I recently caught up with James McGrath who serves as Co-Chairman of Forbes Family Trust investment committee. We discussed his assessment of market activity so far in 2017, challenges looming on the horizon, areas of potential opportunity, and how he is positioning portfolios in light of today’s opportunity set.

1.     Forbes: Many in the media are fixated on the first 100 days of the new administration. What is your take on what has transpired so far in 2017?

The pundits have been focused on the first 100 days of the administration, but we are keeping track a little differently. We’ve started our tally at the start of January. Over that time balanced portfolios have done well, fueled by equities, but a different sort of equities than what led the pack during the 4th quarter of 2016. After the election, US equities charged ahead, particularly smaller capitalization stocks. Small caps have stalled thus far in 2017, but international equities have showed renewed vigor.

The S&P 500 returned more than 6% on a total return basis over the 1st quarter, a good result by any measure, and extended a hot streak accelerated by the November election. However, sector leadership has been changing. We noted how small caps did well in 2016, but so did larger infrastructure companies and banks; this year, attention has shifted to growth names and technology plays, while banks fell -2.9% in March and industrials shed -0.8%. The Russell 1000 Growth index was up 8.5% for the quarter against only 2.6% for the Russell 1000 Value. Tech has been led by large moves from the largest names such as Apple, which climbed 24%. The biggest names did the best: mid-caps returned just under 4%, but small caps just over 1%, a 500 bps gap from the S&P 500.

International equities have done even better. The MSCI All Country World, ex-US Index returned a blistering 7.9%, and emerging markets (EM) equities, paced by Asia, did even better. Broad EM equities returned almost 11.5%, but EM Asian Equities returned nearly 13.5%. Remember, this is for a single quarter. We do note that the USD weakened somewhat in 2017: down -1.5% against the Euro, -4.5% against the Yen, and high single or low double digits against certain EM currencies. For instance, the Russian and Mexican currencies were both up about 10% against the USD. Mexican equities, in USD terms, are one of the top performers year to date, up over 16% in the quarter, while Russian equities, even with the boost from a strengthening Ruble, are in the red for the year in USD terms.

All that said, to put these moves in perspective, while small cap US equities are up 24.6% over the past year (with a tepid 1% 1st quarter), EM Asian equities are up 18% over the same one-year period. Again, this highlights the sharp acceleration of US small caps last year, and the pop in EM equites this year.

2.     Forbes: What is your view on the broader economy? On markets? What metrics are you watching?

The US economy has continued to show signs of strength this year. We’ve been seeing the momentum building for some quarters in employment; while jobless claims are a more volatile measure, with blips up and down, the unemployment rate tends to be a smoother series and more slow-moving. In many economies, as unemployment goes low, inflation tends to follow (of course, that tends to happen when interest rates are really low, too, but we’ve avoided that sequence of events. Until now.) The PCE (personal-consumption expenditures) price index, has finally broken above 2%, the Federal Reserve’s target, for the first time in nearly five years, settling in at 2.1%.

Those are decent metrics, but sentiment measures are also bright. The National Federation of Independent Business reports its index of small-business optimism attained its highest level in 12 years. At the same time, the widely-followed University of Michigan consumer confidence figures released in March were the highest in the past 17 years. Home builder confidence is also at a 10-year high, and recent reports indicate that manufacturing in New York is at both a multi-year high in orders and a decade-high in unfilled orders.

However, while growing confidence is good, the next step is to generate real growth besides just appreciation in asset prices. We are starting to see that. 

3.     Forbes: How does that translate into expected market performance? What are some of the drivers of growth for equities?

We have been emphasizing that equity performance in 2017 should be driven by fundamentals, particularly earnings growth. S&P 500 earnings for the 4th quarter of 2016 were up 8% over the previous year. After-tax corporate profitability increased by 22.3% in the 4th quarter over the year before, which was the largest move up in five years. Revenues are a key part of this equation. While companies had engaged in a lot of cost cutting and retrenching after the 2008 global financial crisis, the S&P 500 is projected to record 7.1% growth in revenues for the 1st quarter, which is also the largest move in five years. Sustained revenue growth will be key to meaningful equity appreciation from current levels. This is a good early indication.  

