Three Key Thoughts:

Markets Herald The Trump Era
Trade and Tax Wildcards
Growing Inflation, Rising Rates

It has been two months since Donald J. Trump pulled off a surprise victory in the US Presidential election. With the Republicans also retaining strong control of the House of Representatives and weak control of the Senate, the GOP has effective control of the Washington agenda for at least the next two years.

Surprising many pundits, stock markets did not react negatively to this news. Indeed, we have seen a strong rally in certain parts of the market that are expected to fare well under a Trump presidency. His agenda is expected to focus on corporate and individual tax cuts, deregulation, infrastructure spending and health care changes. This pro-business agenda caused a spike in interest rates on US Treasury bonds and fueled a sharp dollar rally.

Predictably enough, the sectors that rallied were banks (beneficiaries of deregulation and higher interest rates), industrial companies (more infrastructure spending) and energy-related companies (less restrictions on development and transportation). The biggest beneficiaries were small capitalization companies in these areas which not only have proportionally more to gain but whose US-centric businesses will not be affected by a stronger dollar.

It is our job to look beyond the short term reactions to the longer term fundamentals that are likely to affect our capital markets for the next several years. First, we believe a reduced focus on new regulations (and even a rollback in some of the regulations that were put in place during the Obama era) will be a fundamentally positive development for the business environment. It is very difficult to put a value on this shift but if the initial improvement in business sentiment can be sustained, that will benefit the US economy.

Opening up the tax reform debate is a dual edged sword from our perspective. Certainly, our corporate tax structure is in dire need of change not only to rationalize it but to make the US more competitive in the world economy. Currently, enormous amounts of resources are expended to set up structures to allow corporations to take advantage of more favorable tax regimes elsewhere in the world. However, in any negotiation of this magnitude there are likely to be winners and losers. Our biggest concern is that tax policy could become a tool for trade policy and, on this latter point, we believe the Trump inclinations could be dangerous to the world economy. It is too soon to tell whether the tough talk on free trade is just that or will be followed up with counterproductive measures.

While we aren't necessarily fans of the current tax rate structure for individuals, the current system has one huge advantage over the scheme it replaced: permanence. Looking back over the first decade of this millennium, the phasing ins and phasing outs of various rates and tax provisions were head-spinning, creating needless uncertainty. We hope that some fiscal discipline is attached to the tax negotiations as well. The US fiscal deficit will begin growing in the next few years as entitlement obligations expand, particularly for retiring baby boomers. In our view, sharply higher deficit spending, either on tax cuts or infrastructure could lead inflation and interest rates much higher, choking off the growth they were intended to create.

Even though there are many reasons to be optimistic that growth may well accelerate in the coming years, there are some sobering realities that serve to limit that potential growth. First is the structural issue that an economy’s growth potential is the sum of the growth in the labor force and the productivity of that labor force. Labor force growth is pretty much baked in for the next 5-10 years at around 0.5%, which leaves productivity as the wild card. Save for the 1990s, recent productivity growth has averaged around 1%. Even if we doubled that, we still only get real growth of 2.5%.

We may feel a bit better about that 2.5% real growth though because inflation is likely to pick up, giving us higher nominal (total) growth. With the economy nearly at full employment, wages have begun to rise more quickly. Combine this with stable or rising oil prices (off a low base) and we should expect higher inflation reports ahead.

Speaking of inflation, we believe the other governor on growth may be interest rates. We have already seen a healthy rise in the ten year Treasury bond rate, which is most commonly used in setting mortgage rates. And the Fed is likely to hike short term rates further in 2017, especially if we see wage gains and inflation reports exceeding their targets. The economy is strong enough to withstand a gradual increase in rates and businesses (not to mention savers) will welcome a return to more “normal” interest rate levels. However, there is clearly a risk that rates could rise too quickly, damaging the financial and housing markets.

Our asset allocations views are shifting gradually. We have reduced and will likely continue reducing the allocations to hedged strategies. Returns in this area have largely been disappointing and we believe the period ahead is not likely to be any more kind. We continue underweight in fixed income, focusing on strategies that will do well in a rising rate world. Among stocks, we are adding cautiously to US equities, while maintaining exposure to growth opportunities elsewhere in the world.