President
Trump

Luc Synaeghel, CIO 2016-11-14

Let us begin by apologising to our readers for the late publication of this Investment Letter.
Somewhat distrustful of polls (a lesson from the Brexit referendum), we chose not to put our monthly thoughts to paper until the result of the US vote was known. In hindsight of course, this proved a wise option. The election of Donald Trump as the next President is a true game changer for both the US economy and financial markets.

“Pro-business” is probably the best way to summarize most of Donald Trump’s campaigning program. Investing in infrastructure, cutting corporate taxes, loosening financial and environmental regulations and lowering the burden of administration all resonate with traditional conservative views and should gain support from the renewed Republican majority in Congress – serving to boost the domestic economy. The target of doubling US real GDP growth, fromthe average 1.5% experienced since the Great Financial Crisis, actually seems realistic. But the flip side of the coin is that government debt will continue to mount and, even more concerning, inflationary pressures will intensify – translating into rising US yields.

inflationary pressures

Other items on Donald Trump’s campaign agenda are of a politically more difficult nature, even for a conservative Congress. We refer here of course to the various anti-immigration and protectionist measures, as well as to a US pull-back from international military financing. Should the wall along the Mexican border really be built, huge tariffs be imposed on Chinese imports or international trade agreements be repealed, then rising import prices will only add to domestic cost-push inflationary pressures.

In due course, the Federal Reserve (Fed), perhaps under the helm of a new Chairman, will thus be forced to shift to a more aggressive monetary stance. While this will most certainly cause bond market angst, the impact on the US equity market and the greenback are less clear-cut.

For shares of US-based companies,we believe that the tailwind of higher profits – thanks to faster domestic growth and lower corporate taxes – will outpace the headwind of higher rates, over the next year at least. Our long time caution on the US equity market has been rooted in its stretched valuation. Higher expected profits alleviate this valuation issue, meaning that we now stand ready to take some exposure, preferably during a bout of downward volatility. In terms of the dollar, conflicting forces will also be at work. Rising rates and spreads versus other major currencies argue for appreciation but greater debt and inflation tend to erode currency value. All told, our best guess is for the existing 1.05-1.15 USD/EUR band to remain in place.

massive infrastructure spending

Last but not least, the outlook for commodity producers and bulk shippers has brightened further with the US set to join China in massive infrastructure spending. We thus stand firm on our exposure to select, financially strong, companies in these long-disliked sectors.

FROM CAMPAIGN PROMISES TO POLITICAL REALITY

During his 18 month-long campaign, Donald Trump made numerous – generally aggressive – promises. The Republican party’s renewed majority in both the House of Representatives and the Senate means that he should be able to push a number of these promises through Congress.

That said, while the next two years (up to the 2018 congressional elections) will definitely take on a pro-business bias, we expect protectionistmeasures to fall short of what the President-elect has touted – with Paul Ryan (Speaker of the House) serving as a form of gate-keeper.

Taxes are a subject on which the new President and Congress are likely to act fast. The first months of 2017 should see the corporate tax rate be slashed to 15%, as promised, and a tax holiday be offered to US companies that repatriate profits hoarded in foreign (formerly) taxfriendlier jurisdictions. A 20+ percentage point drop in the tax rate will obviously have a huge impact on US companies’s future reported earnings – not to mention a lesser incentive to dissimulate part of their profits via accounting shenanigans.

Environmentalists are concerned about the consequences of a Trump presidency.

Rolling out his infrastructure investment plan, which was devised at USD 500+ billion during the campaign, will take the President-elect somewhat more time. While the plan should also be delivered upon, notwithstanding financing issues, its kick-off will probably occur only during the latter half of 2017.

It is early days to determine how much of the greener policy turn of the last eight years will be undone, notably whether and how fast the US can renege its international commitments. But the President-elect has certainly made clear his support for domestic coal and shale oil, implying that regulation on such producers should indeed be loosened in due course.

Finally, the repeal – or reform as the objective has been renamed since the election – of Obamacare, and more generally a lowering of the public burden, is also likely to be win Congress support. That said, the legislative process promises to be lengthy and complex, a number of the people who voted for Donald Trump being the very beneficiairies of the 2013-launched public healthcare program.

We now get to the more difficult promises to deliver upon. Frankly, we doubt that even a Republican-dominated Congress will back all the extreme anti-immigration measures that were flagged during Donald Trump’s campaign, from the building of a wall along the Mexican border to the deportation of all undocumented workers.

The same goes for the President-elect’s intent to make other countries pay for American military efforts and assistance, which would call into question the future of the North Atlantic Treaty Organization (NATO). Last but not least, renouncing international trade pacts, in particular the North American Free Trade Agreement (NAFTA), and imposing huge tariffs (45% being the mentioned figure) on Chinese imports also appear somewhat impracticable. Let us wager that Donald Trump’s entourage as well as Senate and House lawmakers will succeed in toning down his presidential “ambitions”.

IMPLICATIONS FOR FINANCIAL MARKETS

In an environment of near full employment, pushing the US economy to grow faster is a perfect recipe for inflation. After a long period of wait and see, the picture for a change in Fed policy thus yells at us loud and clear – validating our cautious outlook for the bond market. US equities should better withstand the rate “shock”, particularly as they will profit from a period of faster growth and lower taxes. But episodes of volatility do appear inevitable: Donald Trump is unlikely to always behave as sedately as he did during his maiden speech as President-elect.

Up to now, the Fed’s attitude has been to let the economy overheat rather than risk breaking the cycle by raising rates too early. Recognizing that core (ex-food and energy) prices in the US are currently rising at a near 2% clip and that wage pressures are already evident, policy measures that conspire to double the growth rate of the domestic economy can only push inflation above the tipping point. Not to mention the disappearance next spring of the low oil price base effect, the future impact of rising commodity prices (as they ride the Chinese and US infrastructure spending wave) and possible pressures on wage costs or import prices from implementation of (some of) the publicized anti-immigration and protectionist measures.

tighter US monetary policy

So regardless of whether Janet Yellen remains Chair when her term expires early 2018, or whether she even makes it to the end of her term, we believe that the Fed will face pressure to raise rates (more than expected by the financial markets) during the course of 2017 – pressure that should intensify in the latter part of the yearwhen roll-out of infrastructure spending begins. This perpective of tighter US monetary policy reinforces our prudent attitude towards bond markets, preferring to concentrate our exposure in inflation-protected instruments and floating rate notes (i.e. holding almost no duration risk).

In equity markets, while we understand the positive reaction of US stocks, particularly those of companies active domestically, we cannot say the same of their European and Japanese counterparts. Put simply, we see nothing in Donald Trump’s policies that works in their favour. Only a very rapid rise in US rates could, via its impact on currency markets, boost their competitive advantage. But we believe that even a more hawkish Fed will balk at tightening to such an extent that it drives significant dollar appreciation. Much higher rates would also overly burden the US government’s budget deficit with interest charges due on its expanding debt pile.

Recognizing also the political risks inherent to Europe (forthcoming referendum in Italy and 2017 elections in France and Germany), we have cut our exposure to European equities.

Instead, we will be looking to gain exposure to the US market, whose valuation gap stands to be resorbed by faster growing earnings.We aim to do so during one of the “correction” phases that will no doubt occur at regular intervals as Donald Trump’s Presidency unfolds.

The other change that we intend to make to portfolios, so as to adapt them to last week’s gamechanging event, is to regain US dollar exposure. Here also though, time needs to be taken in making the move. The greenback currently lies at the upper range of its 1.05-1.15 band versus the euro. We will be buyers if/when it weakens to the lower end of this range.