In the 8th year of the current cycle, GDP is still expanding. Bloomberg’s survey consensus for US GDP growth going forward in 2017 is 2.2%—moderate, but likely with potential room for upside surprises. Those gains could arise from improving business investment, steady consumer spending gains fueled by blooming consumer sentiment, and, just maybe, pro-growth fiscal policy results from Washington.

Other recently released metrics are positive, too, with the Conference Board’s Leading Economic Index (LEI), the Institute for Supply Management’s (ISM) Manufacturing Index, and the shape of the yield curve, suggest a low probability of recession over the next 12–18 months. In general, US economic data have broadly surprised to the upside in recent months, while overseas data are improving as well.  

4.     Forbes: Coming back to goings-on in Washington—what are some other issues on the horizon? What else are you monitoring?

The Obamacare repeal debacle surprised many folks. What surprised us more was how quickly, and perhaps unadvisedly, the White House and Paul Ryan put forward legislation, without lining up the necessary support to get it past the post. Ryan and Trump aren’t channeling Sun Tzu, who admonished something to the effect of “in war the victorious strategist only seeks battle after the victory has been won.” We’d like to see some more of Sun Tzu or Clausewitz from today’s leadership, particularly if they are serious about tax reform—something the markets have been counting on ever since they digested the unlooked-for Trump victory last year.

Why is that so important? It would be very positive for markets: it should help boost economic growth, stimulate corporate investment, reduce incentives for U.S. companies to move offshore, and perhaps most importantly for stock market investors, lift corporate profits—some estimate by 10% or more.

We expect a modulated approach to the legislative landscape from Trump and Ryan, who will have to adapt their approach to the legislative realities and fault lines revealed during the healthcare fight. We’ll see where that leads.

We are also carefully monitoring Europe. Brexit negotiations with the EU will continue and the French presidential election is looming. While some polls give an edge to independent centrist and EU-favoring Emmauel Macron over Marine Le Pen, the rightwing populist National Front candidate who is no friend of the EU, we remain circumspect of polls. At the very least, the contest will be close, with third candidate Francois Fillon, sullied by scandal, but still standing and far-left candidate Jean-Luc Mélenchon now making waves. The race will not be decided until the second round of voting on May 7th. An unexpected outcome could roil the markets more than Brexit, for the UK always had one foot in and one foot out of the EU. France and Germany are the EU, for all practical purposes.

Finally, a more immediate concern closer to home is the extension of the US Government’s borrowing limits. It is sobering that they can change the cast in Washington, but they’ve kept the same script; this debate promises to continue to feature more grandstanding, if not outright fractiousness. Fortunately, the debt ceiling deadline that occurred in late March was not a significant disruption this time, because, as they have in the past, the government employed “extraordinary measures” to kick the can a bit further down the road. Needless to say, it will come up again. 

5.     Forbes: Something else which comes up repeatedly is the Federal Reserve. What are your expectations from the Fed over the coming months?

Fixed income and the impact of Federal Reserve policy decisions loom large. Where do we go from here? At least over the near term, the Fed and futures markets gives us plenty of clues. At the moment, futures are pricing in two additional Fed Funds target rate increases this year, taking that to 1.5%. Meanwhile, the Federal Reserve so-called “dot plot”, which depicts each FOMC member expectations, is not signaling much change from what shown in the last minutes, and is congruent with the two rate hike expectation. We will note that the agreement this time around is different from the divergence this time last year—with the Fed forecasting four hikes as 2016 began while markets were skeptical of more than one (based on fed fund futures)—contributed to a bout of unsettling volatility across global markets in January and February of 2016.

