December 13, 2016

During the 1988 World Series, legendary Los Angeles Dodgers’ announcer, Vin Scully, spoke these now famous words: “In a year that has been so improbable, the impossible has happened.” He was speaking of baseball, not politics, but he could just as well have been describing surprising global political tides in 2016. In June, British voters narrowly passed a referendum to leave the European Union. Then, in October, Colombian voters shockingly rejected a peace accord that had been negotiated over six years and was meant to end 50 years of conflict. And finally, in November, Donald Trump defeated Hillary Clinton in a hard-fought election. What all three of these elections had in common was their “improbable” outcome. Few, if any, forecasted them accurately and, taken in total, you might call them “impossible.”

We will leave it to political pundits and historians to answer the hows and whys and debate whether these results are signs of a broader global movement. Instead, we will focus on this most recent election’s potential impact on the domestic economy and financial markets. It is important to note from the outset that Trump articulated few actual policy specifics on the campaign trail. Despite Republican majorities in Congress, ideas need to be turned into bills and laws before we will know true outcomes. Even if plans and ideas become actionable items, the timing is often unpredictable.

Overall, the equity market reaction has been positive since November 8. To set the stage, prior to the U.S. Presidential election, the S&P 500 Index was up about 6.5% for the year, but sold off about 2% in the days immediately ahead of the election. As we pointed out in an earlier note to clients, as election returns were coming in, there was a sharp shift from an initial negative to a more positive interpretation. As of this writing, the S&P 500 is up an additional nearly 3%, bringing the year-to-date return to approximately 10%. While positive thus far, how the market reacts in the medium- to longer-term will be predicated on how effectively Trump can move from divisive campaigning to constructive governing.

As odd as it may sound, the election has increased the possibility of both good and bad outcomes; status quo will not be an option and the future is unknown. The upside arguments point to four key factors: cutting/simplifying taxes, spending trillions on infrastructure, boosting military spending, and cutting business red tape (regulations).

"The upside arguments point to four key factors: cutting/simplifying taxes, spending trillions on infrastructure, boosting military spending, and cutting business red tape (regulations)."

Fiscal spending, as the thinking goes, would mean less taxes (corporate and personal) and more deficit spending (infrastructure, military), which will have a significant simulative impact on domestic growth. This is likely true, but at this point in our economic cycle, the benefits may be more muted than anticipated. Rising interest rates and a strengthening U.S. dollar during the sixth year of the U.S. expansion will have a lesser impact than at earlier points in our economic recovery. Removing tax roadblocks to offshore earnings repatriation could have a more immediate impact, in contrast to longer lead times for meaningful infrastructure projects. Lastly, removing government shackles should allow businesses to grow more quickly. This is especially true for banking, infrastructure, and energy. Ultimately, Trump’s and the Republican majority’s need and desire to succeed will likely be a motivating force for cooperation on these goals.

The counterarguments are primarily focused on the role of trade within an already fragile global economy. Growing nationalism, evidenced by Trump’s ascension and the vote for Brexit, is not positive for worldwide trade and growth. Additionally, the net effect of these policies is likely to be rising interest rates and a stronger U.S. dollar—possibly choking off the very growth the policies are meant to stimulate. Since the election, 10-year U.S. Treasury rates have moved up 65 basis points (0.65%) which, even without Federal Reserve action, effectively tightens monetary policy. During this same time frame,  the U.S. dollar has strengthened 4.0% relative to other world currencies and is up nearly 9% from its May low. This impact makes imports cheaper, which is good for consumers, but products of U.S. multinationals become less competitive worldwide and earnings growth will be harder to come by for these companies. Finally, while a net positive, infrastructure projects are seldom shovel-ready, and take time to plan, bid, and construct. Their benefits are far from immediate—generally years, not weeks or months, away.

"The counterarguments are primarily focused on the role of trade within an already fragile global economy."

Taken in total, we suspect the election’s outcome is slightly positive for both the economy and markets, but only to the extent a Trump administration can be effective in achieving his economic policies and being constructive on trade. If we sense a significant pullback from global trade practices, we would become more concerned about both economic growth, inflation, and the level of the financial markets.

Turning from a macro discussion to potential investment winners and losers, as you might imagine, we foresee both. From an asset class perspective, in contrast to U.S. domestic markets, both developed international and emerging markets have sold off. This is largely due to concerns about the new administration’s trade policies. Global growth and accompanying higher commodity prices ought to, ultimately, benefit the global markets. In the meantime, the price move upwards in more domestically-focused equities is not surprising, but we suspect this rotation to be short-lived.

In terms of economic sectors, Financials are a winner thus far—yet not a clear winner. Higher interest rates should restore growth in a sector which has struggled for growth in the post Dodd-Frank, low interest rate world. There was talk during the campaign about the roll back of this regulation, but it is unclear whether Congress will support such a change.

Industrials have also shown positive gains since the election. The headlines point to increased infrastructure spending, but as we pointed out earlier, these windfalls, should they come, will not be immediate. Additionally, continued U.S. dollar strength will add an earnings headwind. Clearly, this is one area where repatriation could have a significant beneficial impact on U.S. multinational companies.

The impact on Energy has been mixed. On one hand, less regulation ought to favor coal and oil and gas exploration companies to the detriment of renewable energy, but supply and demand implications still exist. These dynamics will likely continue to keep a lid on crude prices, at least in the short-run. Demand for coal continues to decline and any increases in crude oil supply as the result of less regulation will only serve to keep prices low. Not until we see an increase in demand, led by economic growth, will there be a meaningful move upwards in pricing and profits. One area which will likely benefit will be energy infrastructure, including pipelines, as demand does currently exist there despite today’s prices and opposition from the Obama administration.

While efforts to amend the Affordable Care Act may benefit Healthcare, it is not all green lights for this sector, wherein the impacts are more subtle. The debate over prescription drug pricing, which has become a bipartisan issue, will continue. Efforts to encourage competition across state lines may increase, but the price toward managed care is likely stalled.

Income-oriented equities, including Utilities, REITs, Telecom, and some Consumer Staples, have been on the opposite side of these early trades. As we have written in the past, when interest rates moved down, investment dollars moved into stocks which paid above-market income. Despite lofty valuations, which drove yields lower and lower, money continued to pour into these sectors. Now, with the prospect of higher yields on the horizon, marginal dollars have been exiting these sectors, putting downward pressure on prices.

With regard to the markets, the bottom line is that no one knows for certain how or when many of these potential changes might occur. Let us also add that the markets were not inexpensive prior to the election, nor are they in this post-election run. Using a simple price-earnings metric, the market appears fairly valued. To continue to justify additional new market highs, we will need to see believable upward movement in corporate earnings. While volatility has been muted and skewed to the upside, we expect continued volatility as the impact of unknown policy specifics play out. As a result, individual security selection will continue to be critical.

"To continue to justify additional new market highs, we will need to see believable upward movement in corporate earnings."

To conclude, the policies articulated by the Trump team suggest lower tax rates, reduced regulation, a more business-friendly environment, and increased infrastructure spending. These provide a positive backdrop, no matter the specifics, and that is what is driving the markets—hopes and expectations.

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