What investors need to know about demographics, divergence and disruption
Stocks turned in a strong performance in the front half of 2017 despite geopolitical and monetary policy risks. The question, of course, is whether this performance trend can continue in the second half. I believe these two risks will cast an even longer shadow over markets going forward — making concepts such as diversification and risk management even more important for investors’ portfolios.
The first half in review
International stocks bested US stocks in the first half, although US stocks also posted solid returns. Tech stocks in particular experienced impressive gains, with the NASDAQ Composite Index posting its highest return since 2009. The yield on the 10-year Treasury moved lower for most of the last six months, suggesting an undercurrent of fear in the market despite continued low volatility for the S&P 500 Index.
Perhaps the most interesting market trend thus far in 2017 has been the drop in correlations among stocks. There had been a significant increase in correlations in recent years, since the Federal Reserve (the Fed) and other central banks began their extraordinarily accommodative and experimental monetary policies. (In other words, stocks in different sectors and industries tended to move in the same direction at the same time.) However, correlations have finally begun to fall between sectors. The problem is that correlations are still high among stocks within the same sector — suggesting that the market is not yet focused on company fundamentals and is still being largely driven by macro forces.
Looking ahead: Seeing the world in 3D
As I look to the back half of the year, there are three themes that I believe remain critical for global markets:
- Demographics. Developed markets are aging and emerging markets have younger populations. This has important implications for economic growth as well as debt levels for governments and individuals.
- Divergence. We’re seeing a difference between optimistic business and consumer sentiment, and stagnant spending levels. I believe sentiment and spending will converge — the question is whether spending will rise, or sentiment will fall. In addition, expectations for US economic growth vary widely between the White House and other groups such as the International Monetary Fund. This represents another form of divergence that markets must digest.
- Disruption. I believe that there is growing potential of disruption impacting markets — specifically two key areas: geopolitical risk and monetary policy risk.
Geopolitical risk
There is certainly a risk of geopolitical disruption in the US. America woke on Nov. 9, 2016, to the surprising reality that, after years of government gridlock, the legislative and executive branches would be led by the same party — one with a very pro-growth agenda. The stock market rallied dramatically in the ensuing months, helped by an improvement in earnings but largely buoyed by optimism regarding the positive economic potential that President Donald Trump’s agenda could have, particularly from tax reform and infrastructure spending.
However, despite the fact that Republicans control the House, the Senate and the White House, this agenda has not yet come to fruition — and, in my estimation, it may not ever meet initial expectations. One problem is prioritization: Congress has become mired in the massive effort to repeal and replace the Affordable Care Act (ACA), which had been placed first on the agenda. Health care reform is a very complicated issue with no easy solution — and not surprisingly has helped to polarize the two major political parties rather than bring them together, which does not bode well for the success of the next items on the legislative agenda. And every day spent on health care legislation is a day that is not spent working on tax reform — which I believe is far more important for the US economy. Further, if the effort to repeal and replace the ACA succeeds in Congress, there could be a significant backlash in the 2018 midterm Congressional elections. What’s more, it’s not clear that, when Congress actually tackles tax reform, we will see the kind of sweeping legislation that originally had been contemplated.
To me, the ideal tax reform legislation — and what had been proposed during the election season — would have three parts: corporate tax reform, individual tax reform and a reduction in the repatriation tax. However, this is not what we may get based on the most recent information coming out of Washington, D.C. Recent intel suggests the House will require a revenue-neutral tax reform bill, which could dramatically limit its potential to stimulate the economy because it would require additional taxes or government spending cuts in order to pay for the tax cuts generated. This would likely result in no material cuts in income taxes — with whispers that some in the White House are actually proposing an increase on the highest income tax bracket. We also may not see the sweeping corporate tax reform that arguably is largely priced into the stock market already.
To me, the ideal tax reform legislation — and what had been proposed during the election season — would have three parts: corporate tax reform, individual tax reform and a reduction in the repatriation tax. However, this is not what we may get based on the most recent information coming out of Washington, D.C. Recent intel suggests the House will require a revenue-neutral tax reform bill, which could dramatically limit its potential to stimulate the economy because it would require additional taxes or government spending cuts in order to pay for the tax cuts generated. This would likely result in no material cuts in income taxes — with whispers that some in the White House are actually proposing an increase on the highest income tax bracket. We also may not see the sweeping corporate tax reform that arguably is largely priced into the stock market already.
