James Bevan: First thoughts on the Trump Victory

Donald Trump has won the US presidency. James Bevan looks at the implications for economics, politics, equities and asset allocation.

Economics

Immediate focus should be on areas in which the president has most executive power: revocation of previous executive orders, trade policy and foreign policy.

• Trade: The Trans-Pacific Partnership (TTP) & The Transatlantic Trade and Investment Partnership (TTIP) deals are most probably dead and North American Free Trade Agreement’s (NAFTA) future looks uncertain. The president has the power to impose trade restrictions/tariffs without needing to consult Congress. While the president-elect’s victory speech adopted a softer tone, there remains a real risk that the liberal world order in place since the early 1980s is disintegrating. There are also longer-term questions about the dollar’s reserve currency status.
• Domestic policy: The Republicans’ clean sweep of presidency, Senate and House allows greater scope for change – especially as Trump’s domestic policy platform is more classically conservative: less tax, less regulation. Energy/climate change, healthcare and financial services could all see regulation eased. The Senate victory also puts the Fed in play, with two Fed seats currently vacant. Janet Yellen’s position is possibly under question.
• Fiscal/tax policy: both corporate and personal tax reform look possible, resulting in a significant and permanent loosening of the fiscal stance; these tax reforms have been estimated to add between $2.6 and $6tn to the deficit over the next decade. The promised boost to infrastructure spending could add more to the deficit, but could also prove more complicated to push through Congress.
• The US business cycle: The implications look ambiguous – “doubling growth” is a non-starter. Increased uncertainty could depress investment. Yet, a boost to infrastructure spending could act as an offset, albeit with a lag. The biggest implications could be to growth/inflation mix: looser fiscal policy could prove pro-cyclical. And, combined with a more politicised Fed, this could impart an inflationary bias to policy. Restrictions on immigration could also boost wages and add to inflation pressure.

Politics

The Republicans have won a ‘clean sweep’ of the White House and Congress, with majorities in both the House and the Senate. This likely provides greater scope for Trump to implement policies such as corporate tax reform, for which there is already support among Congressional Republicans, and repeal the likes of the Affordable Care Act and Dodd-Frank financial reform bill.

But questions remain over how much cooperation Trump can expect from Congress. Democrats are likely to unite against him, and it is unclear what his relationship will be like with “establishment” Republicans. Tea Party Republicans may also object to fiscal expansion which widens the Federal deficit. And whilst the Republicans have held onto their Senate majority, they remain vulnerable to filibuster, which could block major legislative changes.

The potential for gridlock suggests executive privilege will remain as important under Trump as it has been under Obama. It seems likely that Trump’s first day project will entail repealing a large swathe of Obama’s executive orders. His own executive orders may include re-starting exploration of the Keystone pipeline and suspending the Syrian refugee programme. As commander-in-chief of the US armed forces, his signals on how the US intends to honour its NATO obligations will influence national security priorities across Asia.

He will also have expansive powers to dictate trade policy. TPP and TTIP now look dead. Nafta is also vulnerable to ‘renegotiation’. The president’s ability to impose tariffs on trading partners deemed to be committing abuses is broad. The Trade Act of 1974 allows the president to impose tariffs in retaliation to unjustifiable, unreasonable or discriminatory trade practices, for example, and Trump has repeatedly threatened to impose 45% tariffs on Chinese imports on this basis.

The channel through which Trump might wield most influence is on foreign policy. In the post-WW2 era, the world has experienced populist and volatile US presidents (both characteristics Trump arguably exhibited during the presidential campaign). Yet the world has not experienced a genuinely isolationist US president.

Over recent decades, Trump has shown remarkable consistency in his belief that America’s allies should fund their own security. He has even suggested that the US should extract “tribute” from European and Asian countries sheltering under its security umbrella. This “transactional” way of seeing security poses threats to international security and free trade.

The scope for an immediate response to this is greatest in Asia. If US allies continue to question America’s commitment to the region, a security vacuum could appear. The tug-of-war between China and the US over the Philippines might portend what replaces the US-led order. If the South China Sea becomes more contested as a result, East Asian supply chains may come under threat.

The impact on Europe could be just as great. Trump highlights the relative similarities between Europeans, creating scope for the EU to resolve some big issues. Some suggest that if a Trump presidency raises questions about the dollar’s reserve status, this could provide an opportunity for the euro to take its place. Hmmm. Trump’s victory, coming so soon after Brexit, may also reinforce some leaders’ views that these outcomes have resulted from taking globalisation to its logical conclusion. As a result, the EU could become more of a “protection union” – free trade within Europe’s borders, yet restrictions on goods, people and capital coming in and out.

Asset allocation

Risk Assets: Based on the OIS curve, the probability of a Fed rate hike in December has eased slightly from the 80% chance earlier in the week, but it is far from an easing.

