2016 Q4 Economic Update from Transition Financial Advisors, Inc.
The U.S. stock market has been in a holding pattern for several months now, as uncertainty over the election and high equity valuations have kept the S&P 500 in a narrow trading range. Analysts expected the headwinds of falling oil prices and a stronger U.S. dollar to dissipate, leading to robust corporate earnings growth. Surging corporate profits could have moved the market higher despite 20+ P/E multiples, but so far, analyst’s have steadily lowered earnings expectations. The silver lining is that third-quarter earnings have mostly beaten these reduced expectations and overall earnings growth looks to be positive for the period, a most constructive development after four quarters of decline.
The 2016 U.S. Presidential campaign has been one of the most divisive we can remember. Driven by widening income inequality and a related perception that the benefits of global trade have only accrued to a few, a surge in populism has led to a backlash against free trade and immigration. The Republican nominee has threatened to pull the U.S. out of the World Trade Organization and slap tariffs on imported goods from various countries. This could raise the risk of retaliatory tariffs and trade wars with other nations. It is clear to us that the markets desire a Democratic victory for these very reasons. But it is important to remember that over the long run, the market has provided substantial returns regardless of who has controlled the executive branch.
No matter which candidate wins, the U.S. has an acute need for new spending on infrastructure. Every four years the American Society of Civil Engineers evaluates the condition and performance of America’s infrastructure, assigning letter grades based on the physical condition and the amount of investment needed for improvement. In 2013, the last assessment, the United States received a dismal score of D+, with the Society concluding that the U.S. needed to invest $3.6 trillion by 2020. Based on likely capital spending levels, the report warned of $1.6 trillion shortfall.
In their proposed fiscal policy initiatives, both candidates have pledged billions in public funding towards improving aging infrastructure, in particular, U.S. roads and bridges. Based on the current research, it is anticipated that the proposed infrastructure spending of either candidate will amount to an additional 0.5% boost to U.S. GDP.
U.S. Real Estate Investment Trusts (REIT’s) have recently taken a hit in the marketplace as investors anticipate a December increase in the Fed Funds Rate. All clients of Transition Financial have a healthy allocation to REIT’s as commercial real estate has historically outperformed both the broader equity market as well as the fixed income sector. We remain exceedingly optimistic about the sector over the long term, as real estate securities will continue to benefit from a business model focused on generating predictable, growing cash flows from rental income. In addition, real estate securities tend to offer above-average dividend yields and have a history of consistently raising payouts to investors. See the accompanying yield comparison by asset class below:
Equity Dividend Yields Fixed Income Yields
|U.S. REITs 4.16%||High Yield Bonds 6.89%|
|Global Real Estate Securities 3.55%||Global Bonds 2.52%|
|Global Stocks 2.69%||U.S. Bonds 2.91%|
|U.S. Stocks 2.18%||10-Year Treasury 1.49%|
As of June 30, 2016. Source: FTSE, Barclays, and Bloomberg.
Oil’s sharp price rebound off the February low of $28 per barrel along with sizable gains in MLP’s and midstream energy companies are welcome news following a two year bear market. While more volatility may lie ahead, we expect the global oil surplus to evaporate over the next year, followed by a widening supply gap in 2017 and beyond. In our view, this presents a compelling investment opportunity in the MLP and midstream energy space as North American shale oil is relatively cheap to produce and quick to market and therefore, should play a crucial role in meeting the market’s future needs.
Going forward, we see continued slow but steady growth in the global economy. We expect the U.S. Federal Reserve will press on with slow interest rate increases while other central banks start to approach limits on their easy money policies. U.S. wage growth is showing signs of accelerating, greasing the wheels for a pickup in household spending. This, of course, is a positive development for corporate earnings as increased consumption leads to higher sales and profits. We just had a very good report on U.S. GDP, which grew at a 2.9% annual rate compared with the same period a year ago – the fastest economic growth in two years.
As mentioned earlier, equity valuations have risen to their highest absolute levels since the financial crisis. This would normally be cause for great concern. Yet we believe elevated equity valuations may make sense in a low-return world where risk-free rates (cash, money markets, CD’s) are expected to stay low for quite a while. Corporate earnings growth has turned positive this quarter and if this trend continues, as we expect it will, valuations will contract and we will see P/E multiples in the teens once again, where we are more comfortable.
Transition Financial Advisors Group, Inc.
Mitch Marenus, Chief Investment Officer
MBA, CFP® (US), CFA®
Brian Wruk, President
MBA, CFP® (US), CFP® (Canada), CIM, TEP
Lucas Wennersten, Financial Advisor