Total US retirement assets are valued somewhere around $25 trillion and have likely increased with the latest stock market rally since Election Day. Most of this money is managed by a third party and if you are the money manager, regardless of your preference between stocks, bonds, index funds or other, you must make a choice between what is cheap and what is rich. Yes rich assets can continue to go up and cheap assets can continue to go down. John Maynard Kaynes, known as the father of modern economics, famously coined the phrase “markets can remain irrational longer than you can remain solvent”. But as a money manager you are constantly looking for yield and not solely riding a wave of overvaluation. The incentive plans for money managers and the billions that can be earned by the top prognosticators has created a system whereby traders and managers are constantly looking for that cheaper asset and identifying and selling that expensive (rich) asset.
In looking at 2016, the stock market began with a thud and the DJIA dropped from 17,425 to 15,660 in less than 45 days. Since that time the index has rallied a little north of 27% through today. Yes the exuberance around the possibility of growth post-election has driven the market much higher than almost anyone had predicted. However do not forget that during the summer months the 10yr dropped to 1.36% during a time in which the Fed’s employment targets had been met and inflation was slowly beginning to pick up. For those that correctly predicted inflation would continue to rise slowly benefitted from a skyrocketing stock market while those still holding bonds certainly lost. The fact is that bonds had become so rich in the summer that stocks looked cheap and if you believed inflation was rising towards 2% then stocks looked very cheap.
Since July the yield on the 10yr has nearly doubled, short term bonds such as the 2yr have more than doubled. On a relative basis don’t bonds now look cheap and stocks look rich? Yes relative to July that is 100 percent true. In absolute terms that is a much more difficult question. The market has now priced in future inflation, likely beyond 2% at this point. I don’t expect a lot of changes between now and January of next year given that the new administration has floated the possibility of tax cuts. Why sell now and pay more taxes, and with the tax bill coming one year earlier?
The key for 2017 will be legislative changes with the new administration, inflation data and the FOMC. Tax cuts to corporations could be very expansionary but also likely to push inflation much higher and with it interest rates. I believe any expansionary legislative changes will likely force the Fed to combat future inflation expectations via interest rate increases. Any controversial legislation could bog down the economy and inflation along with it. The Republicans are certainly in a position to create legislation that could be very expansionary. The key question is whether or not they can execute it. The other key is whether or not future legislation will benefit the business, the employee or both. Tax cuts to businesses with little to no employees will create more debt for the US with little wage inflation. Long term growth depends on rising wages. The US can’t borrow its way into prosperity, it must be organic.
From an inflation data standpoint the real big question is whether or not interest rate policies from 2016 lead to higher inflation in 2017. Recall there is a lag effect between the Fed Funds rate and growth/inflation. Did the Fed keep rates too low during 2016 or are we in a period where rates need to remain at historic low levels in order to maintain near 2% inflation? We may not know the answer to that question ever or possibly not until 2018. Is 2017 a transitory period towards higher growth and interest rates or is there a cold shower of economic reality that globalization and a declining middle class push interest rates to new lows? The third option is that nothing really changes and there is a seesaw of higher and lower rates like we’ve seen in 2012, 2013, 2014, 2015 and 2016. I think the third option is most likely with funds moving back and forth between bonds and stocks. Second on my list of likelihood is that inflation gets close to or surpasses 2% and the Fed is forced to raise rates.