In Leiu of Yield, Risk.
By Dimitri Triantafyllides
January 6, 2017
Our base case outlook for 2017 is for the equity market to post a mid- to high-single digits total return driven by low double digit increase in earnings (of around 11% for the S&P 500), offset by a modest multiple contraction (trailing P/E dropping from 26x to 22x), and a 2% dividend yield. We believe the US economy may surprise a bit to the upside, fueled by hope for fiscal stimulus and tax reform, and inflation stabilizing around the Federal Reserve target of 2%. With resulting nominal GDP growth of 4.5% or better, we expect long term rates to continue to climb as investors seek higher risk assets. Offsetting these positives, pugnacious trade policy from the incoming administration, a pugilistic congressional minority, and protracted Brexit negotiations in Europe could put pressure on this somewhat rosy outlook.
Review & Outlook
What a difference a day makes. As 2016 was strolling through its final stretch, the equity market was on pace for a midsingle digit return, much better than 2015’s less than 1.5% return, but not anywhere close to the double digit returns of most of the post-2008 financial crisis years. But then Tuesday November 8th, 2016 came along, and the market’s playbook was thrown out the window. What was expected to be a Hillary Clinton win that would maintain the status quo of monetary accommodating policy offsetting continued fiscal gridlock with a Republican controlled Congress, was instead replaced with a Donald Trump presidential win and continued Republican majority in Congress which could now unleash fiscal accommodation on an economy which, although growing, had been stuck in the “new normal” of low growth for too long. In the less than two months left in the year, the S&P 500 added 5% to its performance, putting its total return at just under 10% (9.8%) for the year, doubling its performance of the first 10 plus months.
We had expected 2016 to be a mid-single digits return year for equities and although that proved right for most of the year, the November-December rally proved us wrong. The post-election rally in equities was matched by an equally impressive selloff in Treasury bonds, with the 10 year note yield increasing from 1.88% on Election day to 2.45% at year-end. With the Federal Reserved unchanged in its modest rate increase forecast expectations, the yield curve experienced a rapid steepening with the spread difference between 10 year Treasury notes and 2 year Treasury notes increasing 25% from about 100 bps to 125 bps at year-end.
The credit markets started the year bearing the weight of the shakeout in the energy space, as the depressed price of oil proved many balance sheets were unsustainable, particularly in the oil and gas exploration and production space. It is estimated that more than $70 billion of energy debt has defaulted since the peak of oil in 2015. In last year’s outlook report, we highlighted a list of energy companies which we believe had such large amounts of secured and total debt to make their viability extremely perilous in a world of $50/barrel or lower oil price. Of these 17 companies, 6 have been able to weather the downturn and have seen their equity values increase materially. Of the remaining 11 that have witnessed a deteriorating equity value, 7 have declared bankruptcy, wiping out equity holders.
As can be seen by the following chart, the high yield market was able shake off the deluge in the energy space relatively early in the year, and with the lack of contagion to the remaining sectors of the economy, risk appetite started to return to the market. With Moody’s expected speculative grade default rate of 4.5% for this year, we believe risk appetite will continue to drive spreads lower, particularly if fiscal accommodation under the incoming administration materializes. For the full year, we believe the high yield market could post a 10% total return, driven by a current yield of around 6%, and spread tightening of as much as 100 bps. Such an outlook, as compared to our equity market expectations, could make credit risk the most attractive risk adjusted reward for the year.
Although we generally look for individual securities in the debt and equity markets, for those that take more of a sector approach to investing, we believe the following sectors should outperform if our macro-projections prove correct: financials, energy, industrials, materials, and consumer discretionary, while those that may underperform include telecom, utilities, healthcare, and consumer staples.
As always, we thank you for your interest and support, and welcome all questions and suggestions.
About the Author
Dimitri Triantafyllides, CFA
Sixty Guilders Research, LLC
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