USD and Other FX Majors: Eventually, a loose fiscal/tighter money mix may help the dollar vs. other majors. For now, though, isolationist US policy may undermine portfolio and direct investment inflows and questioning the dollar’s reserve currency status.

Emerging market currencies: Other than MXN, EM currencies have got off fairly lightly so far. We could see more weakness in Asian currencies with highest dependency on the maintenance of global supply chains.

Commodities: So far, markets are viewing a Trump victory as a “risk shock” and not a negative “growth shock” per se; industrial metal prices are up today (helped by Trump’s infrastructure comments).

Equities

The knee-jerk equity market sell-off, close to 5%, may be a reflection of the uncertainty and rejection of the status quo represented by Trump’s win. Until Trump’s policy priorities and political possibilities become clearer, the near-term outlook for equities is about perception and sentiment.

US equities are likely to outperform if the narrative focusses on US revival, fiscal expansion and infrastructure spending. Trump is not anti-business, his corporate tax policy proposals are less punishing for corporates than the Democrat proposals. Trump also represents relief for the Healthcare sector, which tends to benefit the US. The risk is a protectionist, isolationist narrative. Should Trump tear up trade agreements he could significantly increase input costs for US companies, weighing on earnings. However, if investors believe non-US market and companies are the relative losers from this, US equities could still outperform.

One area at risk is the Asian supply chain but Asia, ex Japan, is increasingly a domestic/regional growth story, such that the negative impact may be mitigated. Asia could even benefit from some diversification or as an inflation hedge.

Trump’s anti trade agenda does pose a risk to Japan. Given limited domestic growth, Japan is perhaps still a more export-driven story than China or India, for example, and safe haven flows into the Japanese yen present an additional threat. Currency may play a role in relative European equity performance too. Should we see a stronger EUR, this would weigh on Eurozone earnings. To the extent that a win for Trump could fan populist flames in Europe, this may present sentiment headwind.

Risk shock and uncertainty favours quality growth. Uncertainty is felt before any of the macro benefits are seen. Lower bond yields may resurrect “bond proxies” (REITs, Utilities, MinVol), but real assets are now required to offset rising breakevens. Equities must be a mix of fixed income and growth.

A higher (US) equity risk premium favours defensive stocks, while cyclicals feed off global trade growth. Supply chains will not be reconfigured overnight, but optimised cost bases are under threat just as cyclicals had outperformed on the back of positive short term data. Relief for health care comes as US defensives already offered an open opportunity. Tech avoids the worst of the tax fears and will remain a beneficiary of ongoing corporate and personal spend.

Company taxation

Trump has proposed two major changes to corporate tax. First, to cut the headline rate from 35% to 15%, coupled with a simpler tax system. Second, a 10% tax on unrepatriated earnings with no deferral. These changes will require the approval of Congress, where leading Republicans favour a territorial, rather than a worldwide tax system. However, these differences should be reconcilable.

The first change should help companies with higher tax rates, typically asset-heavy, domestic companies, for instance utilities, telecoms and domestic oil. International companies that have aggressively minimized their tax rates could see this advantage removed.

The second change is expected to bring the US Treasury about $200bn from over $2.3trn of unrepatriated earnings. The hit to balance sheets from this liability should be manageable and largely concentrated in technology and healthcare where investors will probably concentrate on the prospects for increased dividends and share buybacks. Of course, there is the second order impact of tax reform turning a buyer of corporate and government bonds into a seller.

Conclusions

We can expect three phases of adjustment in the post-Trump world:

1. Initial “risk shock”. Global equities may fall 5%-10% as market participants focus on the increased risk-premia demanded by the increased policy uncertainty that a vote for Trump entails. Global equities have been jittery since early September and the Trump victory will likely see an initial rotation into lower risk assets such as government bonds, US Treasury Inflation Protected Securities, gold and other real assets. The US dollar may also suffer from uncertainty surrounding the Fed.
2. A second round relief rally could be led by US equities as investors focus on the upside to US growth from increased spending on infrastructure and defence. However, the counterpart will be that Treasuries and global bonds suffer as investors focus on rising inflation risks from the loss of access to low cost global supply chains. European and Japanese assets are likely to under-perform if global trade stalls and the US dollar weakens.
3. The final phase, however, as we move through 2017, could see markets becoming more challenging. Global leading indicators and business cycle indicators have been decelerating. Although the US may benefit from a Trump stimulus, the increased risks to global growth, with costs and inflation rising as global supply chains are constrained would challenge both global earnings and global employment. As the US reassesses its relationships with the G20, IMF and NATO, “institutional volatility” will be elevated, potentially increasing the risk of “policy error” and keeping risk premia high. Finally, any slowdown in global growth will refocus attention on debt sustainability, challenging bond markets and corporate debt in particular.

The Trump presidency, with its rejection of “continuity” in favour of “change”, may usher in an investment environment that is increasingly challenging for both global bonds and global equities and which favours real assets.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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