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Inside the Market

Trump's reign over the markets is well under way

Donald Trump speaks during a rally in New York, Nov. 9, 2016.

The inauguration is weeks away, but investors are already dazzled by the prospect of a gleaming age of growth and fiscal stimulus

It's official: Canada won 2016. Better luck next year, rest of the world.

Canadian stocks rode a confluence of positive forces over the past year as China stabilized, commodity prices rebounded and the Big Six banks delivered another solid year in profits.

The net result was a 22-per-cent total return in the S&P/TSX composite index, which amounts to the best performance among major indexes in the developed world by a healthy margin.

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It is a feat unlikely to be repeated in 2017.

2017 market preview

The annual year-end torrent of forecasts is distinctly positive for the U.S. stock market, both on an absolute basis and relative to Canada. And yet, there is very little to be said with confidence about the year to come. That's a permanent truth, of course, but 2017 is looking like a particularly fickle beast.

"We can't recall a time when a change in leadership in Washington had the potential for such large and diverging effects," Merrill Lynch analysts said in a recent note.

Right now, the market is very much dazzled by the prospect of a gleaming age of growth and fiscal stimulus promised by U.S. president-elect Donald Trump.

The President Trump era doesn't officially begin until his inauguration on Jan. 20, but in financial markets, his reign is well under way.

His shock election victory over the status quo has brought about a wholesale change in sentiment, as investors stampede into the segments of the market best suited to an improving economic environment, while dumping dividend-rich equities that often offer the more predictable and safer returns of fixed income.

The following morning after Donald Trump’s U.S. election victory, the TSX showed positive signs, as seen on a display outside Scotia Plaza.

There is little hint of skepticism in investor attitudes regarding the ability of president-elect Trump to deliver on his pro-growth agenda.

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But unlike his predecessor, Mr. Trump's presidency will begin while equity valuations are relatively high and interest rates still extraordinarily low. That makes for a thin margin of safety in equities, said David Sykes, head of TD Asset Management's fundamental equities team.

"We're not starting with high interest rates that can come down, and low valuations that can go up," he said. "I think there's a lot of potential instability with him as president."

The consensus base case, however, seems to have Canadian stocks again demoted to subordinate status, as the rejuvenation of U.S. equities is generally expected to continue into 2017.

Mr. Trump's victory in November triggered a $2-trillion (U.S.) rotation into equities, largely at the expense of bonds, according to Bloomberg.

Since early November, both the S&P 500 and S&P/TSX composite index have risen about 5 per cent. The Russell 2000 small-cap index rose 14 per cent, while and the Dow Jones industrial average gained about 8 per cent and has spent the past few weeks of December flirting with the 20,000 mark.

"The mania phase of this bull market may be under way," Ed Yardeni, president of Yardeni Research, said in a recent note.

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Yet, the kind of irrational exuberance that has doomed bull markets of the past, with investors abandoning all restraint in pursuit of runaway equity returns, has not emerged in the current bull run.

One of the legacies of the financial crisis has been a widespread skepticism of stocks as an investment class, as individual investors have remained heavily weighted in cash, while sentiment readings have been persistently bearish.

"Euphoria has been glaringly absent in this cycle," Savita Subramanian, Merrill Lynch's head of U.S. equity and quantitative strategy, recently wrote. "The case for a traditional euphoria-driven end-of-bull-market rally is easy to argue for, and 20-per-cent-plus annual returns are the historic norm, putting the S&P 500 index at 2,700 in our bull case."

Ms. Subramanian's bear case target, on the other hand, sits at 1,600, representing an almost 30-per-cent decline from the current value of the S&P 500. That huge spread between optimistic and pessimistic outcomes is typical of this season's batch of forecasts: generally positive on stocks, but with vast uncertainty tied to the tectonic shifts afoot in Washington.

She likened the coming year, the Chinese year of the rooster, to "an erratic bird with fat tails."

Buildings reflected in glass in Toronto’s Financial District, on Thursday January 22, 2015.

One of the bigger emerging risks is that the Trump administration cannot deliver on the growth and inflation the market has quickly come to expect. Even before the November election, U.S. economic fundamentals were improving, particularly on the employment front.

"Then you had the Trump victory. Combine those two things, and there's been a big shift in investor psychology," Mr. Sykes said.

Suddenly, the paradigm that has dominated markets for the past several years has shifted from one propped up by endless monetary accommodation to one fuelled by economic expansion, tax cuts and infrastructure spending.

Financial stocks in particular have screamed higher while stocks more sensitive to interest rates, such as utilities, have flipped from leaders to laggards.

