ISSUE 32: 2017

Investment Outlook

New Administration, New Realities for Investors

Optimism about the impact of President Trump’s potentially pro-growth policies accelerates tectonic shifts in the markets.

Photograph by Andy Ryan

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Prior to the presidential election, many economists predicted that, if enacted, the protectionist policies advocated by President Donald Trump during his run for the White House would usher in a recession — or worse. For investors, that concern has faded. After the election, equity market indices raced to record levels on hopes that tax reform and regulatory relief will bring higher asset prices. In the Q&A below, Christopher M. Hyzy, chief investment officer at U.S. Trust, shares his thoughts on the macroeconomic impact of the new administration’s potentially pro-growth policies and what it means for investors. 

After President Trump’s election victory, the U.S. equity markets hit record highs. What is driving the “Trump rally?”

Actually, the table was set for a stock market rally late last summer. At that time, we started to shift from record low — if not negative — rates and anemic economic growth to a stronger economy driven by a turn-around in the industrial and manufacturing sectors, rebounding oil prices, and strong consumer spending. This set us up for stronger growth — and higher stock prices — in the second half of 2016 and early 2017.

With a new administration now in office, the markets are reflecting the potential for change in policy.

Is some of the run-up in equity prices a result of optimism around President Trump’s pro-business, pro-growth agenda?

The economic trends were positive before the election, but there is now more confidence in the economy’s prospects — and the markets’— now that it may be easier to pass pro-growth initiatives like tax reform and regulatory relief. So I think we would have seen higher stock prices regardless of who won the election, but this administration’s proposed policies to date are probably fast-tracking the market gains we might not have seen until later in 2017 if the election had gone differently. With a new administration now in office, the markets are reflecting the potential for change in policy.

If President Trump’s policies trigger stronger
economic growth, what will that mean for the markets?

It will accelerate the transition to the new market regime that started to emerge late last summer with the uptick in economic growth and corporate earnings. So instead of an economic environment marked by deflation, low interest rates and sub-trend economic growth, we’re beginning a cycle where we have a reflation of the economy, trend growth of 2.5%, maybe better, and higher interest rates. If specific stimulus measures are passed, those policies should
accelerate and magnify these changes.

So, presumably, stronger economic growth translates
into higher corporate earnings, which allows for multiple
expansion and higher asset prices.

Not just higher asset prices, but an entirely different opportunity set for investors. Under the old market regime, which reflected secular stagnation and below-trend economic growth, investors flooded into defensive sectors, like consumer staples and utilities. Today, it’s the cyclical sectors — those whose fortunes correspond to the strength of the economic cycle — that are drawing investors’ dollars. So it’s companies in sectors like financials, industrials and materials that are likely to benefit from the stronger economy we’re anticipating.

How has the prospect of more robust economic growth
affected your asset allocation guidance?

We’re overweight equities despite current valuations, which are slightly expensive, but when you factor in potentially stronger economic growth and improved corporate earnings, an overweight to equities makes sense. Within equities, we like value stocks and U.S. small-cap equities, and we continue to prefer high-quality U.S. large caps that are likely to grow their dividends. We’re less constructive on international equities in the developed economies, but we’re overweight emerging markets because accelerating growth in the U.S. and nascent growth in Europe and Japan could drive up commodity prices.

In this environment,
investors need to consider diversifying their equity and fixed income holdings.

What about fixed income? Does a significant allocation to bonds still make sense when yields are likely to
rise quickly?

It does make sense, but with the market environment changing, the role of bonds will change as well. Bonds are shifting from an asset class that for a long time had been a total-return investment, meaning they provided both price appreciation and income. Now that yields are rising — and likely to normalize in the years ahead — bonds should be viewed as a cash-flow producer rather than a total-return asset. They’re also an important portfolio diversifier — and a volatility dampener under unforeseen worst-case scenarios.

What advice do you have for investors as they position
their portfolios for the new market regime you’ve described?

My most important recommendation for investors to consider is to take portfolio diversification to a new level. We’re in the late stages of our current business cycle, and these late-cycle phases tend to have higher volatility as inflation rises and central banks shift from stoking growth to checking inflation. 

In this environment, investors need to consider diversifying their equity and fixed income holdings. They also should consider increasing their allocation to alternative investments (only for suitable investors), especially hedge funds. Illiquid assets make sense for investors who can tolerate the additional risk. Final point: investors may need to make tactical adjustments to their portfolios multiple times because the markets are likely to be very fluid over the next year. 

