December 20, 2016 EXECUTIVE SUMMARY JIM BAIRD

Transcription

1 EXECUTIVE SUMMARY December 20, 2016 JIM BAIRD CPA, CFP, CIMA Partner, Chief Investment Officer President-elect Trump s pro-growth economic policies focus predominantly on tax reform, infrastructure spending, and regulatory reform. While the policy direction of the incoming administration seems clear, the devil is in the details on a host of matters. The first 100 days of the incoming Trump administration should provide some clarity. Most economists expect that the economic policies that have been proposed during the campaign will be priorities for the incoming administration, but some degree of bipartisan support and thus some compromises will be needed to push legislation through the Senate in particular. Even before the election, there were signs that inflation was building and the Fed was moving closer to tightening. Since then, markets have priced in an expected uptick in growth and inflation, and long-term bond yields have moved higher as a result. Pro-growth policies should be supportive of equities on the whole, providing the underpinning of stronger growth in corporate profits. One potential headwind for large multinationals and foreign equities is the potential for the dollar to continue to strengthen should growth accelerate and interest rates rise. Revenue and earnings from foreign markets would be diminished when translated back to dollars a negative particularly for those companies that generate a significant portion of their profits outside the U.S. On the whole, stronger domestic growth, the policies aimed at generating that growth, and the potential for dollar strength would all appear to favor domestic over foreign stocks, and smaller companies over larger companies. Many questions remain about the specifics of expected legislation, and thus the degree to which growth could be boosted over the next few years. The market reaction in the past month suggests a degree of optimism that growth will be bolstered, carrying inflation and interest rates higher, but also boosting equity market returns.

2 2 THE TRUMP ECONOMIC AGENDA: WHAT IT MEANS FOR INVESTORS Overview The unexpected victory of Donald Trump in the U.S. Presidential election last month was a surprise for many, including the overwhelming majority of pollsters, much of the American public (who listened to those pollsters), and of course the capital markets. As the first indications emerged that the race was tighter in several key states than expected, equity futures plunged, and the dollar, gold, and Treasuries rallied. The roller-coaster ride extended through the night, before reversing course abruptly while much of the nation was still sleeping. In one of the most pronounced market reversals in memory, major equity indices and long-term bond yields were higher by the close of trading on the day after the election. In terms of the reaction to a Presidential election, the volatility (first to the downside and then to the upside) in the course of about twelve hours was without precedent. Not only was the election outcome itself a surprise, but the reaction of the markets in the subsequent weeks didn t remotely resemble the consensus view heading into the election. The widely held expectation was that a Clinton victory would represent an extension of the status quo and would be embraced by investors. Conversely, a Trump victory would mean a marked change in direction on a number of policy fronts (tax, regulatory, fiscal, and trade), and would introduce a much higher degree of uncertainty. And, of course, markets eschew uncertainty. As with the election outcome itself, the consensus was wrong on how equity markets would react. There s a lesson in this as well, and that is in the risk of trying to time the markets or assume that one can predict what will happen over the short term. Getting out of stocks in anticipation of a selloff precipitated by a Trump victory would have proven to be quite costly. With the election and the immediate reaction now behind us, we turn to an examination of what this change in direction means for the economy and capital market return expectations. Of course, there are still many questions to be answered. The bottom line is that, while we can opine on the potential impact of a Trump Presidency, its policy initiatives, and ultimate impact, the degree of uncertainty around what will eventually become reality remains substantial. The Trump Economic Agenda Political candidates make plenty of promises, many of which never come to fruition. Even with the best of intentions, the reality of trying to effect change in Washington is much more difficult than making a campaign promise to do so. While President-elect Trump has put forward several principles and provided indications of the direction that he would like to take policy to boost the U.S. economy, many questions remain. Moreover, it remains to be seen whether or not Republicans will unite behind the President-elect s policies or whether some will push for moderation in the interest of controlling spending and the deficit. In the Senate, Republicans hold 52 seats, creating a majority that falls well short of the 60 required under Senate rules to break a filibuster. Consequently, the Trump administration will need to be able to find enough moderate Democrats in the Senate to strike some deals to push legislation through. On the surface, that may seem like a daunting task, but the 2018 mid-term elections will loom large. Of the 33 Senate seats up for grabs, 23 are currently held by Democrats (plus 2 held by Independents that caucus with the Democrats), with 10 of those in states that were won by President-elect Trump. Democratic incumbents in those states may feel the need to demonstrate a willingness to compromise on legislation to increase