Even more substantial than the moves seen in market indexes in both Canada and the United States over the past two months, the dramatic underlying sector rotation indicates investors are going into 2017 positioned for growth, inflation and rising rates.

Skeptics of the so-called Trump rally say this behaviour puts an extraordinary amount of faith in the incoming president and his ability to turn his economic platform into policy.

"I think it is very dangerous to be basing investment decisions on expectations of government policy. What is done and when it is done is far too uncertain," David Rosenberg, chief economist with Gluskin Sheff + Associates Inc., said in a note.

Merrill Lynch's December global fund manager survey found expectations for "above trend" growth and inflation at five-year highs. A majority felt the outperformance of cyclical and inflationary sectors would continue well into 2017.

And cash weightings among those surveyed dropped to 4.8 per cent, from 5.8 per cent in October. While a drop of that magnitude is rare, cash balances are still high relative to bonds and equities, Merrill Lynch's chief investment strategist Michael Hartnett wrote. He said he does not yet see signs of "peak greed."

But investor sentiment is unquestionably getting more optimistic.

Prior to the election, bullish sentiment among smaller investors had spent a record 54 weeks below 40 per cent, according to surveys conducted by the American Association of Individual Investors. That mark was exceeded for the seventh straight week as of Dec. 28, which has not happened in two years.

"The market seems to be treating it as a guarantee that we're going to see this all play out in fairly rapid fashion. But I don't think it's going to be an overnight phenomenon," said Craig Fehr, an investment strategist at Edward Jones.

People walk near Bay and King Streets in Toronto on Thursday, November 24, 2016.

Wall Street strategists have caught up to the market by raising targets for stock values over the next year. The portents of economic and financial doom that immediately followed Mr. Trump's upset victory have vanished. In their place is a consensus gravitation toward the reflation narrative.

"When inflation expectations and interest rates are low, equities respond positively to reflationary pressure – a sign of more robust conditions," Jonathan Golub, chief U.S. market strategist at Royal Bank of Canada's investment arm, said in a report.

Many forecasts see an extension of the market's recent pro-cyclical about-face continuing into next year, with financials and industrials ranking as favoured sectors in a number of reports, while utilities and telecoms are relegated to underweights.

A problem for many bullish forecasters is their forecasts no longer look so bullish. They've been rendered tepid by the market's relentless upward slope. The average Wall Street 2017 year-end target of 2,354 for the S&P 500 is barely higher than the index's current value.

That latest leg up in stocks has lifted valuations in the United States and Canada alike. The average S&P/TSX composite index stock now trades at trailing price-to-earnings ratio of about 20 times, which is the highest since 2011, according to a Russell Investments report. "Valuations are no longer compelling," the report said, predicting a flat year for Canadian equities with a year-end target of 15,300.

The comparable metric on the S&P 500, meanwhile, sits at about 17 times, compared with a long-term historical average of about 15, a Boston-based LPL Financial report said. "But it is nowhere near the euphoric levels of the late-1990s, when P/E multiples were consistently in the upper 20s."

Mr. Rosenberg argued that current trading multiples only make sense if earnings in the coming year grow by 30 per cent, which itself is plausible only if Mr. Trump's economic agenda unfolds flawlessly.

"If we get an earnings profile that is more befitting of a late-cycle backdrop, it is tough to get an estimate for the S&P 500 much above 1,950," he said.

With valuations relatively full, substantial equity gains are more likely going to have to come from earnings growth rather than multiple expansion – investors' willingness to pay more for existing corporate profits, Brian Belski, chief investment strategist at BMO Nesbitt Burns, said in his 2017 outlook.

FactSet reports that analysts are expecting earnings growth of about 11 per cent for S&P 500 companies next year over 2016. The market forecast for S&P/TSX composite index earnings growth is closer to 20 per cent, which is "ambitious," Russell Investments said in its global market outlook. "Negative revisions may be a headwind," the authors said.

Having correctly predicted last year that Canadian equities would end a five-year losing streak against the U.S. benchmark, Mr. Belski now expects a resumption of U.S. leadership.

An improving economic backdrop within Canada's largest trading partner should be of some consolation, however.

"In fact, Canadian stocks are becoming even more correlated with the U.S. and less so with emerging markets," Mr. Belski said. "Canadian investors should focus on the potential positives that the new regime in America will generate."

Heightened U.S. housing and infrastructure activity should be beneficial for Canadian materials and industrials sectors, he said. Among his underweighted sectors are rate sensitives such as utilities and real estate.

With the market's sector preferences shifting dramatically, Mr. Fehr has a radical suggestion for Canadian investors positioning for the coming year: diversification.

"I think diversification is going to show its mettle in 2017, as we continue to see this rotation between leaders and laggards."

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