Navigating Policy Uncertainty

Markets finished slightly lower for the previous trading week shortened by the Martin Luther King holiday. Investors kept close watch on Washington, D.C. for potential changes from the new administration in advance of Donald Trump’s inauguration Friday. Political uncertainty most likely was the culprit as trading volumes were relatively light through most of the week, despite the arrival of many closely watched fourth-quarter earnings reports. Small-cap stocks, which are typically more volatile, ran behind larger cap benchmarks.
 
Trading began Tuesday after the holiday with a reversal of the so-called “Trump rally.” Many of the stocks that have appreciated the most since the presidential election underperformed, while sectors that have lagged ran ahead. In particular, the financial sector, which has benefited from hopes for deregulation and improved lending margins, pulled back sharply as investors appeared to doubt whether Trump’s plans would come to fruition. Even solid earnings from Morgan Stanley failed to improve sentiment in the sector. Conversely, defensive stocks reversed recent poor performance and fared better, with consumer staples and utilities stocks both recording good gains.
 
On Wednesday, a positive earnings surprise from Netflix was similarly unable to lift the Internet sector, or the overall market for that matter. Instead, politics again took center stage as Trump’s Commerce Secretary nominee Wilbur Ross, in his confirmation testimony, promised to address NAFTA soon after the inauguration. Ross also suggested that the administration might raise tariffs on Chinese steel and bring anti-dumping actions against the country. Domestic steel stocks rallied, even if the broader market did not.
 
While investors are prudent to pay close attention to paradigm shifts in the political world, it appears that markets have been a little too hasty to react to speculation about the new president’s policies and winner/loser guessing games. There are many policy unknowns from where we sit today, and predicting the near-term direction of the markets or individual sectors based on perceived insights into the mind of the administration may prove futile.
 
Across the pond, the European Central Bank (ECB) kept interest rates and monetary stimulus unchanged at its January monetary policy meeting during the week. At a press conference following the announcement, ECB President Mario Draghi downplayed Eurozone inflation risks.
 
We continue to monitor events in the UK, where Prime Minister Theresa May announced early in the week that she will put the final Brexit deal to a vote. Significantly, that means the British parliament could ultimately block the deal, although such an action would no doubt precipitate an enormous backlash from the popular majority who voted for Brexit in the first place. The Prime Minister made it clear that she wanted the UK to trade as a single market as part of the European Union, but maintain control over other issues such as migration and free movement of labor.
 
May’s speech clearly exacerbated an already tense situation and further heightened uncertainty in global markets. Business decisions are likely to be constrained or put on hold both in the UK and around the world, especially for international companies looking for opportunities within the UK. While the negotiations surrounding Brexit (the UK exit from the European Union) could take at least two years to complete, there are concerns that punitive tariffs will be introduced or other distortions to trade will come as a result of these negotiations. And since markets clearly dislike political uncertainty, expect these issues to affect global markets for some time to come.