After 34 years, could the secular bull market in bonds finally be ending? Interest rates spiked—meaning bond prices fell—in the wake of the Republican Party’s shocking electoral sweep. The move ran counter to conventional wisdom, which says that investors flee to the safety of sovereign debt in times of uncertainty.
The sudden leap in sovereign yields could be interpreted simply as an acceleration of a trend that began in the middle of the year. This view understates the obvious impact of the election, however. About half of yields’ total move from July’s lows occurred within the three days following the election results, with the other approximately one hundred trading days since early July sharing credit for the other half of the move. So why did yields go up on Donald Trump’s election, and why so dramatically?
One possibility is that a new, pro-business political administration suddenly has investors’ animal spirits rearing again after a long hibernation. One way economic optimism manifests itself is in capital investments. Interest rates reflect the market price for investment capital, and a surge in demand for capital would naturally cause interest rates to rise. If the new regime can goose the economy with a meaningful stimulus package and take advantage of some of the low-hanging fruit on the supply side—rolling back onerous regulations and reforming the corporate tax code to name two examples—then investor optimism could well be rewarded. Optimism can also be a self-fulfilling prophecy as investment activity helps generate the very same growth that investors are anticipating.
A pessimist might argue that higher interest rates are actually a warning of higher inflation stemming from the feckless fiscal policies that might emanate from a naïve, new government. Happily, no other economic signal would seem to confirm this interpretation. Gold prices fell 6% in the week following the election. The U.S. dollar rose 2% against a basket of foreign currencies.
We should pause for a minute to remember just how low interest rates remain, even after their recent surge. The 10-year Treasury note currently yields just 2.2%. German 10-year debt yields 0.3%. Japanese 10-year bonds still pay 0.0%, give or take a few basis points. It’s possible that interest rates have reached a depth where investors have finally become dubious of their traditional safe haven status. At these low levels, it does seem possible that the relationship between uncertainty and bond prices could be inverted. Once again, however, we have a plausible-sounding theory with no corroborating data. What evidence exists all points to investors shifting into an optimistic, pro-growth mindset.
For evidence, look at the stock market. The S&P 500 has not reacted as dramatically as the bond market, but it has scored meaningful gains since the election. This strength is remarkable considering that stock valuations typically contract when interest rates rise. Beneath this modestly positive composite average lies a tremendous amount of volatility. Cyclical industrials have increased almost 6% on average, while safe, dividend-paying consumer and utilities stocks have declined 3.5% and 5% respectively. Dividends aren’t cool anymore, while growth is back in style.
Business fundamentals do seem to support this view. As of November 11th, FactSet’s Earnings Insight measures the S&P 500’s blended earnings growth rate at 2.9%. Once the entire index has officially reported, Q3 2016 will mark the first positive showing for composite corporate earnings growth since Q1 2015.
Political uncertainty could jeopardize the continuing economic recovery. According to data compiled by FactSet, the companies comprising the S&P 500 derive 31% of their composite revenue overseas. That statistic probably understates the importance of trade in an age of global supply chains. Yet the U.S. has just elected a candidate who campaigned against free trade. How sanguine can investors really feel about a man who threatens to start trade wars? That’s for investors to decide. They are voting with their dollars, and so far the answer is, perhaps surprisingly, “pretty darn sanguine.”
This recent market rally has notably left behind large cap technology names such as Facebook, Amazon, Netflix, and Google—the so called FANG stocks—which have been tossed out along with the widow-and-orphan dividend payers. All of the FANG stocks are down 5% or more since the election. What gives?
These companies have been strong performers for years (that’s how you win yourself a special acronym, after all). Their weakness may be a simple story of rotation, whereby investors monetize their winners to reinvest where they see better value. There is a directly political angle as well. Big technology companies habitually rely on importing a lot of skilled foreign workers, and Donald Trump has threatened to end the popular H1B guest worker program while also making it harder to get permanent resident status vis-à-vis a green card. It is certainly understandable why the animal spirits that appear to be lifting industrial stocks don’t extend to Silicon Valley.
The point of our style of growth investing is to tilt the tables in your favor by owning good companies trading at reasonable valuations. Not every market is equally rewarding to our style. After a period of underperformance, our favored small- and mid-cap growth stocks have generally fared better than the overall market since the election. This feels a bit lucky. We would normally expect our stocks to lag the market a little during times of uncertainty. Instead, we seem to be benefiting from the return of investors’ animal spirits. May this newfound optimism be richly rewarded.