Rate hikes (or decreases, for that matter) are old hat, so to speak—that has been a very conventional lever of Federal Reserve policy-making for a long time. What’s different today is the byproduct of the Fed’s extreme measures—the so-called quantitative easing—undertaken in response to the 2008 upheaval. The Federal Reserve has accumulated an unprecedented portfolio of $4.5TT of mortgage and Treasury securities, purchased in an effort to slush liquidity into the global financial system. The Fed’s balance sheet grew from under 6% of US GDP before the financial crisis to nearly 25% today.

To start to slim this ponderous balance sheet, the Fed has suggested they would look to effect the two telegraphed rate hikes, and then pause for a while, concentrating on unwinding some of these positions. Many details need to be worked out: for instance, will Treasurys or munis be prioritized and will the “roll” (using proceeds from maturities to buy new securities) be ended or just slowed? Over what period of time? A consequence of this unwind would be upward pressure further out on the yield curve (the opposite of what the accumulation of these positions initially achieved.) Upward-sloped yield curves are generally a good thing, suggesting longer-run growth, perhaps some inflation, and allowing for more conventional behavior in the lending markets. Financials, whose bread and butter depends in no small part on the yield curve, may appreciate such a development. 

6.     Forbes: Are there things you are looking at outside of stocks and bonds?

At the end of 2015, we took a deep dive into oil prices, identifying numerous conditions which we thought argued for a rebound. That rebound happened through 2016, buttressing producers and others involved in energy exploration, production, and transportation, washing over into high yield debt and other areas. Now, with inflation creeping over 2%—which is hardly high by historical standards—we might say that those effects are starting to filter into the broader economy. However, as we noted, the Federal Reserve is shifting into gear with respect to various types of monetary tightening, which could start to pour cold water on further gains in energy. At the end of March, we saw a bit of a pullback in energy: the weekly petroleum status report from the US Energy Administration suggested oversupply, but, most industry analysts and regulatory bodies feel this may be a blip, with supply and demand to be more equilibrated in the latter part of the year.

Real estate is another area where the outlook is mixed, and where a differentiated, nimble approach could be essential. Broadly speaking, real estate hasn’t thrilled since the election, up only 3.3%, trailing almost everything else; fears of rate hikes haven’t helped. With low yields to investors, at around 3% on a blended basis, we don’t feel that REITs offer great value. Higher rates cut into project profitability, at the same time that operators are seeing lower rental yields. That said, some real estate sectors have performed better: hotel and resort REITS are up 15% and office REITs up 11%. A growing economy could boost the latter. On the other hand, CRE (commercial real estate) lease rates are already high, limiting the potential for further growth. The CRE price index is already 23% higher than its pre-crisis peak in 2006-2007.

There may be more room for growth in housing. Home prices, by some measures, are only up 0.5% during the same time, and supply is low. But, mortgage rates are now rising, while post-crisis strict underwriting rules mean getting any kind of mortgage is harder than it used to be. If there were policy developments with respect to mortgage provision while rates are still low, at least from a historical perspective, residential prices could climb. A lot of “ifs”.

7.     Forbes: Forbes Family Trust has always advocated a dynamic approach to long-term asset allocation. Is this suited to the current environment?

We think very much so.  The leadership rotation we’ve seen across markets, as well as the divergence across sectors, is a good thing. For so long, markets have been trading in lock-step. The past 12-15 months have marked a breakdown in correlations. For instance, average cross asset correlations among US equities, international developed equities, and EM equities are lower over the past one year than they have been over the past three and five year periods. Correlations between commodities and different classes of equities are also appreciably lower over the past year than they have been over various rolling periods over the past 10 years. Interest rates are moving again and we are seeing some more volatility in different asset classes. Valuation matters and a careful assessment of distinct opportunities in broader asset classes (such as in real estate, as we already discussed) will be critical.

This argues for benefits from careful asset allocation and a dynamic approach to portfolio management. Given our extremely rigorous data-driven approach and keen analytical capabilities, we expect to be quite busy adjusting positioning to effectively negotiate the investment landscape going forward.