How elections and interest rates could influence the US markets

It took the best part of 14 months but America’s S&P 500 benchmark equity index finally set a new all-time high this month while US government bonds, or Treasuries, also continue to perform strongly.

That both asset classes are doing so well at the same time may not sit easily with all investors, especially those who are used to seeing them do well (and badly) at differing times of the economic cycle.

Equities’ surge on the face of it speaks loudly in favour of the longed-for inflationary, economic recovery and a shift in sentiment to “risk on”.

The US stock market is setting fresh new all-time highs....

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

Bonds’ continued advance would usually point to the danger of recession and a flight to safety, even fears of deflation, such has been the power of the move.

....even as bond prices and bond yields respectively rise and fall sharply

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

A collapse in US five-year forward inflation expectations to just 1.57% would favour bonds, if history is any guide, as this suggests the prevailing concern is recession. 

Yet bonds may be benefitting from inflows of capital that are fleeing sterling (owing to Brexit), the euro (ditto) and the yen (owing to the Abe administration’s apparent determination to run its currency into the ground), and seeking a short-term haven in the form of the globe’s reserve currency, the dollar.

Equally, equities are in turn seemingly receiving support from those very low bond yields, as investors seek yield and shun Government paper as it offers ever more meagre coupons.

Yields continue to sink lower across the range of US Government debt

Source: Thomson Reuters Datastream

In the short term, investors who are tempted to go with the (capital) flow in the view that US dollar assets represent the best (or least bad) option available, still need to consider long-term issues such as valuation, which this column discussed in the context of US equities two weeks ago.

They also need to be aware of how the Presidential election slated for 8 November and the four remaining meetings of the Federal Reserve Open Market Committee (FOMC) could influence sentiment, at least if history is any guide. 

This column will now look at both, in the context of trends seen over the past few decades.

There is at least a good selection of active and passive funds from which to choose, open and closed-ended, should investors feel American assets fit with their overall investment strategy, target returns, time horizon and appetite for risk.

Best performing US Large-Cap Blend Equity OEICs over the past five years

OEIC	ISIN	Fund size £ million	Annualised five-year performance	Twelve-month Yield	Ongoing charge	Morningstar rating
Fidelity American Special Situations W (Acc)	GB00B89ST706	954.7	19.2%	0.8%	0.95%	****
Fidelity America Y (Acc) USD	LU0318939179	6,726.0	18.5%	n/a	1.13%	*****
HSBC American Index C (Inc)	GB00B80QG490	1,914.7	17.1%	1.5%	0.08%	****
JP Morgan US Select I (Acc)	GB0031835225	328.7	17.1%	0.9%	0.60%	****
Royal London US Tracker Z (Acc)	GB00B5172X16	3,260.6	16.9%	1.4%	0.23%	****

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

Best performing North American investment trusts over the past five years

Investment Trust	EPIC	Market cap £ million	Annualised five-year performance	Dividend yield	Gearing	Ongoing charge *	Discount to NAV	Morningstar rating
North Atlantic Smaller Companies	NAS	344.5	17.0%	n/a	0%	1.04%	-14.1%	****
JP Morgan US Smaller Companies	JUSC	110.8	16.3%	n/a	9%	1.69%	-11.1%	***
JP Morgan American	JAM	869.3	14.6%	1.2%	9%	0.69%	-3.6%	*****
North American Income	NAIT	300.2	13.4%	3.2%	10%	1.03%	-12.2%	****
Jupiter US Smaller Companies	JUS	171.6	10.5%	0.0%	0%	1.01%	-12.5%	***

Source: Morningstar and the AIC, for North America and North American Smaller Companies Categories. * Includes performance fee
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

Best performing US Large-Cap Blend Equity ETFs over the past five years

ETF	EPIC	Market cap £ million	Annualised five-year performance	Dividend yield	Total Expense Ratio	Morningstar rating	Replication method
iShares Core S&P 500 GBP	CSP1	11,973.7	17.2%	n/a	0.07%	*****	Physical
Lyxor S&P 500 D-USD	LSPU	1,667.4	17.2%	2.0%	0.15%	*****	Synthetic
HSBC S&P 500	HSPD	1,619.3	17.1%	1.7%	0.09%	*****	Physical
db x-trackers S&P 500 1C USD	XSPU	1,739.5	17.1%	n/a	0.20%	*****	Synthetic
Source S&P 500	SPXS	1,885.0	17.0%	n/a	0.05%	*****	Synthetic

Source: Morningstar, for US Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

Race to the White House

The Republican convention in Cleveland (18-21 July) and its Democrat equivalent in Philadelphia (25-28 July) fire the starting gun on the last leg of the race to the White House.