It is worth noting that every day that we delay the passage of tax reform is a day that companies may forego significant spending decisions — such as capital expenditures (capex) and hiring — because they are waiting to see what is contained in the tax legislation. Inaction can be dangerous, given that there has historically been a close inverse relationship between economic policy uncertainty and business investment spending.
The other key agenda item that could have a significant positive impact on the US economy is infrastructure spending, which (like tax reform) would likely gain support from both political parties. Infrastructure is a particularly important focus because it not only provides shorter-term economic stimulus, but it also provides a return on investment for years afterward. Think of it as America’s capex; it is an important investment in the future of the country.
Because America’s capex spend has been relatively low for decades, infrastructure spending is not only about the future — it is necessary today to prevent potential problems, from replacing hundred-year-old water pipes in the Northeast to repaving crumbling highways in the West to rebuilding bridges and levees in the South to creating telecommunications networks in remote areas. Unfortunately, infrastructure had early on been labeled a “2018 event” — now it seems less likely to be passed in 2018 and may be pushed back further. And, quite frankly, whatever is not accomplished in the Trump legislative agenda by 2018 will be in jeopardy of ever coming to fruition depending on the outcome of the 2018 midterm elections for Congress.
Finally, we also have the potential for a debt ceiling crisis brewing. Treasury Secretary Steven Mnuchin has quietly been beseeching Congress to raise the debt ceiling before leaving for August recess, or else he fears the government could possibly run out of money in September. However, that might be difficult for legislators who are already working on health care legislation — particularly if the debt ceiling issue becomes politicized. If Congress does not raise the debt ceiling in time, the country would face another government shutdown, which could roil markets and significantly impact business and consumer confidence. (It would be the first time since the Carter administration that there would be a government shutdown with the same party in control of the executive and legislative branches.)
Of course, geopolitical risk extends far beyond the US:
- North Korea’s increasingly aggressive actions are a cause for grave concern, as the US, South Korea, Japan and other allies struggle with how to respond and contain this frightening threat.
- In the UK, Prime Minister Theresa May’s insistence on pursuing a “hard Brexit” despite her party failing to gain power in the recent parliamentary elections suggests the potential for some disruption as the UK manages a tight timeline and economic pressures.
- Russia’s maneuvers over the last several years — from the annexation of a part of the Ukraine, to questions about its involvement in US elections — are also a cause for concern.
- Continued Middle East instability also presents some geopolitical risks.
- Finally, there are the risks created by the recent move toward greater protectionism, which has been seen in the US and other countries. Some economists have argued that the global trend toward protectionism in the 1930s may have helped create — or at least exacerbate — the Great Depression. We will want to follow developments closely in this area.
Monetary policy risk
Some major central banks, most notably the European Central Bank (ECB), appear to have signaled a turning point, as indicated by yields moving back up recently. It seems central banks are peaking in terms of monetary policy accommodation and will soon begin to proceed with monetary policy normalization, as the US already has begun.
However, after such extreme policies as aggressive quantitative easing and negative interest rates, it will be difficult to normalize without potentially triggering some level of disruption. The Fed will soon begin the delicate task of balance sheet normalization while still in the throes of a rate hike cycle. While the Fed’s plans are measured and thoughtful — intended to create the least amount of disruption possible — there are always risks. The Fed therefore needs to be cognizant that its actions could have a serious dampening impact on credit growth. The Fed may find that normalization cannot simply happen “in the background” and may instead become “front and center.” Adding to the risk is that three open Federal Open Market Committee (FOMC) seats may soon be filled, and there may soon be a new FOMC chair. The new members could potentially hold more hawkish views and may try to move the FOMC to a more aggressive tightening stance.
Market outlook
Against this backdrop of potential risks, however, we have solid economic growth prospects. I concur with Invesco Fixed Income’s view that gross domestic product growth for the US in 2017 will likely be between 2.3% and 2.5%. I expect global economic growth to be stronger, driven by strength in many emerging markets countries and helped by improved economic growth in Europe.
