Cap: Valuations aren’t great and with 44% of revenues coming from overseas, according to S&P, a stronger dollar and the potential for trade wars doesn’t bode well for big cap companies.
Key Takeaway: Not an optimal time for big cap companies.
- U.S. Small Cap: Guess what? If the title of the paper didn’t give it away, we think small cap has a lot going for it at present. Here’s why
The valuation of an asset at the time of purchase matters greatly to long-term returns, but is admittedly uncorrelated to short-term performance. Regardless, investors need to add to asset classes when valuations indicate that it is advantageous to do so. Current valuations for small cap companies relative to their large cap peers are about as attractive as they’ve been over the last 15 years, especially based on cash flow and sales. To be fair, small caps aren’t cheap relative to their own history based on trailing 12-month earnings, but then again, much of our (and the market’s) optimism is based on changes that are expected to accelerate earnings.
Related to valuation levels, over the 10-year period ending December 2016, the payoff to investing in small cap stocks, for which we know there is a long-term premium, has been almost zero. The Russell 1000 Index annualized at 7.08% over this time period, and the Russell 2000 Index annualized at 7.07%. According to Ibbotson’s Stocks, Bonds, Bills & Inflation Yearbook, from December 1925 through December 2016, the premium to small cap stocks has been 189 basis points annualized. Having a 10-year run when that premium didn’t exist, while not exactly rare, is certainly less common, as can be seen from the following chart. And when that premium begins to expand, failing to have meaningful exposure can be painful, as the payoff is asymmetric (i.e., positive premium period highs far exceed negative premium period lows).
However, some might be inclined to worry, if rates are expected to rise, won’t that hurt valuations because of the effect on discounted cash flows? We’ve seen this argument many times in recent years, as strategists made the opposite case, that is, that low rates supported higher valuations, but we believe that argument falls flat in both directions, as we explained previously in one of our blog posts:
“…the siren song of the discounted cash flows argument is worth digging into a bit more. Investors put money in equities in part because they are a good inflation hedge over time. Why is that? If inflation is high or increasing, nominal earnings growth will likewise be high or increasing (although that isn’t necessarily true of real earnings growth), and if inflation is low or declining, nominal earnings growth will follow the same pattern. If stock prices follow earnings growth, which is a nominal number, all else equal, valuation levels shouldn’t be affected [as rates change], as both the P (Price) and the E (Earnings) adjust to the changing environment.” (October 5, 2016)
Further, research by JPMorgan, has shown that, “When yields are below 5%, rising rates have historically been associated with rising stock prices.”
All things considered, we believe that the valuation picture for small cap companies is quite supportive of adding to allocations at present. In addition, small cap companies may be poised for a re-rating, because valuation levels are a function of sentiment, and sentiment, as we’ll explore next, is decidedly positive.
We’ve seen a growing change in sentiment expressed in a number of ways of late. For one, the post-election jump in consumer sentiment added to an already strong trend that paints consumers as being as optimistic as they’ve been since January 2004. That optimism is a function of the fact that the consumer is in great shape. Debt service as a percentage of disposable income is near an all-time low going back to 1982. Unemployment is quite low. Average hourly earnings have been increasing at close to their fastest rate since the Great Recession. Housing prices have risen almost 40% since the bottom in 2012. And of course, the stock market has been increasing for the better part of eight years. All of this has contributed to consumers’ euphoria.
Credit spreads have also continued to narrow over the last eight weeks, and are indicative of a risk-on mentality. Historically, small caps have benefited in such an environment.
More specifically, the change in sentiment in favor of small caps is evidenced by the 837 basis point outperformance of the Russell 2000 relative to the Russell 1000 over November and December. That outperformance is most certainly a function of the changes in tax, regulatory and trade policy expected of the new administration. We’ll touch on how those changes may impact earnings in the next section, but suffice to say, small caps look to be bigger beneficiaries of the expected changes than their large cap brethren.
Lastly with regard to sentiment, investor enthusiasm post-election has been greatest for Financials, Energy and Industrial Stocks, while Staples, Utilities and Technology have all been left behind. With that in mind, and again, assuming that pro-growth policies take hold and play out as investors expect, the small cap asset class has a sector exposure advantage. The Russell 2000 is overweight three of the five best performing sectors and underweight three of the five worst performing sectors since the election.
In particular, we like the advantage in Financials, as the steeper yield curve and the reduction in financial services regulation could accelerate earnings at a substantial rate. Industrials and Basic Materials should also do well with an infrastructure and manufacturing push. Offsetting this affection for small caps, however, is reduced exposure to Energy, which is also a sector we believe will do well in the coming year.
In theory, the surge in sentiment for small caps should be connected to the outlook for earnings. So how might the new administration’s policies affect earnings? For one, pro-growth policies that lead to higher rates will mean a stronger dollar. As mentioned previously, the 500 largest companies in the U.S. derived almost 44% of their revenue from abroad in 2015, according to S&P. Their exposure to overseas consumers and the currency translation back to the dollar is material. In contrast, small cap companies are more of a domestic play, safe from the effects of currency swings. According to Credit Suisse, companies comprising the Russell 2000 only attribute about 19% of their revenue to international sources, or less than half that of the overseas revenue exposure of large caps. A domestic orientation may end up simply being a relative benefit vs. large caps, as opposed to a driver of earnings, but then again, if the U.S. does lead the growth resurgence, such an orientation will provide an earnings boost as well.
That same line of thinking regarding overseas revenue exposure can be applied to the expected impact of tariffs and other anti-globalization policies. Large companies will be affected much more directly as both buyers and sellers, than will small, domestically-oriented companies. Therefore, should President Trump go down that path, investors will be better off on a relative basis in small cap stocks.
As for tax reform, Credit Suisse estimates that the current effective tax rate for small cap companies is about 32%, while large cap companies enjoy a six-point advantage, with a 26% effective rate. Small cap companies generally lack the legal resources to manipulate the tax code to their benefit, and as such, they pay higher rates. A simplification of the tax code and a reduction in the overall corporate tax rate would thus be more beneficial to small companies.
Finally, small cap companies carry a slightly lower debt burden (approximately 4% based on debt-to-capital ratios) and while less financial leverage was a headwind in a declining rate environment, the reverse will be true as rates increase.
We believe that 2017 will be quite rewarding for U.S. small cap investors. However we also acknowledge that attempting to make major tactical changes to portfolios at a time of great hope, but without much in the way of details as to how change will be effected, would be unwise. Likewise, sitting on long-term strategic allocations at a time of unquestionable change strikes us as imprudent. Investors need to be dynamic in their approach to asset allocation, migrating portfolios towards those assets that are better priced, with improving sentiment, and ultimately, with stronger earnings potential. Based on those metrics, everything is setting up for small caps to be “the” asset class that you need exposure to in this year.