3 3 their re-election chances. A politically pragmatic, rather than ideologically strident, stance on the part of Democratic Senators that could be vulnerable in 2018 may be the difference between some legislative wins for the President-elect and a stalemate in the Senate. Bottom line: We will all know a lot more after the first 100 days of the Trump administration. We believe that the President-elect will ultimately be successful in working with Congress to craft legislation to address his key campaign themes, although concessions may be necessary to get that legislation through the Senate. The Three Policy Pillars: Tax Reform, Infrastructure Investment, and Regulatory Reform Although the Trump policy agenda extends well beyond the three primary areas we will focus on below, these represent perhaps the most influential to the near-term economic and market outlook. From an economic perspective, the most notable absence from our more detailed comments is his stated desire to renegotiate agreements with our major trading partners. The Trans-Pacific Partnership negotiated by the Obama administration is now expected to be effectively dead, although Secretary Clinton had also taken a similar stance, so the outcome of the election mattered little to its future. At this point, it is unclear how high on the list of priorities the President-elect will place on renegotiating North American Free Trade Agreement (NAFTA) or other existing pacts. Further, the lack of specifics make it difficult to assess the nature, likelihood, or timing of any tangible changes, let alone the impact. We acknowledge that trade policy will be a major issue, but it does not appear likely to be the most urgent priority. It also has the potential to become a messy one, should negotiations break down and one or more sides dig in their heels. The rising populist movements abroad and growing skepticism about the benefits of global trade in those circles illustrate that this is not only a U.S. issue. Trade policy, perhaps more so than any of the other key economic policy initiatives, could prove to be the thorniest. However unlikely, the breakout of a temporary trade war or a more pronounced turn away from the prevailing free trade direction shared by much of the globe over many decades would be negative for not only the U.S., but the global economy. It will certainly be an area to monitor closely. Tax reform During the campaign, the President-elect made corporate tax reform one of his central themes. The applicable corporate tax rate of 35% is currently the highest in the developed economies, and compared to some, by a wide margin. Trump has proposed cutting that tax rate to 15%, which would put it among the lowest, making the case that it will improve the competitiveness of U.S.-based corporations and help to keep them here in the U.S., rather than relocating to countries with more favorable tax regimes. A vigorous debate is a certainty, as Congressional Democrats (and some Republicans) will push to close loopholes and settle for a more limited reduction in rates. A second critical component of the Trump plan is to provide relief to U.S.-based companies with accumulated profits of $3 trillion held outside of the United States. Some bipartisan support exists for a tax holiday a one-time reduction in the applicable rate that would be applied to any capital repatriated to the U.S. If successful, it would be a positive development for companies with capital earned and still held abroad, and for the U.S. economy, although the benefit is difficult to quantify. Corporations bringing capital back to the U.S. will then have to decide what to do with it: reinvest in the operations of the business to address an aging capital stock, restructure their balance sheets, reduce debt, target M&A activity, or return it to shareholders in the form of share buybacks or special dividends. The direct benefit to the economy would appear to come from the potential for increased business investment, with additional benefits coming from the wealth effect of capital being returned to shareholders, and the available tax revenue, which could be used in part to offset the cost of proposed investment in infrastructure or other spending.

