How elections and interest rates could influence the US markets

It took the best part of 14 months but America’s S&P 500 benchmark equity index finally set a new all-time high this month while US government bonds, or Treasuries, also continue to perform strongly.

That both asset classes are doing so well at the same time may not sit easily with all advisers and clients, especially those who are used to seeing them do well (and badly) at differing times of the economic cycle.

Equities’ surge on the face of it speaks loudly in favour of the longed-for inflationary, economic recovery and a shift in sentiment to ‘risk on’.

The US stock market is setting fresh new all-time highs ...

Source: Thomson Reuters Datastream

Bonds’ continued advance would usually point to the danger of recession and a flight to safety, even fears of deflation, such has been the power of the move.

... even as bond prices and bond yields respectively rise and fall sharply

Source: Thomson Reuters Datastream

A collapse in US five-year, five-year forward inflation expectations to just 1.57% would favour bonds, if history is any guide, as this suggests the prevailing concern is recession.

Yet bonds may be benefitting from inflows of capital that are fleeing sterling (owing to Brexit), the euro (ditto) and the yen (owing to the Abe administration’s apparent determination to run its currency into the ground), and seeking a short-term haven in the form of the globe’s reserve currency, the dollar.

Equally, equities are in turn seemingly receiving support from those very low bond yields, as advisers and clients seek yield and shun Government paper as it offers ever more meagre coupons.

Yields continue to sink lower across the range of US Government debt

Source: Thomson Reuters Datastream

In the short term, advisers and clients who are tempted to go with the (capital) flow in the view that US dollar assets represent the best (or least bad) option available, still need to consider long-term issues such as valuation, which this column discussed in the context of US equities two weeks ago.

They also need to be aware of how the Presidential election slated for 8 November and the four remaining meetings of the Federal Reserve Open Market Committee (FOMC) could influence sentiment, at least if history is any guide.

This column will now look at both, in the context of trends seen over the past few decades.

There is at least a good selection of active and passive funds from which to choose, open and closed-ended, should advisers and clients feel American assets fit with their overall investment strategy, target returns, time horizon and appetite for risk.

Best-performing US Large-Cap Blend Equity OEICs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Best-performing North American investment trusts over the past five years

Source: Morningstar and the AIC, for North America and North American Smaller Companies Categories. * Includes performance fee

Best-performing US Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Race to the White House

The Republican convention in Cleveland (18-21 July) and its Democrat equivalent in Philadelphia (25-28 July) fire the starting gun on the last leg of the race to the White House.

Despite attempts from within his (adopted) party to thwart him at the last Donald Trump will run for the Republicans, with Indiana state governor Mike Pence as his vice-presidential candidate.

Hillary Clinton has beaten off the determined challenge of Bernie Sanders and will select her running mate in the coming week. Second-guessing her choice is a mug’s game, but Senators Elizabeth Warren, Tim Kaine and Sherrod Brown, Colorado governor John Hickenlooper and Cabinet members Tim Vilsack and Julian Castro are all names being bandied around by the US media.

The final three months or so of the battle are likely to be gruelling but the fight may hinge on the four televised debates between the candidates, three for the would-be Presidents and one for the would-be vice-presidents:

The televised debates could be crucial in the race to the White House

Source: www.uspresidentialelectionnews.com

The key for advisers and clients is what policies the candidates will espouse now they have finished the job of beating their own party rivals and can start on setting out their own stall, while rubbishing that of their opponent.

Barring Hillary Clinton’s tweet that she would look to crack down on drug pricing, and Trump’s railing against the machinations of Wall Street, neither candidate has as yet offered much that is likely to influence securities valuations – or at least short-term sentiment – though that could well change.

The US system of checks and balances, as established by the Legislative, Executive and Judicial branches of power, are in any case designed to stop a President from over-stepping the mark but there are three historic trends which are worth noting with 2017 in mind, the first year of the new President’s term – even if they are no guarantee for the future.

  • First, the market tends to perform solidly enough in the first year of a Presidency, although on average the Dow Jones Industrials has done better in the second and third years, perhaps as advisers and clients become more accustomed to the new leader’s policies.

The Dow Jones has, on average, risen during the first year of a Presidency

Source: Thomson Reuters Datastream. * Includes Barack Obama's second term up to 19 July 2016.

