Political risks are once again front-and-center as we analyze the major factors that will impact markets in 2017. In the US, President-elect Trump and the Republican Party have laid out an enormously ambitious plan of legislative action that will be difficult to enact without a few speedbumps along the way. In Europe, a long slate of important elections and other political events is set to elevate volatility throughout the year. As a global tactical asset allocator, we see opportunities in the disconnect between perceptions of political risk and actual market outcomes.
The political agenda that President-elect Trump and the Republican Party have laid out to pursue immediately is extraordinarily ambitious. Tax reform, healthcare reform, immigration reform, major infrastructure investment, renegotiation of trade deals, a Supreme Court appointment—half as much could be considered ambitious. Trump’s picks for many leadership positions are talented business people who understand that comprehensive reforms are necessary to stimulate American economic growth (shown in the table below). However, they have little experience navigating Washington’s bureaucracies and may find themselves strangers in a strange land in our nation’s capital, leaving markets vulnerable to disappointment.
Meanwhile, European investors will have to navigate an equally dizzying series of important political events. Elections in the Netherlands, France, and Germany will be held in March, April/May, and October, each with its own set of risks. Furthermore, ongoing negotiations surrounding Great Britain’s Brexit vote and the fallout from Matteo Renzi’s failed constitutional referendum in Italy will add to the ongoing uncertainty. Despite these risks, we are optimistic that the political situation will improve markedly this year. In particular, we expect Franҫois Fillon to win the French Presidency and partner with German Chancellor Angela Merkel to spearhead meaningful pro-business reforms which have been lacking on the European continent for quite some time.
Despite all of this policy uncertainty, equity market volatility has remained quite low (below, right). This is in part because central banks have adopted in recent years the responsibility for backstopping markets in the wake of other policymakers’ mistakes. As the importance of fiscal and regulatory policy return to the forefront and central banks take a back seat role, we may see the power of this “central bank put” diminish.
Our portfolios are positioned to benefit from the continued “Trump reflation rally.” This entails owning assets that will benefit from an environment with greater economic stimulus in the US and global capital flows which reflect that. Overall, our portfolios are allocated towards cyclical equities over defensive, and shorter-duration fixed income holdings focused on corporate credit spreads. However, as a result of the high expectations for successful and timely implementation of President-elect Trump’s platform, we have initiated positions which may benefit from disappointment in progress towards those goals.
In the wake of the US elections in November, interest rate differentials between US dollar bonds and other major currencies have widened to extreme levels. We therefore allocated away from foreign currency fixed income in order to capture higher yields available in US dollar bonds. We no longer own any foreign currency fixed income.
The bulk of our fixed income holdings are held in high yield bonds and preferred stock. This increases our portfolio’s yield while maintaining a relatively short duration. In addition, it gives us significant exposure to US corporate credit spreads, which should tighten as a result of stimulative economic policy. We also continue to hold a position in US dollar denominated emerging markets bonds. This helps diversify the portfolio while avoiding foreign currencies.
We have recently exchanged our position in US Treasury inflation-protected securities (TIPS) for long duration US Treasury bonds. While we continue to believe that interest rates, inflation, and inflation expectations are in a cyclical uptrend in the US, markets may have discounted too much too quickly. Investor positioning anticipating higher rates has become extreme, which makes markets vulnerable to disappointments in Trumps policy implementation. We have therefore sought to protect our portfolio, which is otherwise positioned to benefit from successful implementation of these policies, against possible hiccups along the way.
Our equity portfolio favors cyclical over defensive sectors in order to benefit from the acceleration in economic growth likely upon implementation of President-elect Trump’s economic policy platform.
In the US we favor financials, technology, biotech, and small cap. Financial stocks have been hurt by persistently low interest rates and a flattening yield curve, and a reversal of that process will support them. Additionally, we expect the regulatory environment to improve under a Trump presidency. US technology companies are the most innovative in the world and will continue to expand their scope into new industries, displacing many older companies and industries through the process of creative destruction. Small caps are more US-centric than the broader US equity market. They tend to have much less foreign exposure, both in terms of production and sales, and therefore will benefit from Trump’s “US first” policy philosophy. We have recently initiated a position in biotech equities. Biotech stocks have underperformed in expectation of healthcare reform. They therefore represent good relative value and also potentially serve to protect the portfolio against underwhelming progress made towards reform in Washington.
Internationally, we hold positions in European, Japanese, Australian, and Mexican equities. European equities, and particularly financials, offer strong relative value and should be supported as the political environment becomes clearer over the course of the year, especially if Franҫois Fillon wins the French Presidency. Fiscal and monetary stimulus in Japan will continue to put downward pressure on the Yen, which will support the Japanese equity market. We have maintained our position in Australian equities which are also supported by pro-growth fiscal policy and a recovering commodity market. Lastly, we have recently added a position in Mexican equities. Following a major selloff as a result of Trump’s victory, they offer deep value and a cheap way to protect the portfolio against disappointment in reform implementation.
We continue to hold a position in gold. Its status as an alternative currency should support it as global central banks continue to pursue extremely aggressive policies. Furthermore, as an asset with low correlations to most others, it helps lower overall portfolio volatility. However, we have recently exited our position in gold miners, which have been under pressure as a result of increasing real interest rates and a rising US dollar.
Our Global Tactical Income Portfolio uses the same global macro framework as our other three Global Tactical Portfolios, but due to its income and capital preservation investment goals, its holdings differ to some degree. It does not participate in some equity allocations, and owns some additional fixed income holdings.
Currently, GTI owns Treasury inflation-protected securities, Build America Bonds, and interest-rate-hedged high yield bonds, in addition to the fixed income holdings common across all four portfolios. These holdings help reduce volatility, while increasing diversification and limiting concentration. Its equity exposure avoids Australia and Mexico in order to reduce volatility.
**Individual account allocations may differ slightly from model allocations.
*Some Emerging Markets allocation overlaps with regional allocations.
^Excluding GTA’s 49% fixed income, alternative, and cash positions.
Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market. Some products/services may not be offered at certain broker/dealer firms.
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