Despite attempts from within his (adopted) party to thwart him at the last Donald Trump will run for the Republicans, with Indiana state governor Mike Pence as his vice-presidential candidate.

Hillary Clinton has beaten off the determined challenge of Bernie Sanders and will select her running mate in the coming week. Second-guessing her choice is a mug’s game, but Senators Elizabeth Warren, Tim Kaine and Sherrod Brown, Colorado governor John Hickenlooper and Cabinet members Tim Vilsack and Julian Castro are all names being bandied around by the US media.

The final three months or so of the battle are likely to be gruelling but the fight may hinge on the four televised debates between the candidates, three for the would-be Presidents and one for the would-be vice-presidents:

The televised debates could be crucial in the race to the White House

Debate	Candidates	Where	When
1	Presidential	Wright State University, Dayton, Ohio	26-Sep
2	Vice-presidential	Longwood University, Farmville, Virginia	04-Oct
3	Presidential	Washington University, St. Louis, Missouri	09-Oct
4	Presidential	University of Nevada, Las Vegas, Nevada	19-Oct

Source: www.uspresidentialelectionnews.com

The key for investors is what policies the candidates will espouse now they have finished the job of beating their own party rivals and can start on setting out their own stall, while rubbishing that of their opponent.

Barring Hillary Clinton’s tweet that she would look to crack down on drug pricing, and Trump’s railing against the machinations of Wall Street,  neither candidate has as yet offered much that is likely to influence securities valuations – or at least short-term sentiment – though that could well change.

The US system of checks and balances, as established by the Legislative, Executive and Judicial branches of power, are in any case designed to stop a President from over-stepping the mark but there are three historic trends which are worth noting with 2017 in mind, the first year of the new President’s term – even if they are no guarantee for the future.

• First, the market tends to perform solidly enough in the first year of a Presidency, although on average the Down Jones Industrials has done better in the second and third years, perhaps as investors become more accustomed to the new leader’s policies.

The Dow Jones has, on average, risen during the first year of a Presidency

Source: Thomson Reuters Datastream. * Includes Barack Obama's second term up to 19 July 2016.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

• Second, the market has tended to do better under a newly-elected Democrat than a Republican. Perhaps this is because the Republicans are seen as more fiscally austere, the Democrats are more likely to tax and spend, to the potential benefit of short-term economic growth.

The Dow Jones has, on average, done better during the first year of a Democrat President than a Republican one

Election	President	Party	Year 1	HoR	Senate
1948	Harry S. Truman	Democrat	12.9%	Democrats	Democrats
1952	Dwight D. Eisenhower	Republican	-3.8%	Republicans	Republicans
1956	Dwight D. Eisenhower	Republican	-12.8%	Democrats	Democrats
1960	John F. Kennedy *	Democrat	18.7%	Democrats	Democrats
1964	Lyndon B. Johnson	Democrat	10.9%	Democrats	Democrats
1968	Richard M. Nixon	Republican	-15.2%	Democrats	Democrats
1972	Richard M. Nixon **	Republican	-16.6%	Democrats	Democrats
1976	Jimmy Carter	Democrat	-17.3%	Democrats	Democrats
1980	Ronald Reagan	Republican	-9.2%	Democrats	Republicans
1984	Ronald Reagan	Republican	27.7%	Democrats	Republicans
1988	George H. W. Bush	Republican	27.0%	Democrats	Democrats
1992	Bill Clinton	Democrat	13.7%	Democrats	Democrats
1996	Bill Clinton	Democrat	22.6%	Republicans	Republicans
2000	George W. Bush	Republican	-7.1%	Republicans	Democrats
2004	George W. Bush	Republican	-0.6%	Republicans	Republicans
2008	Barack Obama	Democrat	17.5%	Democrats	Democrats
2012	Barack Obama	Democrat	26.5%	Republicans	Democrats

Average		5.6%
Average - Democrat		13.2%
Average - Republican		-1.2%

Source: Thomson Reuters Datastream
* John F. Kennedy assassinated in November 1963 and replaced by Lyndon B. Johnson
** Richard M. Nixon resigned August 1974 and replaced by Gerald R. Ford
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

• Third, this trend becomes particularly noticeable when a Republican replaces a Democrat. The Dow Jones index has fallen on all four occasions this has happened since the Second World War, whereas it has fallen seven times in nine during the first year of all Republican Presidencies since 1948.

