How might financial markets react to the new US president?
One of the most overlooked risks for financial markets over the next decade is the potential for the US to impose tariffs on imports. This risk is greatest if Donald Trump wins on 8 November. Yet our analysis suggests conditions are ripe for protectionism to have broader popular appeal: less extreme politicians than Mr Trump could use it to secure votes.
Barack Obama — arguably one of the most ardent advocates of free trade since Ronald Reagan — dabbled with protectionism in the early days of his presidency as the global financial crisis undercut his popularity rating. More recently, popular Democrats have used fiercely anti-free trade rhetoric.
A protectionist turn for American trade policy would lower our forecasts for the long-term returns from US equities. As we discuss in our new investment report, Trade of the century, protectionism inhibits productivity because it leads to tit for-tat policies from trading partners (figure 1).
This matters because contributions to economic growth from labour and capital are set to be much smaller over the next two decades, with an ageing population and an ongoing slowdown of investment. The result is that the growth of developed economies in the 21st century is likely to rely on productivity.
Any drastic change in trade policy could cause uncertainty over the price at which US firms can sell their products and services overseas and vice versa. Our analysis suggests that any increase in uncertainty would depress US GDP and reduce employment.
Uncertainty correlates strongly with the equity risk premium (ERP) of the S&P 500 Index. The ERP is the compensation investors demand in return for taking on the risk associated with future earnings. Unsurprisingly, rising uncertainty is associated with a higher risk premium. In other words, investors start discounting tomorrow’s earnings into today’s valuations at a higher rate as they become more uncertain.
They are already demanding a notably higher ERP than we would expect at this point in the cycle. Although this gives us some comfort, we would still expect a Trump victory — or a Democrat clean sweep — to cause the ERP to increase further, lowering equity market valuations.
Figure 1: Productivity suffers under protectionism
Protectionism is bad news for productivity, thereby stemming what will arguably be the most important contribution to growth in the 21st century
The impact of protectionism
An increase in protectionism will affect some sectors more than others. We expect a Trump win to hurt those with a high
sensitivity to economic uncertainty, a high correlation with the US business cycle and a high proportion of earnings originating in China. Automotives and parts, general industrials, technology hardware and equipment, and electrical and electronic equipment rank poorly across all measures. Manufacturers that source components from China would also suffer — many are also found in these sectors.
We also consider ‘growth’ and ‘value’. Growth stocks tend to outperform during periods of economic uncertainty and when the business cycle turns down (figure 2). That said, value stocks have half the revenue exposure to China of growth stocks (4% of total revenue versus 8%) and derive 74% of sales from the US, compared with 65% for growth stocks.
Which UK sectors are most exposed to US revenue streams and its business cycle, and most sensitive to US economic
uncertainty? As one would expect, the classic ‘defensive’ sectors in the UK outperform when US uncertainty rises. Yet many of these sectors also derive a considerable amount of income from US sales — over 35% in the case of pharmaceuticals and utilities. US uncertainty tends to precipitate a global ‘risk off’ environment in financial assets
that benefits defensive sectors.
However, this may not play out as expected if uncertainty is driven by trade policy disruption and a policy-induced threat to potential economic growth over the longer term. UK investors should be mindful of revenue exposures when selecting domestic defensive names.
A victory for Hillary Clinton is unlikely to generate the same uncertainty as a Trump win. Yet if the Democrats take a clean sweep — winning majorities in both the Senate and the House as well as regaining the presidency — investors should still
be nervous. In such a scenario, Mrs Clinton may look to strengthen support within her party by making populist concessions to the left.
Getting tough on Wall Street
Mrs Clinton has already backtracked on the Asian free-trade deal (TPP), and promised to make life difficult for fossil fuel companies, investment managers, student lenders and bigbrand pharmaceutical producers. In addition, she could make life tougher for Wall Street, reduce corporate tax relief programmes, tax profits stored overseas or raise the minimum wage.
Furthermore, her anti-fracking policy could push up the price of oil, given that US shale is the marginal producer at today’s prices. This would be bad for US manufacturing as well as lower income households, leaving less disposable income available for discretionary spending.
If the Democrats win a clean sweep they are most likely to enact policies supporting those left behind by technological change and globalisation, and reverse the growing gap between the rich and poor. This would help to stem the rise of popular protectionism, but in the short term, either by increasing their average tax rate or labour costs, these policies are unlikely to help companies’ bottom lines.
Some investors believe that a Trump presidency with a split Congress (one party winning the House and the other the Senate) is the best outcome for markets, because he would be unable to enact his more renegade plans and would have to concentrate instead on cutting taxes. However, the president has at least four executive powers with which he
could impose tariffs on China and Mexico without congressional approval.
Mr Trump has outlined $9 trillion of tax cuts, which would benefit the highest earners, while corresponding spending
cuts would hurt the bottom earners. The spending patterns of the top earners are largely insensitive to extra income,
so this would be negative for overall consumption. Given his voter base is largely middle and working class, such tax cuts would need to be accompanied by heavily protectionist trade policies.
Investors would do well to look for stocks that could benefit from either Democrat or Republican initiatives. An increase in defence spending has been well flagged by both candidates. Low-end consumer discretionary stocks should fare well under both parties as they pledge to help out the working and lower-middle classes. But given a Democrat victory sweep, investors may wish to focus on firms that have already implemented a
Infrastructure is perhaps the standout, although investors should watch for overseas earnings in this sector. Giant walls aside, the Clinton plan is the larger one, promising to spend $250 billion over five years and a further $25 billion to establish an infrastructure bank. There is even talk that the $250 billion will be financed by quasi-government ‘Build America’ bonds. Comparing the quality of US infrastructure to that of other countries, rail and broadband stand out as
particularly poor (few high-speed rail lines and very expensive broadband). In addition, America’s roads and utilities are
of middling quality.
Lastly, regional banks may outperform. Mr Trump has discussed reinstating the Glass-Steagall Act, which banned Wall Street from Main Street. Mrs Clinton is unlikely to do this (her husband repealed it), but could push through similar legislation to appeal to the anti-Wall Street section of her party.
The risk of protectionism is not limited to the US. Populist rhetoric will no doubt have an effect on next year’s German and French elections: as Mrs Clinton has found, it takes a strong and secure politician to argue against populist politicians and speak up for free trade.
Figure 2: Growth outperforms during periods of uncertainty
When the economy becomes more uncertain, growth outperforms value.
This article first appeared in Investment Insights Q4 2016