Donald Trump will become the 45th President of the United States, and the Republicans will retain control of the House and the Senate for the 115th Congress.
So lightning can strike twice. After the UK voted to leave the European Union, the US has elected a president that many had dismissed as unelectable. While there are clear differences between the two events, both involve anger about the perceived costs of globalisation and a rejection of the ‘political elite’. When the status quo is no longer working for you, change can seem a risk worth taking.
We are not political commentators, however. So what are the financial implications of Mr Trump’s election? It is difficult to answer this with certainty. Mr Trump fought an audacious, 21st century campaign that was heavy on sound bites and social media, but light on policy details. Some indications of his likely direction of travel were wrapped up in extreme language. The truth is that no-one really knows what his presidency will involve. He may continue to be a loose cannon or, having been elected and constrained by political realities, he may return to being an outcome-focused businessman. The two months until his inauguration are likely to be interesting.
Uncertainty doesn’t help markets
Taking his policy announcements to-date at face value, however, we believe they would undermine economic confidence in the US and around the world, and lead to downward revisions to global growth. At the very least, there will be a period of uncertainty and our research has uncovered a strongly negative correlation between economic uncertainty and equity valuations.
It is important to remember the starting point, however. The US economy is nearing full employment, wage growth has picked up and consumer confidence, while trending down, remains buoyant. Both residential and non-residential investment remains weak by historical standards and the manufacturing sector has been hurt by a strong exchange rate, although the data have even improved here. Globally, third-quarter GDP looks set to beat consensus, while our leading economic indicator of global output suggests that this momentum was set to continue into 2017. However, this result shifts the spread of likely outcomes materially.
While congressional checks and balances may arrest his most extreme pledges, President Trump will be freer to pursue his damaging trade policy. There are at least four powers that a president can invoke unilaterally to impose tariffs. Mr Trump could use these on Chinese and Mexican imports, thereby risking a ‘beggar-thy-neighbour’ tariff war that would lower the outlook for economic growth – and therefore investment returns – for many years to come.
Second-guessing which policies may pass through Congress and pre-empting which tariffs may be applied is a hugely speculative task. We prefer a simpler approach with far fewer assumptions in order to get a handle on how tariffs might affect growth over the first two years. We model the scenario as a ‘shock’ increase in economic uncertainty. In this case, growth would be 1-2% lower after two years relative to what it would have otherwise been. While this does not necessarily mean there will be a recession, it will require reductions in earnings forecasts, which is likely to undermine equities. Growth could be significantly lower still if the Federal Reserve (‘Fed’) is unable to deliver sufficient monetary stimulus.
The fiscal black hole
Beyond this two-year period, there is a risk that Mr Trump’s fiscal plan will require remedial spending cuts severe enough to plunge the US into recession. Oxford Economics suggests that under such a scenario, the US could be in recession by late 2018.
Conventional wisdom suggests that Mr Trump’s plan to reduce taxation will boost private sector expenditure, while Hillary Clinton’s plan to increase it would have had the opposite effect. That is negated, however, by the skewed nature of the plans’ beneficiaries as well as the accompanying impact of the candidates’ plans for the expenditure side of the public ledger. The non-partisan Tax Policy Center has shown that nearly 20% of Mr Trump’s tax cuts accrue to the most affluent 0.1% of households, who have a low propensity to spend additional income. He has promised that his policies – and his trade policy in particular – would boost economic growth to 3.5-4.0% a year from the 2.1% average of the last five, thereby filling government coffers and offsetting the impact of his tax cuts without the need to cut government spending. This is pure fantasy.
Growth has been low for three reasons: the working age population is growing more slowly; investment spending is low; and productivity growth is weak. Mr Trump’s immigration policy would cause the working age population to contract in year one; the uncertainty that he brings is likely to undermine investment intentions; and protectionism, as discussed in our recent report, Trade of the century, is the death knell for productivity. Unsurprisingly, the bipartisan Committee for a Responsible Federal Budget has concluded that Mr Trump’s fiscal plan would add another $5.3 trillion to national debt. Therefore, if Mr Trump were to proceed with tax cuts for the wealthy, it seems inevitable that he would be forced to reduce spending further down the line. This would dampen growth still further.
Over the long term, shareholder returns are tied to economic growth. With declining contributions from the growth of the workforce and investment spending, productivity will drive economic growth in the 21st century. Those countries enacting policies that impede productivity are likely to generate the lowest returns for investors.
Mr Trump’s campaign was conspicuously light on detail of his plans for government spending. He referred in passing to improving public infrastructure – how we refer to roads or digital networks, for example – but it was not a central plank of his campaign as it was for Mrs Clinton. It is interesting therefore that remaking US infrastructure as the best in the world was the only policy to which Mr Trump referred in his acceptance speech. While his protectionism weakens the outlook for productivity growth, a major infrastructure programme should offer some support.
When we compare the quality and sophistication of US infrastructure to that of other countries, rail and broadband stand out as in need of the greatest amount of investment. The US has very few high-speed rail lines and its citizens face very expensive broadband connections. Meanwhile, the World Economic Forum assesses America’s roads and utilities to be of middling quality. A basket of stocks from the engineering, industrial, construction and utility sectors most geared into public spending has dramatically outperformed the broader S&P 500 index since May, when Mr Trump and Mrs Clinton were confirmed as candidates, reflecting the bipartisan support for infrastructure spending.