In terms of earnings growth, it is solid and improving in the US and most other major markets. According to FactSet Research Systems, analysts are projecting earnings growth for US stocks of 7.4% and revenue growth of 5.1% in the third quarter, and earnings growth of 12.4% and revenue growth of 5.1% in the fourth quarter (as of June 30, 2017). This should help to provide some support for stocks as monetary policy accommodation is slowly taken away.
It is clear that valuations are stretched as US stocks in general are priced close to “legislative perfection,” which means they are vulnerable to disappointment if the Trump legislative agenda does not come to fruition in terms of timing or scale — or both. I would not be surprised to see a relatively modest stock market drop in the back half of this year if we see some kind of disruption. However, I also believe any kind of drop would likely be short-lived as fundamentals are clearly solid and improving for stocks.
Takeaways for investors
At Invesco, we believe the greatest opportunity for clients to achieve their investment objectives is by using a well-constructed portfolio combining a variety of strategies allocated to meet their unique needs. Given all of the above, I believe investors should focus their portfolio-construction efforts on seeking a balance between growth potential and downside protection. This means being sensitive to stock valuations, ensuring wide-ranging diversification and focusing on income.
In its broadest sense, diversification means exposure to a wide variety of asset classes that have historically had lower correlations to each other:
- For many investors, this could mean adding real estate, commodities and alternative strategies (such as long-short and market neutral strategies) to their portfolios.
- Investors should also talk to their advisors about their ideal allocation to international securities, including both developed and emerging market stocks, as many may be underexposed to securities outside the US.
- Diversification can also include an allocation to stocks with lower valuations. That can be achieved through an actively managed or factor-based value strategy — or both.
- And investors may also need to “think outside the box” to garner adequate income from their portfolio. That could mean the inclusion of dividend strategies, municipal bonds, convertible bonds, bank loans and “core plus” strategies that supplement investment grade bonds with other bond opportunities.
Given that macro forces are likely to continue to dominate markets in the back half of the year, we could continue to see lower correlations — and, therefore, rotations in leadership — among asset classes and factors and sectors. Investors who seek to take advantage of this type of environment might consider an actively managed tactical asset allocation or factor strategy that has the flexibility to search out the best opportunities across these areas.
For investors with a long-term time horizon, fundamentals will matter. As Benjamin Graham said, in the short run the stock market is a voting machine, but in the long run it is a weighing machine. In other words, short-term market movements can be based on popularity, but longer-term trends have more to do with the actual value of a company. I believe it is important for investors to maintain adequate exposure to assets with growth potential, but they should do so with prudence, emphasizing diversification and income.
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Kristina Hooper
Global Market Strategist
Kristina Hooper is the Global Market Strategist at Invesco. She has 21 years of investment industry experience.
Prior to joining Invesco, Ms. Hooper was the US investment strategist at Allianz Global Investors. Prior to Allianz, she held positions at PIMCO Funds, UBS (formerly PaineWebber) and MetLife. She has regularly been quoted in The Wall Street Journal, The New York Times, Reuters and other financial news publications. She was featured on the cover of the January 2015 issue of Kiplinger’s magazine, and has appeared regularly on CNBC and Reuters TV.
Ms. Hooper earned a BA degree, cum laude, from Wellesley College; a J.D. from Pace University School of Law, where she was a Trustees’ Merit Scholar; an MBA in finance from New York University, Leonard N. Stern School of Business, where she was a teaching fellow in macroeconomics and organizational behavior; and a master’s degree from the Cornell University School of Industrial and Labor Relations, where she focused on labor economics.
Ms. Hooper holds the Certified Financial Planner, Chartered Alternative Investment Analyst, Certified Investment Management Analyst and Chartered Financial Consultant designations. She serves on the board of trustees of the Foundation for Financial Planning, which is the pro bono arm of the financial planning industry, and Hour Children.
Important information
Blog header image: Denis Rozhnovsky/Shutterstock.com
Diversification does not guarantee a profit or eliminate the risk of loss.
All investing involves risk, including risk of loss.
Valuation is how the market measures the worth of a company or investment.
Factor-based strategies make use of rewarded risk factors in an attempt to outperform market-cap-weighted indexes, reduce portfolio risk, or both.
The opinions referenced above are those of Kristina Hooper as of July 7, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (PowerShares) and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.
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Second-half market outlook: Seeing global markets in 3D by Invesco
