In the waning days of 2016 we approach a new year, a new President and a Republican Party that holds a majority in both Houses of Congress with an ambitious new policy agenda. The S&P 500’s strong 6.2% advance since the election seems to express investors’ hopes and expectations of some favorable changes forthcoming; possibly changes that can spur our economy out of the slow growth trajectory it has been in since the Great Recession (December ’07 – June ’09). To know whether this optimism is justified, we need to assess the changes the new administration may be able to accomplish, when the changes might occur and what will be the economic and investment implications.
President-elect Trump’s ‘Make America Great Again’ campaign made several promises, many of which have the potential to meaningfully affect the economy and financial markets in the immediate months or years ahead if they are achieved. Here is a partial list of those promises:
- Cancel immediately all illegal and overreaching executive orders and remove all onerous regulations and barriers to business,
- Reduce and simplify personal taxes across the board, especially for working middle-income Americans,
- Lower the business tax rate from 35 percent to 15 percent,
- Work with Congress to fully repeal the defense sequester and submit a new budget to rebuild our depleted military,
- Rebuild and update infrastructure,
- Repeal and replace Obamacare with Health Savings Accounts (HSAs),
- Appoint justices to the United States Supreme Court who will uphold our laws and our Constitution,
- Negotiate fair trade deals that create American jobs, increase American wages, and reduce America’s trade deficit,
- Control the borders and prioritize the jobs, wages and security of the American people,
- Clean up corruption in Washington by enacting new reforms to reduce special interests and lobbyists’ influence on the White House and Congress.
Trump’s priorities for achieving many of these objectives are written in his ‘Contract with the American Voter’ and posted on his website, https://www.donaldjtrump.com. It is a very bold and comprehensive agenda, but how much of it will his administration be able to accomplish? Let’s take a closer look at some of his promises and how they might affect your investments if passed.
For starters, Donald Trump is in the fortunate position of having his Republican Party in control of both the House and the Senate. The degree to which a President’s political party has control over both houses of Congress often determines his or her political muscle to get things done, such as the ability to have Cabinet members and judges approved, pass legislation and ratify treaties. Since 1945, the balance of power has only been this lopsided about 39% of the time. That puts Trump in a much better position, at least until the mid-term elections in two years, to get more of his ambitious plans accomplished.
He will be able to immediately overturn onerous regulations or roadblocks to business that were created in previous administrations by executive order or memorandum. With the stroke of his pen, many of these executive orders will be history in the early day(s) of his administration.
Most of the other items on his wish list will go through a legislative process fraught with potentially grueling negotiations and concessions before they can ultimately muster enough votes to pass Congress. It’s likely The Trump Administration will be able to pass meaningful tax reform early on, as there appears to be good support for it on both sides of the isle. The markets would view success in this area as very pro-growth and capable of kick-starting not only the economy, but the broader Trump agenda.
It will not be all clear sailing for the Trump agenda. Early signs suggest there may be some potholes in the immediate legislative road ahead. Senate Democrats have already discussed plans to slow legislative progress by gearing up to challenge every appointee Trump submits. They don’t have the numbers to reject an appointee, but they can drag out the process for some time.
Democrats also plan to exploit any divisions between Trump and his Republican Party. There was an example of this type of division recently when Republicans in the House and the Senate tried to temper one of Trump’s freewheeling populist positions. They declined to endorse one of his weekend tweets that threatened to impose import tariffs on American companies that move jobs overseas. Top Republican leaders suggested the use of free market policies, such as undertaking comprehensive tax reform, would be their preference for encouraging companies to stay and produce their products here. Differences like this could impede progress toward reaching agreement on legislation. At the same time, the scope of infrastructure spending and other initiatives may also be limited by Congress’ willingness to boost deficit spending any more than necessary.
The foregoing describes how politics play a critical role in putting into place regulations and fiscal policies that are economy friendly. Trump was not a conventional Republican Presidential candidate and will conduct his Presidency in an equally different way than we have grown accustomed to – so prepare for twists and turns along the way. Political risk is elevated into the new year as the world gets to know Trump and his leadership style and observes the degree of his early success. We will pay special attention to Trump’s trade policies, as any significant digression into substantial trade disputes could seriously dampen the current enthusiasm markets are having over his pro-growth agenda.
