Portfolio Manager Charlie Dreifus on the market’s enthusiastic response to Trump’s election and what to watch for going forward.
An Unexpected Market Advance
The market’s post-election advance was as unexpected as the results of the election itself. We wonder if the unexpected remain the dominant theme.
Some market implications seem clear to me. U.S.-centric small-cap is a desired, perhaps even preferred asset class now. Higher GDP and profits benefit equities.
However, if one accepts my argument that prior to the election the market was attractive only relative to the alternative—that is, the 10-year Treasury—then the market is vulnerable given its rapid advance last week. The “P/E” of the bond has dropped while the P/E of the market has risen.
The Dow had its best week since 2011 following the election and recently reached an all-time high.
Another takeaway is that the ‘FANG’ (Facebook, Amazon, Netflix, & Google) concept has been diminished because the premium for growth is perhaps not as valuable as it was in a slow-growth environment.
Among the factors needing reconciliation in the equity market are pro-growth policies and higher interest rates. We may not know the resolution of this for quite a while.
Right now, amid the uncertainty and inherent messiness of a new administration taking shape, we’re also seeing shock from the Establishment’s political players and an obviously angry, politically motivated demographic.
Looking For Signs Of A Pragmatic Approach
President-Elect Trump’s selections for Cabinet and advisory positions will be important, if not critical. This could provide valuable insight as to whether we are headed into a Smoot-Hawley or Reaganomics kind of environment.
President-Elect Trump is, first and foremost, a showman who will try to garner the greatest impact from whatever he does.
Yet the country wants bipartisan cooperation. True, Congress has Republican majorities, but another unexpected and attention-grabbing positive could be Trump’s seemingly bipartisan desires.
Much of the campaign rhetoric is empty and will need to be addressed. To take just one example, the notion of totally abandoning the NAFTA trade treaty. All U.S. car manufacturers produce cars in Mexico not only for the U.S. market, but also for export.
Moving that production back to the States (besides the interim decline in production until capacity is increased in the U.S.) would increase production costs, raise the price to U.S. consumers, lower manufacturer’s profits, and potentially reduce U.S. car makers’ market share.
Much of President-Elect Trump’s campaign talk needs stress testing against the economic realities he now faces. A lot of it is likely to be watered down, if not ultimately abandoned, perhaps another unexpected outcome.
To consider a previous observation of mine—that the markets and the world have become revenue starved—Trump’s perceived pro-growth policies give hope of better GDP growth ahead.
This has been seen not only the equity market’s advance but also in interest rates and expected inflation, caused by the anticipation of tax cuts and government spending.
Perhaps the double bottom in the 10-year Treasury of 1.37% in both 2012 and 2016 will have proven to be the bottom of the long decline in interest rates.
It’s A Whole New World
The question is, has the Trump victory, along with a Republican congressional majority, really changed the world or at least the U.S.?
So far, the evidence would suggest an affirmative response based on the movement of interest rates and renewed inflation expectations, not to mention the moves within certain previously beaten-down market sectors.
But it may be too soon to say for sure. Much lies ahead of what may be a honeymoon rally.
In order to make the U.S. strong again, President Trump will need America to spend again. The deficit will balloon even without the creeping negatives of Social Security, Medicaid, and Medicare. There is little room for error.
Backed by the full faith and credit of the U.S. government, debt cannot be extinguished by declaring bankruptcy. Like Japan and other nations, we too may have an unacceptable ratio of debt to GDP. Furthermore, rising debt and interest rates, in and of themselves, widen the deficit.
Since 1933, when we have had both a Republican President and Congress, the market performs best. However, entry level matters and this market was already fairly to fully priced. If rates and inflation expectations rise, we must also have higher GDP growth to allow for profit growth.
Without profit growth, the higher rates and inflation could result in lower market levels.
One of the biggest concerns is, how will world trade be affected by this new government?
Clearly, the President has executive authority on some trade matters. And even in those instances when he needs Congress, he is likely to earn easy approvals.
Again, we point out that campaign rhetoric is probably not an accurate indicator of policy. Further, as it concerns the U.S. only, trade is a small part of our overall economy, though Mexico and Canada may not be happy to hear that.
Besides less regulation, perhaps the biggest boost to equities is coming from the expectation of lower taxes, including these on repatriated earnings.
Tax reform, even with a Republican majority in Congress, will not be easy to accomplish. Unless deficits rise precipitously, which a Republican Congress ostensibly opposes, cuts need to be made without harming the economy or causing people to feel even more impaired by increasing (rather than decreasing) income inequality. Of course, much the same could be said of eliminating and replacing the Affordable Care Act.
Striking the Right Tone for Growth
How will President Trump deliver his messages? Will we hear more of the measured, calm, and deliberate tone of the third debate and election night victory speech, or will he revert to his former contentious note?
One hot spot to watch could be the tenor of his communication with Federal Reserve Chair Yellen. Will he be attention-grabbing in a populist vein, or will he be even-handed and pragmatic?
We need to carefully watch not only what he says but also how he says it. We saw how the markets turned based not only on what he said in his victory speech, but also on how he said it.
Trump’s victory is the biggest election upset in U.S. history and thus could become problematic based on the perception he created versus the realities we all face.
We will have real time barometers of how his actions are resonating, with consumer and business confidence being monitored most closely. A recalibration of many investors’ mindsets may be needed if President Trump’s actions actually look like they will produce more rapid growth.
Make no mistake about the outcome of the election—subpar GDP growth in the U.S. was probably the catalyst for change.
The electorate, or at least a large portion of them, have been harmed and are demanding change. Without greater economic growth, populism will continue to spread. While not impossible, this task will prove difficult to achieve.
And there will be missteps and errors until things begin to gel. The populist implications for Europe and the rest of the world should be obvious.
With Trump’s victory being the most recent market-shaking event, what else may be out there? We could see a repeat of the 2013 “taper tantrum” that negatively impacted asset valuations worldwide, this time the result of a flight from emerging market currencies due in part to the expectation of higher U.S. interest rates, which are already moving higher.
Of course, this would be in addition to any perceived damage to those emerging markets affected by potentially more restrictive U.S. trade policies. Mexico obviously stands out here. Such concerns, if they spill over as they have in the past, could deflate the recent advance. We will see and, for now, hope for the best.
Article by Charlie Dreifus, The Royce Funds