The holidays have passed and that one gift you couldn’t wait to open has lost a little bit of its luster. Sure, you are still excited about the prospect of using it over and over again, but the thrill that came from anticipation has waned.
Stock investors produced a significant rally during the fourth quarter, largely as a result of the U.S. election’s outcome. With a Clinton victory, investors perceived that future policies affecting businesses would look much like those of the last 8 years. Of course, we won’t know now. President-elect Trump’s victory has boosted stock investors’ perceptions of fiscal policies that are more business friendly, including lower corporate tax rates, better tax treatment for capital expenses and less regulation. As a result, stock prices have been bid up in anticipation of these changes providing greater profitability.
As we approach the inauguration and appointment confirmations, the policy picture will become clearer and more importantly, the timing of policy change implementation will also be easier to discern.
Fourth Quarter Stock Rally
The total stock market Russell 3000 index was up over 4% during the fourth quarter and finished the year up almost 13%. The small cap focused Russell 2000 was also up almost 9% during the fourth quarter and more than 21% for 2016. So, while the election had a positive influence on markets, improving economic data had already been a catalyst for higher prices. There were certain sectors of the market that did especially well due to the election. Energy sector stocks were up 7% during the fourth quarter and finished the year up over 25% both because oil prices more than doubled and because the Administration-elect looks to be very friendly to U.S. based exploration and production of energy commodities. It is also likely to reduce regulation.
The financial services sector was up over 21% just in the fourth quarter! There are two reasons for this. First, the potential reduction in the regulatory burden from Dodd Frank and the Consumer Financial Protection Bureau has investors thinking that the return on capital for financial service companies may improve. In addition, because investors expect a lot of fiscal stimulus from the new Administration and Congress, it is perceived that economic growth and inflation will increase. As a result, bond yields have risen almost 1% from their 2016 summer lows. Higher interest rates mean better earnings for savers and financial service companies.
Health care stocks didn’t fare so well during the fourth quarter, declining by almost 4% and finishing the year down almost 3%. The Republican proclamation that the Affordable Care Act will be repealed has created a tremendous amount of uncertainty in the sector. Still long-term demographics suggest that revenues will continue to climb for some segments of this sector.
Where are Those Batteries?
As we begin 2017, investors will attempt to determine the timing of policy changes in order to quantify their economic benefit. In the past, when new administrations announced new plans, it took 6 to 8 months for them to be implemented. Tax policy takes time to legislate so we would expect a bigger impact in 2018. Still, businesses and consumers may continue to see a lift in sentiment which could cause an increase in capital investment and consumer spending ahead of the actual implementation of policy, and benefit 2017 as well.
The increase in infrastructure spending will also take at least three months to agree upon and perhaps another three months to implement. This could mean that we are only several months from the end of the government’s fiscal year (September 30th) by the time spending is agreed upon, and making its way through bureaucratic channels. However, the knowledge that changes are being implemented could create a positive environment for investors.
With markets already counting on much more favorable fiscal policy and reflecting them in asset prices, there are two things to consider and watch for. First, will policies be implemented with the magnitude implied by the current rally? Secondly, will the underlying economic performance continue improving or begin to decline? In other words, will the benefit of new policies add growth to an economy growing at 2% or more, or will it be something less?
While we are optimistic about the improvements offered by new policies, it is possible that the size and timing are such that the change in fiscal policy is a little like getting a great gift and not having the right size batteries to make it work. You can go out and find them but the delay can be frustrating.