Let’s look closer at several items on his wish list and assess what successful implementation might mean for the markets and our asset allocation decisions:
Reducing and simplifying personal taxes – Significant changes to current tax laws are expected to be a priority as Congress meets early next year. The likelihood of some degree of legislative success in this area is high. If achieved, this would serve to put more money into the pockets of consumers and strengthen the current economic expansion. The proposal to make child care expenses fully deductible from taxes, if enacted, would allow some one wage-earner families to expand to two and others to pocket or spend the tax savings.
Tax rate reductions and simplification should spur additional economic growth and especially benefit cyclical stocks that are sensitive to the economy, including consumer discretionary, energy, industrials and materials sectors. Financial stocks have also been responding well to increasing yields that should lead to better margins and greater loan growth. Defensive sectors such as staples, health care, utilities and telecom are beginning to be left behind as expectations of greater growth ahead have reduced the appeal of defensive sectors.
Anticipation of favorable tax legislation and faster economic growth ahead is already reflected in recent returns in each of these sectors (see chart below).
Lowering the business tax rate – The current U.S. corporate tax structure has increasingly presented a problem for American companies that have garnered a larger share of their revenues from overseas. Trump’s tax proposal to lower the corporate tax rate from the current maximum of 35% to 15% has a good chance of some measure of legislative success because the current rate is one of the highest in the world. This high tax rate combined with our taxation of repatriated profits has caused many companies to build up huge cash stockpiles overseas – an estimated $2.5 trillion. For example, Microsoft and GE have more than $100 billion abroad each, while Apple and Pfizer have more than $80 billion each. If the Trump Administration is successful in lowering the tax rate to 15%, it would become one of the lowest in the developed world.
Lower taxes, especially on foreign earnings, could draw much of this vast pile of cash back into America and provide a considerable boost to GDP. The tax savings to corporations could be used to increase wages or to hire more employees, to expand operations, to update facilities, to increase research and development, buy back shares or to pay out more dividends to stockholders, among other possible uses. The proposed tax cuts along with new provisions to enable the immediate expensing of capital expenditures could spur capital investment and support stronger economic growth.
Repealing the defense sequester and increasing the military budget – According to the Defense Department, the biggest challenge to the military’s state of readiness is sequestration. Sequestration is the hard cap on military and other categories of spending imposed in 2013 as part of budget negotiations. Other sources mirror the Defense Department’s concerns about the current size and readiness of our forces. Naval History and Heritage Command has reported that our Navy is among the smallest it has been since before World War I, while ArmyTimes, an independent voice for military news, recently described our Army as the smallest it has been since before World War II. Air Force Times informed readers on Jan. 19, 2016, that the average age of our Air Force aircraft is 27 years old. With this disturbing data, it seems likely efforts to repeal the defense sequester and increase military spending will garner enough Congressional support to have some degree of success.
Rebuild and improve infrastructure – Priorities here for Trump are to target transportation, clean water, telecommunications, a modern and reliable electricity grid and other pressing domestic infrastructure needs.
Historically, infrastructure spending has been promoted by Democrats more frequently than by Republicans. In an interesting twist, by supporting Trump’s push for infrastructure spending, Democrats may be able to pit the new President against some conservative Republican leaders that favor less government involvement in such programs, favoring instead to put more emphasis on free market principles. Bi-partisan support, albeit potentially fractured, may improve the chances of getting legislation passed here. Concerns over the expected growth of government deficits may keep a lid on the size and scope of the legislation that can get passed.
Fiscal stimulus from an infrastructure bill should increase jobs, and help growth. It should also strengthen the already improving trend in commodity prices. Just the prospects of an infrastructure plan have already caused the construction materials and machinery industry to gain sharply.
