As investors in US equities, it is natural at this moment in time to be asked for views on the current administration. However, irrespective of where you fall on the political divide, as well as your personal view on President Donald Trump and his tweeting, it is important to remain objective about the economic policies.
In this regard, the tax reform bill passed late last year has provided another round of fiscal stimulus to the economy, even though we are in the later stages of the business cycle. While the first order effect of mathematically increasing earnings has been priced in, we do not believe the second-order effects of tax cuts are fully appreciated yet. These effects are showing up in higher capital expenditures, accelerating GDP and rising consumer confidence.
In addition to this, federal-level deregulation is also helping to extend the business cycle, helping to lower costs and speed up implementation of new projects. It is for these reasons we have been, and continue to be, bullish on the US economy.
The results of the midterm elections will not have material changes to our economic outlook. Results were mixed, with Democrats retaking control of the House of Representatives, while Republicans won seats in the Senate. With divided government, further tax cuts or spending measures are likely to be restrained as political compromise will be needed to pass legislation. We think this could be beneficial for bonds, due to lower odds of more tax cutting, and bonds rallied the morning following the election. Our overweight position in utilities could benefit if this trend continues. Divided government scenarios can be bullish for stocks, as it decreases the risk of extreme or unexpected government actions hitting markets. With no tax cuts expiring in the next two years, and deregulation firmly in the hands of the executive branch, we think the most important drivers are safe. If Democrats and Republicans find areas to compromise on in the areas of infrastructure spending or drug price reforms, stocks exposed to those themes may be affected, but those potential themes are very light on details.
Aside from the administration, central bank policy is another hot topic of discussion, and in our view monetary policy is more important today than fiscal policy. In response to strong growth and low unemployment, the Federal Reserve has been raising interest rates and, in our view, will likely overtighten at some point. Based on hawkish communications early in October, the market is pricing in this overtightening now, even though the yield curve typically does not invert until 18 months prior to a recession. Debt levels around the world remain high, so higher interest rates will be felt eventually.
Markets generally follow the direction of earnings, so as long as we have growing GDP and a positively sloped yield curve, we believe the outlook for both earnings and positive stock returns is encouraging. However, a softening of the hawkish tone from central bankers is required to change the current negative market sentiment.
At SYZ Asset Management, our US Equity Strategy has a bias towards mid caps, an often-overlooked area of the equity market. Despite investor affinity for high-flying small-cap stocks and blue-chip large caps, mid-cap stocks have provided more favourable risk/return characteristics than the larger and smaller segments of the market over the long-term.