The Dow Jones has fallen all four times in the first year of a Republican President who has replaced a Democrat one

Election year	Republican winner	Dow Jones performance in first year of office after switch to Republicans
1952	Dwight D. Eisenhower	-3.8%
1968	Richard M. Nixon	-15.2%
1980	Ronald Reagan	-9.2%
2000	George W. Bush	-7.1%

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

Quite whether Trump’s economic policies will be classically Republican is unclear. Even if he has vigorously campaigned on a deficit reduction platform, he has given few clues as yet to how this might be achieved.

Thus far Hillary Clinton has espoused lower taxes for the squeezed middle class, higher minimum wages, hinted at higher taxes on the wealthy and championed infrastructure spending. This sounds like fairly standard Democrat fayre, at least from this side of the Pond, and does chime with the gathering global narrative that sub-standard economic growth requires fiscal stimulus to join monetary stimulus – Japan, Italy, Canada and possibly the UK are already leaning that way.

Federal authority

When it comes to monetary stimulus, attention switches from the White House to the Marriner S. Eccles building, home of the Board of Governors of the US Federal Reserve system.

Back in December the Federal Open Markets Committee sanctioned it's first interest rate rise in a decade, as chair Janet Yellen presided over a quarter-point hike, taking the Fed Funds target range from 0-0.25% to 0.25-0.50%.

However, the four additional 0.25% hikes planned then for 2016 have not happened. The Fed has not moved and there are just four meetings left this year:

• 26-27 July
• 20-21 September
• 1-2 November
• 13-14 December

In sum, the market is attributing a zero per cent chance of a rate rise in July, 18% in September, 19% in November and 39% in December (with a 6% chance of two hikes by the final meeting).

Fed Futures markets are pricing in one rate hike this year, with an outside chance of two

Source: Thomson Reuters Datastream

The Fed’s dithering has helped to stoke risk appetite, as higher interest rates have historically been bad for the US market – or at least less good than falling ones.

Note how a rate hike has historically slowed down the S&P’s momentum – although the index has slowly gathered steam after a rate hike, presumably on the basis that the underlying economy and therefore corporate earnings were strong, or else the Fed wouldn’t have needed to hike in the first place:

The S&P 500 has historically stalled (at least temporarily) after the Fed’s first rate hike of  a cycle

					Performance of S&P 500 index
Rate hike cycle				Before first rate hike			After first rate hike
From	To	From	To	1 year	6 months	3 months	3 months	6 Months	1 Year	2 years
15-Jul-71	25-Apr-74	3.50%	11.00%	32.0%	6.7%	-4.1%	-1.5%	4.1%	7.6%	4.8%
01-Aug-77	18-May-81	4.75%	19.00%	-4.2%	-3.2%	-1.0%	-7.8%	-9.3%	1.6%	5.1%
31-Mar-83	09-Aug-84	8.50%	11.56%	36.6%	27.0%	8.8%	9.9%	7.8%	4.3%	23.9%
04-Dec-86	04-May-89	5.88%	9.81%	23.9%	33.2%	-0.3%	14.1%	16.6%	-11.5%	7.4%
04-Feb-94	01-Feb-95	3.00%	6.00%	4.5%	4.7%	2.7%	-3.9%	-2.4%	1.9%	35.3%
30-Jun-99	16-May-00	4.75%	6.50%	21.1%	11.4%	5.5%	-6.6%	6.7%	6.0%	-10.8%
30-Jun-04	29-Jun-06	1.00%	5.25%	17.1%	2.8%	1.2%	-2.3%	6.4%	4.4%	11.3%
16-Dec-15		0.25%		5.1%	-1.1%	3.9%	-2.2%	0.2%
AVERAGE				17.0%	10.2%	2.1%	0.0%	3.8%	2.0%	11.0%

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.​

For the moment, the US stock market may therefore be having its cake and eating it – growth is not robust enough to force rate hikes and the prospect of Federal Reserve inactivity, plus possible fiscal stimulus, is enough to dangle the prospect of improved corporate profits while keeping bond yields low enough to tease investors to look elsewhere for yield.

That is the bull case, anyway and there are lots of bulls around – the S&P 500 would not be at its all-time high otherwise.

The latest Investors Intelligence survey saw the bulls score rise to 52.5, the highest since early May, while those expecting a correction fell to just 22.8, the lowest score since June 2014. Bears came in at 24.7 so the bull-bear spread rose to nearly 28, the highest in a year.

This is not to say the bulls are wrong and the stimulus story is gathering pace, as carefully outlined by Ben Hunt in his ever-informative Epsilon Theory blogs.

But perhaps all investors would do well to remember Mark Twain’s aphorism that “Whenever you find yourself on the side of the majority, it is time to pause and reflect” – especially when US equity valuations look lofty by historic standards.

Russ Mould
AJ Bell Investment Director