Repeal the Affordable Care Act (ACA) – Trying to repeal ACA (often referred to as Obamacare) is a clear priority for many Republicans. Passing “reconciliation” legislation early in 2017 to repeal most of the existing law is one scenario. But more details of how the current plan would be replaced are critical to its success. There is substantial uncertainty regarding whether this approach will be followed or whether amending Obamacare is a better route to gain broader Congressional support. Regardless, it will take time to advance a comprehensive plan to reform the system and months more to pass it. Whatever route is taken, Obamacare will need to be repealed or face significant changes to continue to be viable. Enrollment in health insurance through the exchanges has disappointed estimates and several insurance companies are pulling out of the program – leaving limited choice and rising costs.
Since Obamacare’s long-term viability has been in question, any reasonable resolution to the healthcare dilemma will provide better visibility to healthcare stocks, which have been the worst performing sector this year.
Negotiate fair trade deals – This promise is probably the biggest wildcard in Trump’s basket of campaign promises. He has said he wants to find all foreign trading abuses and then push for fairer trade. The President has significant latitude to do this. As he takes over his leadership role we will see how this develops.
We can expect new conversations regarding trade with other countries. He wants to renegotiate a fairer deal from NAFTA or withdraw from it and withdraw from the Trans-Pacific Partnership. Everyone is for fairer trade with foreign countries, but it is unclear how much of Trump’s get-tough dialog is designed to stake out a stronger negotiating position for talks. Regardless, the prospect of increased tariffs and other trade restrictions the U.S. might enact is a noteworthy cause of anxiety in many countries. China and Mexico could respond in kind if we raise tariffs on them, risking an all-out trade war that would benefit no one.
>Will Trump’s negotiating skills work to the advantage of American business or pose new concerns? We simply do not know yet – time will tell. Fairer trade arrangements with other countries is desirable and would have a long-term positive influence on the U.S. economy. However, if a disruptive global trade war ensues, it could pressure inflation higher and have a negative influence on both U.S. and global growth. This in turn would be troubling to global markets, especially the heavily export dependent emerging markets. We will monitor these developments closely.
Control the borders – Trump’s plans here are to triple Immigration and Customs Enforcement (ICE) agents, build a physical wall on the border with Mexico, reform and enforce immigration laws, end catch-and-release and funding for sanctuary cities and to deport more than 2 million criminal illegal immigrants.
Speaker of the House, Paul Ryan, recently told “60 Minutes” in its Sunday, December 11, broadcast that he is working with Trump on securing our border. He stated, “Here’s what we’re working on with respect to immigration — securing our border, enforcing our current laws,”. Ryan said Trump along with other Republicans had no plans for a deportation force to round up people in the U.S. illegally. There has also been some softening on the idea of the wall along the border with Mexico to include possibly fencing in some areas rather than a solid wall.
What’s Next?
Given the agenda that is expected to start taking shape in the first 100 days of Trump’s administration, it appears likely US corporations and US investors alike will benefit. Since his surprise win, cyclical stocks have outperformed defensive stocks, commodity prices have climbed, the dollar has strengthened and inflation expectations seem to be on the rise as well – all of which seem to reflect expectations of increasing future economic growth.
The US Treasury market’s rise in yields, especially at the long-end of the yield curve also reflect a dramatic upgrade in growth expectations since the election. A steeper yield curve reflects enhanced expectations of future growth (see chart below) and a demand by investors to be compensated for future inflation risks.
Some industries and countries have been negatively affected by Trump’s proposals, but the broader markets are expecting a much friendlier growth environment ahead. Investors are anticipating an effective fiscal stimulus package, a more favorable regulatory environment and limited disruptions to trade. Much hinges on the early legislative successes the Trump administration achieves and whether trade and immigration issues become a meaningful impediment.
Our Outlook for Asset Classes
Domestic Equities – The potential fiscal boost from the Trump administration is expected to come by mid-to-late 2017. It should increase GDP growth in the US and boost the earnings outlook that is already improving on the back of higher oil prices. This environment should be more supportive to the cyclical and value oriented sectors of the economy, which have already responded strongly to improving growth expectations. As stronger growth materializes, late cycle industries, such as, financials, materials, energy, industrials and technology sectors should continue their recent outperformance.
Higher yielding equities, often referred to as “bond proxies”, such as utilities, REITs,