  • Second, the market has tended to do better under a newly-elected Democrat than a Republican. Perhaps this is because the Republicans are seen as more fiscally austere, the Democrats are more likely to tax and spend, to the potential benefit of short-term economic growth.

The Dow Jones has, on average, done better during the first year of a Democrat President than a Republican one

Source: Thomson Reuters Datastream
* John F. Kennedy assassinated in November 1963 and replaced by Lyndon B. Johnson
** Richard M. Nixon resigned August 1974 and replaced by Gerald R. Ford

  • Third, this trend becomes particularly noticeable when a Republican replaces a Democrat. The Dow Jones index has fallen on all four occasions this has happened since the Second World War, whereas it has fallen seven times in nine during the first year of all Republican Presidencies since 1948.

The Dow Jones has fallen all four times in the first year of a Republican President who has replaced a Democrat one

Source: Thomson Reuters Datastream

Quite whether Trump’s economic policies will be classically Republican is unclear. Even if he has vigorously campaigned on a deficit-reduction platform, he has given few clues as yet to how this might be achieved.

Thus far Hillary Clinton has espoused lower taxes for the squeezed middle class, higher minimum wages, hinted at higher taxes on the wealthy and championed infrastructure spending. This sounds like fairly standard Democrat fayre, at least from this side of the Pond, and does chime with the gathering global narrative that sub-standard economic growth requires fiscal stimulus to join monetary stimulus – Japan, Italy, Canada and possibly the UK are already leaning that way.

Federal authority

When it comes to monetary stimulus, attention switches from the White House to the Marriner S. Eccles building, home of the Board of Governors of the US Federal Reserve system.

Back in December the Federal Open Markets Committee sanctioned its first interest rate rise in a decade, as chair Janet Yellen presided over a quarter-point hike, taking the Fed Funds target range from 0-0.25% to 0.25-0.50%.

However, the four additional 0.25% hikes planned then for 2016 have not happened. The Fed has not moved and there are just four meetings left this year:

  • 26-27 July
  • 20-21 September
  • 1-2 November
  • 13-14 December

The chart below summarises how Fed futures are trading, with the help of the very useful CME FedWatch tool, which can be found at http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

In sum, the market is attributing a zero per cent chance of a rate rise in July, 18% in September, 19% in November and 39% in December (with a 6% chance of two hikes by the final meeting).

Fed Futures markets are pricing in one rate hike this year, with an outside chance of two

Source: Thomson Reuters Datastream

The Fed’s dithering has helped to stoke risk appetite, as higher interest rates have historically been bad for the US market – or at least less good than falling ones.

This next table shows how the S&P 500 has performed on average across interest rate cycle since 1971:

The Dow Jones has tended to do less well when interest rates have been rising

Source: Thomson Reuters Datastream
* Assumes easing cycle ran beyond last rate cut and lasted until Fed stopped adding to QE, 29 October 2014

Also note how a rate hike has historically slowed down the S&P’s momentum – although the index has slowly gathered steam after a rate hike, presumably on the basis that the underlying economy and therefore corporate earnings were strong, or else the Fed wouldn’t have needed to hike in the first place:

The S&P 500 has historically stalled (at least temporarily) after the Fed’s first rate hike of a cycle

Source: Thomson Reuters Datastream

For the moment, the US stock market may therefore be having its cake and eating it – growth is not robust enough to force rate hikes and the prospect of Federal Reserve inactivity, plus possible fiscal stimulus, is enough to dangle the prospect of improved corporate profits while keeping bond yields low enough to tease advisers and clients to look elsewhere for yield.

That is the bull case, anyway and there are lots of bulls around – the S&P 500 would not be at its all-time high otherwise.

The latest Investors Intelligence survey saw the bulls score rise to 52.5, the highest since early May, while those expecting a correction fell to just 22.8, the lowest score since June 2014. Bears came in at 24.7 so the bull-bear spread rose to nearly 28, the highest in a year.

This is not to say the bulls are wrong and the stimulus story is gathering pace, as carefully outlined by Ben Hunt in his ever-informative Epsilon Theory blogs.

But perhaps all advisers and clients would do well to remember Mark Twain’s aphorism that “Whenever you find yourself on the side of the majority, it is time to pause and reflect” – especially when US equity valuations look lofty by historic standards.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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