Photo credit: Franckreporter/Getty Images; Aluxum/Getty Images.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments.

Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Prior to the presidential election, many economists predicted that, if enacted, the protectionist policies advocated by President Donald Trump during his run for the White House would usher in a recession — or worse. For investors, that concern has faded. After the election, equity market indices raced to record levels on hopes that tax reform and regulatory relief will bring higher asset prices. In the Q&A below, Christopher M. Hyzy, chief investment officer at U.S. Trust, shares his thoughts on the macroeconomic impact of the new administration’s potentially pro-growth policies and what it means for investors. 

After President Trump’s election victory, the U.S. equity markets hit record highs. What is driving the “Trump rally?”

Actually, the table was set for a stock market rally late last summer. At that time, we started to shift from record low — if not negative — rates and anemic economic growth to a stronger economy driven by a turn-around in the industrial and manufacturing sectors, rebounding oil prices, and strong consumer spending. This set us up for stronger growth — and higher stock prices — in the second half of 2016 and early 2017.

With a new administration now in office, the markets are reflecting the potential for change in policy.

Is some of the run-up in equity prices a result of optimism around President Trump’s pro-business, pro-growth agenda?

The economic trends were positive before the election, but there is now more confidence in the economy’s prospects — and the markets’— now that it may be easier to pass pro-growth initiatives like tax reform and regulatory relief. So I think we would have seen higher stock prices regardless of who won the election, but this administration’s proposed policies to date are probably fast-tracking the market gains we might not have seen until later in 2017 if the election had gone differently. With a new administration now in office, the markets are reflecting the potential for change in policy.

If President Trump’s policies trigger stronger
economic growth, what will that mean for the markets?

It will accelerate the transition to the new market regime that started to emerge late last summer with the uptick in economic growth and corporate earnings. So instead of an economic environment marked by deflation, low interest rates and sub-trend economic growth, we’re beginning a cycle where we have a reflation of the economy, trend growth of 2.5%, maybe better, and higher interest rates. If specific stimulus measures are passed, those policies should
accelerate and magnify these changes.

So, presumably, stronger economic growth translates
into higher corporate earnings, which allows for multiple
expansion and higher asset prices.

Not just higher asset prices, but an entirely different opportunity set for investors. Under the old market regime, which reflected secular stagnation and below-trend economic growth, investors flooded into defensive sectors, like consumer staples and utilities. Today, it’s the cyclical sectors — those whose fortunes correspond to the strength of the economic cycle — that are drawing investors’ dollars. So it’s companies in sectors like financials, industrials and materials that are likely to benefit from the stronger economy we’re anticipating.

How has the prospect of more robust economic growth
affected your asset allocation guidance?

We’re overweight equities despite current valuations, which are slightly expensive, but when you factor in potentially stronger economic growth and improved corporate earnings, an overweight to equities makes sense. Within equities, we like value stocks and U.S. small-cap equities, and we continue to prefer high-quality U.S. large caps that are likely to grow their dividends. We’re less constructive on international equities in the developed economies, but we’re overweight emerging markets because accelerating growth in the U.S. and nascent growth in Europe and Japan could drive up commodity prices.

In this environment,
investors need to consider diversifying their equity and fixed income holdings.

What about fixed income? Does a significant allocation to bonds still make sense when yields are likely to
rise quickly?

It does make sense, but with the market environment changing, the role of bonds will change as well. Bonds are shifting from an asset class that for a long time had been a total-return investment, meaning they provided both price appreciation and income. Now that yields are rising — and likely to normalize in the years ahead — bonds should be viewed as a cash-flow producer rather than a total-return asset. They’re also an important portfolio diversifier — and a volatility dampener under unforeseen worst-case scenarios.

What advice do you have for investors as they position
their portfolios for the new market regime you’ve described?

My most important recommendation for investors to consider is to take portfolio diversification to a new level. We’re in the late stages of our current business cycle, and these late-cycle phases tend to have higher volatility as inflation rises and central banks shift from stoking growth to checking inflation. 

In this environment, investors need to consider diversifying their equity and fixed income holdings. They also should consider increasing their allocation to alternative investments (only for suitable investors), especially hedge funds. Illiquid assets make sense for investors who can tolerate the additional risk. Final point: investors may need to make tactical adjustments to their portfolios multiple times because the markets are likely to be very fluid over the next year. 

Photo credit: Franckreporter/Getty Images; Aluxum/Getty Images.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments.

Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.