We have mentioned in numerous communiqués, including at our recent Investment Symposium, that the stock market’s performance since the election has been fueled by prospects for less regulation, tax reform, tax cuts, and a boost to infrastructure spending. We cautioned that the principal risk to the stock market would be the failure of the new Administration to deliver on its aggressive agenda. Therefore, the recent unsuccessful attempt to repeal and replace the Affordable Care Act (“ACA”) had the potential to curb the rally. The rally prevailed. In fact, political developments did not hinder at all the stock market from recording an exceptionally strong First Quarter.
One could argue that the market assigned a low probability to ACA repeal, and for that reason, concerns over a stock market pullback were misguided. One could also argue that the market is more interested in infrastructure spending, de-regulation, and tax cuts. Some commentators have suggested that the failed attempt to repeal ACA makes other aspects of the agenda more difficult to achieve. That may well prove to be the case. Our view, however, is that there is now pressure on the Republican Congress to put forth proposals that will garner broad-based support. This implies, for example, tax cuts or tax reform packages stripped of controversial features such as the border adjustment tax. It also suggests that Congress will be less inclined to pursue a “permanent” tax cut. Instead, they will likely utilize the reconciliation process to avoid filibuster and pass legislation with sunset provisions.
We anticipate the market will have its fair share of political news to digest over the next two quarters. Investors will have ringside seats as meat is put through the proverbial sausage grinder of the legislative process, both here and abroad. The UK Parliament invoked Article 50 of the EU Treaty in the last week of March, initiating the process of exiting the European Union. The Scottish referendum clouds the picture of how these negotiations will ultimately settle. Elections in France and other parts of Europe could indicate whether the populist wave crested last year or is gathering momentum. In the US, there could be a debt ceiling showdown in the Second Quarter. We also expect the new Administration will work with Congress to deliver a tax cut/reform package before the August recess. Finally, the market will soon turn its attention to leadership transitions at the Federal Reserve as several Governors face expiring terms.
Short term market gyrations are most often associated with traders and speculators who react immediately to political developments. If one is inclined to gauge the probability of stock market corrections, we believe heightened volatility associated with legislative negotiations is highly probable over the summer months. However, investors respond to policy, not politics, and as fundamental investors, our first inclination is to identify opportunities, provided fundamentals remain intact. Additionally, as we discussed at our Symposium, the narrative of a cause and effect relationship between stock market corrections and economic recessions is well established, but inaccurate. Economic fundamentals, particularly in the US, are strong and improving, and the rest of the world is finally beginning to make a contribution.
All that said, we acknowledge that the US is in the third longest economic expansion since the Civil War. We understand that the current expansion must end eventually, and every White House has had to contend with a recession at some point. The current Administration will not be spared that challenge. With respect to timing, that is anyone’s guess, but we are encouraged by growing corporate earnings. Those estimates, we would note, do not yet include the impact of any fiscal stimulus or tax cuts. Therefore, we do not believe an economic contraction is imminent, although market volatility during the summer months could suggest otherwise.