Short- and long-term rates
An uncertainty shock is likely to see long-term borrowing rates fall relative to short-term rates. This ‘flattening’ of the bond market’s yield curve is driven by a downward revision to potential GDP growth – which long-term borrowing costs are tethered to. At the very least, the Fed should stop raising interest rates – standard economic modelling suggests that this would provide monetary stimulus equivalent to a 1.5-2% cut to base rates. However, exactly where yields will settle is difficult to predict for three reasons.
Firstly, the cavernous hole in Mr Trump’s fiscal plan could undermine the ‘safe haven’ status of US treasuries, as could the possibility of deteriorating relations between the US government and its major creditors. As the currency of a country perceived to be impervious to foreign aggression, the dollar has been the global standard since 1945. It is difficult to envisage an alternative, especially given the question marks over the future of the euro. Gold will almost certainly benefit, but it is not such a readily fungible medium of exchange. That said, it is conceivable that the dollar’s status could change if the US becomes more isolationist and it withdraws from supranational affairs. Some may remember how demand for dollars and dollar assets plunged in the early 1970s as the Bretton Woods currency framework collapsed and President Nixon abrogated the convertibility of the dollar to gold.
Similarly, Mr Trump’s recent excoriation of Fed Chair Janet Yellen could lead to speculation that the central bank may lose its independence. However, Mr Trump may simply have hitched his campaign to the ‘Fed-bashing’, ‘low-rates-hurt-savers’ Republican wagon to gain wider party support. In high-profile interviews during the primaries, Mr Trump declared himself the ‘king of debt’, who liked low interest rates, ‘certainly as a developer’, and that Mrs Yellen had done a ‘serviceable’ job. As such, he may not upend the monetary policy regime as much as his rhetoric might imply.
Thirdly, nominal yields are in part a function of inflation expectations, which depend on the impact of a Trump presidency on the dollar. Analysts are far from unanimous about the immediate direction of travel, largely due to the ‘safe haven’ question discussed above and uncertainty about the Fed’s likely reaction. Inflation is already set to rise as commodity prices stabilise and healthcare costs increase in 2017. An appreciating dollar would dampen inflation, while a depreciating dollar would increase it. An analysis of the recent relationship suggests that a 10% fall in the exchange rate increases inflation by c. 0.5% after three months.
The US dollar
In the long term, we believe a Trump presidency and US protectionism will cause the dollar to devalue, especially against sterling. While, at face value, higher tariffs would mean fewer dollars sold to buy foreign goods, this would not necessarily support the dollar, especially if trading partners retaliate with tariffs of their own, which we believe is highly likely. Moreover, protectionism may corrode the economic fundamentals that drive currencies over the long run.
Firstly, protectionism is likely to lower productivity in tradable industries, through market barriers as well as lack of competition. Secondly, contrary to Mr Trump’s thinking, protectionism may deteriorate the terms of trade – how many imports one can buy with one’s exports – as many Chinese imports (particularly component parts) cannot be substituted by US goods, forcing costs up. Finally, if it is accompanied by anti-immigration policies, the population would age more rapidly. Fewer people working reduces national savings and decreases the current account balance, thereby requiring a lower exchange rate to generate the trade surpluses necessary to service external liabilities. Given the dollar already appears considerably overvalued, the long-term outlook becomes bleaker still.
The primary driver of the surging FTSE 100 since the Brexit vote has been a weaker sterling exchange. Twenty percent of FTSE earnings stem from the US and even more are denominated in dollars. A weaker dollar would therefore reverse some of the index’s recent currency-driven gains.
Of course, Mr Trump offers corporate America one major boon: the reduction of corporation tax from 35% to 15%. However, investors must remember that the value of a company is the discounted value of all future cash flows. While the tax cut may represent a sizeable one-off gain, the impact on equity prices would be more than offset by a relatively modest (say 15%) reduction in long-term earnings growth due to his protectionist and anti-immigration policies. Mr Trump may also offer firms a tax break to bring offshore cash back onshore. This could spur more mergers and acquisitions, particularly in the tech sector, where firms can be rewarded for looking beyond cyclical downturns.
Our research shows how economic uncertainty is negatively correlated with equity market valuations. Where style is concerned, growth tends to outperform value during periods of uncertainty. We suggest that automotives & parts, general industrials, technology hardware & equipment and electrical & electronic equipment are the sectors most at risk due to a higher correlation to US growth, a high sensitivity to economic uncertainty, a high proportion of Chinese sales and high proportion of imported component parts. Conversely, many of the classic defensive sectors screen well, but in the UK we caution against pharmaceuticals and utilities as over 35% of earnings stem from the US.
Of course, the longer-term impact on stock markets will depend on the extent to which Mr Trump follows through on his most gaudy pledges. Still, the new president represents a significant risk to both near-term and long-term financial returns.
Can America recover from the bitterest campaign in living memory? In the weeks until his inauguration, more details will emerge about Mr Trump’s approach to the presidency, and his key policies and appointments. In the meantime, uncertainty will not help stock markets. In the longer term, Mr Trump may be more moderate and adopt more economically coherent policies than his campaign suggested. Only time will tell. We will monitor the major developments and how they might affect financial markets, and keep you updated.