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Written by: David Lafferty , CFA® | Natixis Investment Managers
Throughout most of 2015-16, we had been writing about central banks and the effects of their extremely accommodative policies. It seemed to be all that mattered for global markets. When would the Fed raise and by how much? Could the European Central Bank do more? Would the Bank of England do more post-Brexit? Does it even matter what the Bank of Japan does anymore? Monetary policy had a gravitational pull that sucked in all other macro topics and events. But it seems this era is ending, or maybe it’s just being shoved aside by global politics.
Sadly, we are stuck in a new rut: Trumponomics. October was “What if he wins?”, November was “What does his win mean?”, December was calibrating our 2017 outlook for Trump, and January was handicapping his platform and its likelihood of success. Now, the equity market’s strong February performance – including new highs and a string of 12 positive days for the Dow Jones Industrial Average 1 (DJIA) – merits continued discussion of Trumponomics.
The Hope
The president’s platform and agenda have been well covered. While the market languished on a lack of detail from mid-December through January, February saw a resurgence in animal spirits as the administration has done little to constrain promises of fiscal stimulus. These include large tax cuts for both individuals and businesses, a $1 trillion infrastructure spending plan, a dramatic expansion in defense expenditures, and a broad program of deregulation. All of these were reconfirmed by the president in his address to Congress on February 28, sending the DJIA up over 300 points the following day.
Consistent with these animal spirits, US economic survey data has moved significantly higher (including the Institute for Supply Management ® Report on Business ® , Purchasing Managers’ Index, 2 and various regional manufacturing surveys), while small business confidence has skyrocketed (as measured by the National Federation of Independent Business Monthly Survey 3 ).
On the heels of essentially flat earnings for the S&P 500 ®4 in 2015 and 2016, bottom-up growth estimates for 2017 and 2018 are +10% and +12% respectively (according to FactSet). Apparently, happy days are expected again and many market watchers have turned bullish.
While we won’t know for some time whether this exuberance will be justified, judging by equity gains since the US election, the market seems overweight hope.
The Reality: Scenario #!
Perhaps the market’s upside based on the new administration’s fiscal audacity is warranted. But the president’s congressional address was chock-full of symbolism – none more than the proximity of the commander in chief to House Speaker Paul Ryan. President Trump seemed to promise a lot in his speech that Ryan may not want to pay for.
Thus we arrive at Scenario #1, where political infighting over spending, debts, and deficits has a real possibility of derailing the president’s fiscal promises. If these promises have been the dominant force driving equity markets upward since the election, the market is at real risk of a sharp retrenchment once this reality sets in. Can President Trump strong-arm Congress? Perhaps. Even so, there are at least two major obstacles to President Trump getting what he wants this time. The first, ironically, is Obamacare (the Affordable Care Act). Tackling corporate and individual tax reform before repealing and replacing Obamacare is operationally difficult. It’s particularly problematic because there seems to be no coherent plan for getting rid of Obamacare while keeping the benefits Americans want, much less paying for them. As a result, tax reform may become inextricably bogged down by complex and heated healthcare discussions.
The second obstacle is that there is effectively zero flexibility in the discretionary spending portion of the US budget. The president has no appetite for addressing social welfare programs (Social Security, Medicare, and Medicaid) and is looking to dramatically expand, not curtail, defense spending. With supply-side constraints on labor, it’s unlikely even the rosiest “dynamic scoring” assumptions will produce enough growth to square this math in a “budget-neutral” way. (Did we mention debt service costs will also rise with higher interest rates?) Whether real or perceived, Republicans claim to be the party of fiscal conservatism. It is far from clear that Ryan and the Republicans will be willing to cede the high moral ground on debts and deficits simply to give President Trump what he wants.
The Reality: Scenario #2
Scenario #2 is essentially the “be careful what you wish for” outcome. Here, we assume the Republicans in Congress roll over, handing the president an open checkbook (which Democrats can’t do a single thing about) for his “America First” fiscal dreams: huge tax cuts and massive spending increases (on infrastructure and defense). As we discussed last month, with inflation already nearing or above 2% (depending on which measure you use) and an economy near full employment, this type of fiscal ecstasy will almost surely bring about more inflation – and a more aggressive response from Federal Reserve Chair Janet Yellen and her colleagues at the Fed.
In an economy still grounded in credit in all its forms (public, corporate, and consumer), higher interest rates could certainly throw cold water on the market’s recent bliss. Moreover, higher yields and a more aggressive Fed will likely push up the US dollar, further tightening monetary conditions and weighing on US corporate earnings, via both falling export competitiveness and currency translation effects.
Letdown or Dragged Down?
To summarize, in Scenario #1, much of the Trump fiscal agenda goes unfulfilled by internal Republican bickering and fiscal realities, which would clearly be a letdown for markets that have fallen in love with the upside possibilities of Trump. In Scenario #2, fiscal stimulus results in monetary restraint (more aggressive Fed, higher rates, and a stronger dollar) dragging down (or offsetting) these recent animal spirits. Either way, we think the market is in for a rough patch at some point in 2017 whichever scenario plays out.
Is there a third “Goldilocks” scenario whereby Trump’s fiscal expansion succeeds without being undone by higher rates and tighter monetary conditions? Potentially, but that is threading a pretty small needle and probably not one that investors should be betting on.
Moreover, all of this is happening in an environment where US-based risk assets, stocks and corporate bonds, are hardly cheap. Stock prices are generally elevated and corporate credit spreads 5 (particularly in high yield bonds) are beginning to narrow. This adds to our more cautious nature right now.
Portfolio Implications
Based on the scenarios above, we expect a market correction at some point in 2017. This is hardly an outlier prediction: historically, market corrections – a drop of 10% or more from a market highpoint to a low point – happen almost every year. 6 Our only point is to isolate a likely proximate cause; that is, a failure in implementation of Trump’s stimulus or the offsetting risk that it might be undone by more restrictive monetary policy. Simply put, the market may have gotten ahead of itself by pricing in too much optimism.
Our cautious stance should not be seen as bearish. US economic momentum was gradually improving in the second half of 2016 and we expect that to continue in 2017. At this point, Q1 gross US domestic product (GDP) 7 looks OK, but not great. Economic growth in Europe may also be firming.
Moreover, we expect the credit cycle 8 to remain benign, at least for the next 6-18 months before refinancing and roll-over risk builds in 2018-2019. Given our longer-term outlook, a sharp (and warranted) near-term correction in risk assets could serve two purposes: First, a chance to rebalance and pick up assets at better valuations, and second, to reset market expectations around Trump closer to reality.
1 The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.2 The Purchasing Managers Index (PMI) is produced by the Institute for Supply Management (ISM) and the Markit Group. An indicator of economic health of the manufacturing sector, it is a monthly survey of private sector companies that accounts for indicators including new orders, inventory levels, production, supplier delivers, and employment.
3 The National Federation of Independent Business surveys its members monthly to generate its Small Business Optimism Index.
4 The S&P (Standard & Poor’s) 500® Index is an index of 500 stocks often used to represent the US stock market.
5 The term credit spread refers to the difference in yield between two bonds of similar maturity but differing credit quality.
6 “S&P 500® intra-year declines vs. calendar year returns: 1980-2017." Factset.
7 The total value of goods produced and services provided in a country.
8 The term credit cycle refers to the evolving access to credit on the part of borrowers. Periods of easier borrowing are characterized by lower interest rates and fewer lending requirements. Periods in which borrowing is more difficult are marked by higher interest rates and greater lending requirements.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
Natixis Investment Managers does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.