Q&A: Market set to climb a 'Wall of Hope' this year and next


Taking advantage of late-2016’s slight pullback in stocks, Federated Investors recently shifted from neutral to a modest equity overweight in its PRISM stock-bond model on expectations the S&P 500 will drift higher this year and next, reaching if not exceeding a 2,500 target by year-end 2018. We asked Chief Investment Officer Steve Auth to elaborate on this bullish outlook.

Q: You’ve described the stock market as climbing a “Wall of Hope’’ vs. the “Wall of Worry’’ dynamic that prevailed for much of the past eight years. Beyond the symbolism of a Republican sweep led by Donald Trump, what’s really changed in the last two months? Quite simply, the radically altered policy and “tone at the top’’ conditions being ushered in by the Trump revolution. These are not at all small things. On all levels, Trump represents a 180-degree turn for the economy and market, including specific proposals we think have a good chance of being enacted that would take us from highest-in-the-world to globally competitive corporate taxes, and from economy-choking regulations to those balanced between costs and benefits.

As important, if not more so, is the fundamental sense of optimism in our country that comes from a “Make America great again’’ mindset. Call it sloganeering if you will, but it’s a sea change from the “You didn’t build it” high-mindedness that radiated from the outgoing administration and many of its supporters. It’s refreshing to see our political leaders actually embrace capitalism, entrepreneurism, the profit motive and risk-taking. The abandonment of an anti-business, low-growth-world-forever model for one that is pro-business, pro-growth and productivity-enhanced is both significant and meaningful.

Q: But didn’t the market get a little ahead of itself with one of the strongest post-election rallies in modern history for a new president who’ll take office with the lowest approval ratings in modern history? In the near term, we would expect the market to remain in pause mode while awaiting evidence on whether Trump can deliver. Most strategists and political analysts we are speaking with do believe his ability to execute his plan is limited. Then again, nearly all of them also thought Trump couldn’t win. We think they are again underestimating him and that he will be more effective than anticipated in pushing through key elements of his plan by mid-year. As people then factor this into forward earnings, the market should resume its rise.

One key element we feel the market is missing is Trump’s desire for real and lasting structural reforms. It’s too focused on near-term fiscal stimulus, which is traditionally the way Washington has supported the economy in the last 20 years but is missing from Trump’s actual plan. Structural reforms are much more powerful because they improve economic productivity and raise the long-term growth outlook. Deregulation, for instance, should eliminate wasteful, growth-choking regulations that have very little benefit to consumers or the economy. Tax reform should streamline the tax code and encourage investment, which improves productivity. Trump’s infrastructure plans, similarly, seem more targeted at breaking through economic bottlenecks, such as airport congestion and bridges, than creating New Deal-style make-work projects for unemployed workers.

Q: Against this new backdrop, what is Federated’s outlook for the S&P? We expect the economy to be growing by 3% in 2018 and inflation to perk up to 2.5%, causing nominal GDP to almost double to 5.5%. That’s important for stocks because they eat nominal GDP. As a result, we are projecting S&P earnings of $140 by 2018. As the markets begin to discount this number, we see the S&P riding up the “Wall of Hope” to 2,500 (using a reasonable 18 forward P/E multiple) and, eventually, beyond.

Nearer-term, we believe there are many sources of new cash to fuel stocks in the months ahead and we expect all of them to do so.  Most investors are underweight stocks given the previous low-growth outlook.  With confidence up, tax rates down, regulation more friendly and incentives high for U.S.-based production, mergers & acquisitions should experience a new boom. And with the dollar strengthening, we also expect foreign investment in the U.S. to pick up.

Q: What specific sectors does Federated believe are positioned favorably in the current environment? Nearly all, to be honest. We think Financials should resume their rise after their big post-election pop as they stand to benefit from nearly all improved elements in the outlook (rising interest rates, less regulation, improved nominal GDP, lower taxes). Stronger growth and lower taxes also are favorable for Cyclicals (industrials and materials). And Energy is a big beneficiary of both the OPEC agreement to cap production and a more carbon-energy supportive White House.

We think even the so-called defensive sectors are poised to do well. Telecoms, for example, currently pay some of the highest net corporate tax rates in the U.S. and thus should benefit from potentially low rates as well as from an improved regulatory outlook, with revenue streams linked to nominal GDP.

Thank you, Steve.