As We Begin The Trump Era
We write this week’s Commentary hours before Donald Trump is to be inaugurated as the 45th president of the United States. We will not dare to guess the immediate reaction of financial markets to Trump taking office on January 20, but will rather reflect on the longer-term market environment we expect under the Trump administration.
Donald Trump was elected on a populist platform: close the borders, lower taxes, deregulation, and keep jobs in the U.S. While the post-election Trump has done a 180 degree turn on numerous issues (banning Muslims, being the anti-Wall Street candidate, or prosecuting Hillary), we expect that he will pursue these aforementioned promises. The short-term impact of lower taxes and deregulation is indisputably positive for the economy. However we see the economy and financial markets are two entities to keep separate. Since annualized GDP peaked at 3.3% in Q1 2015, the S&P 500 has nevertheless risen +10%. It’s unlikely that the U.S. will dip into recession right away under Trump. However, we don’t believe that equity markets need to wait for a recession to correct. If equities could rally with slowing economic growth, it seems reasonable to expect equities to correct…even with accelerating economic growth.
In the short term, markets are trading off emotions, or “animal spirits”. We believe that investor enthusiasm for Trump, coming at the end of an already over-extended market, makes U.S. equities more than “priced for perfection”. As such, we share our longer-term concerns, any of which would deflate the equity bubble.
1.) Valuations
We have been cautious on equities since last year based on now excessive valuations. Our series of valuations charts show the growing divergence between what companies earn (EPS) and their share prices. At some point, markets will realize that the inherent value of a stock is based on the earnings the company produces. A stock (at least in the long run) is not a tool to speculate on Central Bank policy projections or campaign promises of a candidate.
S&P 500 trailing 12/month P/E is up to 21.1x earnings (below). In a recent Commentary (“The Triumph of Greed Over Fear”), we showed that the Shiller CAPE P/E is now at the third highest level on record (just behind 1929 and 2000 levels). Forward P/E’s will always look more attractive, and seem to be a justification to buy equities. However, analysts will always predict stronger future earnings – it’s part of Wall Street’s business model.
In our Commentary “Have Equities Reached A New Permanent Plateau”, we posted the chart below showing that each year Wall Street begins by over-estimating earnings, then constantly revises earnings down throughout the year so that companies can report earnings beats. At some point investors will refocus on earnings. The day this occurs, the bear market in equities will be violent.
2.) Promises Versus Reality
Another long-term concern is our doubt that everything will play out in Washington as markets are hoping. The U.S. president can make no meaningful decisions (except through executive orders with limited scope) without Congressional accord. Trump was elected as the Republican candidate, but his populist tone leaves many Congressional Republicans (McCain, Graham) hostile to Trump’s programme. Not to mention all the Democrats hostile to a president who stole the election from their candidate. With Republicans far from a 2/3 majority in either chamber, the odds of seeing the Trump tax cuts and deregulation proposals getting through Congress “en état” is close to nil. We predict that the 15% corporate tax rate has about 0% chance of passing….which is higher than the odds of a full repeal of Dodd-Frank.
As the haggling between Congress and Trump begins in 2017, and the realization that Trump promises don’t equal reality, we can not foresee equities continuing to rally.
3.) More Debt
We have been bewildered for several years at the assumption of markets that governments and central banks have “solved” one of the worst debt crises in history by adding more debt to the system. If you stop and think about Trump’s plan — cut taxes drastically and implement massive spending increases — coupled with an already $20 trillion U.S. debt level, you should get cold shivers down the spine. Getting back to our second concern above, it’s unlikely that Congress will rubber stamp the amounts of tax cuts and spending that Trump has proposed. Nevertheless, adding more debt over the next years (rather than making the fiscally prudent decision to reduce debt) would seem to be a ticking time bomb. At some point this has to implode. If the U.S. increases spending (even marginally) while drastically cutting taxes, necessarily the Treasury must increase borrowing. With the Chinese and Japanese – the largest buyers of Treasurys – cooling their purchases on a structural basis, U.S. Treasury interest rates will have to climb….and perhaps steeply. It will become soon a question of mathematics: can the U.S. federal government service $22 trillion or $24 trillion in debt at 3% or 4% for 10-years?
4.) Protectionism
Trump has succeeded in keeping Carrier and Ford, who were planning to open factories in Mexico, in the U.S. In our Market Update for January 17 we also reported Trump’s threat to impose a border tax of 35% on foreign auto manufacturers hoping to import cars into the U.S. This is a small sample of what is to come. A populist candidate will do economically inefficient things to appease his populist base. Protectionism has, and always will, erode free trade and global economic growth. What hurts global economic growth will have to eventually hurt company profits and in turn their share prices. When, or if, Trump’s protectionist agenda plays out, don’t expect other countries to sit idly by and let the U.S. steal a greater share of global trade. A rise in protectionism around the world could easily trigger a bear markets in global equities. In the near-term, we would at least avoid buying auto manufacturers and other firms dependant on global sales for more than 50% of their revenue.
Conclusion
We are in a U.S. and European equity market melt-up until markets decide otherwise. While the above risks are being over-looked generally by investors today, these are all factors that could hit the market in 2017. We remain cautious in equity markets that “seem” to have only one direction. When investors see that the Trump era will not be market-friendly as currently anticipated, equities will re-discover the “other direction”.
