The Volatile Path Back to “Old Normal”
After 2 weeks of absorbing the U.S. election results, watching the financial markets and reading countless market and economic commentaries, we offer the following condensed thoughts.
What was Expected?
While the election was thought to be close, the odds makers and thus the financial markets were clearly expecting a Clinton victory. That meant continued heavy entitlements, higher taxes, very low GDP growth, low inflation and a decent chance of a recession in 2017. All of this led to ultra-low interest rates and a relatively high stock market based on no real alternatives for positive risk based returns.
But Trump won. Now if, and a big if, Trump’s Republican-led houses get their way, we will see lower taxes (lower personal and corporate taxes and no 3.8% Obamacare tax), less regulation and all manner of fiscal stimulus that has so far been absent in our weak recovery over the last eight years. This would lead to higher GDP, higher wages, no recession and eventually higher inflation. The new premise is that we are headed back to the “old normal” of 3-4% GDP, 3%+ 10 year government bonds and higher corporate growth rates. Therefore, valuations multiples would also “normalize” with lower P/E ratios and higher cap rates for real estate.
Initial Market Reactions
Based on the above, money quickly moved out of medium to long-term bonds and fixed yield investments (utilities, REITs, preferreds) and into growth vehicles, mainly US stocks. Small caps, banks and energy are seen as having the most near-term potential benefit. The move out of bonds was particularly large. In about 2 weeks, we saw a three-fourths of one percent rise on 10-year bonds which equates to an increase of about 25% in the cost of borrowing. The consequence for this has raised havoc in the commercial real estate pending sales. Lenders backed out of loans and properties are falling out of escrow or re-traded at lower prices to reflect the higher cost of borrowing.
What is Likely to Happen Next?
Valuations, based on a multiple of earnings (P/E ratios and cap rates,) are affected by two big factors: 1) interest rates, as they represent known returns, and 2) expected growth in earnings (corporate profits or real estate rents). In a reversion to the mean “old normal”, these two factors will work against each other in determining valuations. In the decade of the 1970s, earnings grew at an average of 7%, doubling over 10 years, but the P/E ratios halved from 15 to 7. Double the earnings and half the multiple meant the Dow Jones started and ended the decade at about 1,000 with an inconvenient 50% drop in the middle.
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