4 4 Finally, it s reasonable to expect some effort to reform individual income and estate taxes. There have been some mixed messages on what form income tax reform will take. A reduction in marginal tax rates has long been expected and is a likely component of the broader package. More recently, President-elect Trump s pending nominee for Secretary of the Treasury (former Goldman Sachs Executive Steve Mnuchin) has suggested that any changes to the tax code for the wealthiest Americans would be revenue neutral. While rates would be reduced, the loss of tax revenue would be offset by other modifications that could limit deductions or other provisions that would be expected to result in no targeted reduction in taxes paid or revenue. Instead, he suggested that any net reduction in income taxes would be targeted at the middle class. Bottom line: The specifics of all three facets of tax reform remain very much in play, but the direction that the Trump administration will take is clear. Tax rates will be headed lower. Who will benefit and to what extent? Those questions will be answered in due time. Infrastructure Investment A major underpinning of Trump s growth and job creation initiatives is his proposal to invest $1 trillion on rebuilding the nation s infrastructure over the next ten years. Although the plan is still short on details, it appears to be one key policy area in which bi-partisan support for the spirit of the proposal is likely. Since the election, House Democratic leader Nancy Pelosi signaled an interest in collaborating with the Trump Administration to expedite the passage of an infrastructure bill. The devil, as the cliché goes, is in the details. How will these investments be paid for? Any specific option (raising taxes, cutting other spending, or increasing the deficit) will all be unacceptable to some group of policymakers. How big will the infrastructure bill actually be? How will those dollars be allocated? When would the spigot actually open, creating jobs and boosting growth? Those are among the many questions yet to be answered. Bottom line: It appears that the passage of a major infrastructure investment bill will be a high priority item on the legislative agenda next year, and one that economists have projected to contribute positively to growth in the latter half of 2017 and beyond. Regulatory Reform Of the three key initiatives, regulatory reform is perhaps the most difficult to evaluate at this time because of its potential breadth, the lack of specifics that have been offered to date, and the corresponding difficulty in assessing the probability of meaningful changes or the corresponding economic impact of those changes. Suffice it to say that the more noteworthy targets for potential reform Dodd-Frank and the Affordable Care Act (ACA) were broad-reaching, complex pieces of legislation. While it is a near certainty that the President-elect and Republican-controlled Congress will target both, it is highly unlikely that either will be repealed outright, since both include some provisions that still have bi-partisan appeal. Even in recent weeks, President-elect Trump has already indicated that he would stop short of pushing for a full repeal of the ACA. Instead, we anticipate that a more targeted approach will be taken to modify or eliminate certain elements of the legislation, but the details will take time to sort out. In the near-term, it is possible that President-elect Trump could address some elements of this through executive order, particularly focusing on those regulations that were put in place by his predecessor using the same tool. Such an approach would focus on matters less consequential than Dodd-Frank or the ACA, but could enable him to advance his agenda and point to some tangible steps taken to honor his campaign promises. Bottom line: President-elect Trump will attempt to advance an agenda to reduce regulation broadly and specifically target Dodd-Frank and the ACA, but an outright repeal of either looks highly unlikely.

5 5 The Impact: What These Policies Mean for the Economy and Capital Markets Impact on the Economy For the past several years, fiscal stimulus has been constrained, while monetary stimulus from the Fed in the form of exceptionally low interest rates and quantitative easing has been the primary source of stimulus for the economy. In recent years, monetary policymakers have repeatedly signaled the need to hand off responsibility to fiscal policymakers. President-elect Trump s proposed economic policies could help to fill that perceived gap and provide a boost to growth over the course of the next few years. Prior to the election, evidence of a pickup in the economy was already present. Growth in Q3 topped 3%, but the story extended beyond the headline number. For the past several years, U.S. consumers have accounted for virtually all of the growth in the economy, while lackluster business investment and more austere government spending have contributed comparatively little. That changed in Q3, as consumer spending growth remained positive, but cooled. At the same time, the picture brightened for business investment, net exports, and federal government spending. Any forecast of the direct impact of the Trump economic agenda requires significant assumptions, starting with the ultimate terms that any legislation would include. Estimates vary, but most economists point to a modest increase in GDP in 2017, with the greater positive effects coming in 2018, perhaps topping 1% to top-line growth. However, the range of potential outcomes are exceptionally wide. Even President-elect Trump s own campaign pledge for infrastructure spending ranged from $550 billion to $1 trillion, with the potential that even the low end may have trouble clearing Congress. The specifics around tax and regulatory reform are even murkier, arguably requiring any forecast to be subject to a wide range of potential outcomes. Finally, while many economists are projecting a positive growth impulse from the expected fiscal stimulus as early as late next year, the longer-term impact is less clear. Tax cuts typically provide a boost in the near term and the beneficiaries of the savings have additional capital for spending. Conversely, targeted deregulation can have a longer-lasting positive effect, easing the cost and burden on the impacted businesses. The hope, in part, is that stronger growth will compensate for at least a portion of the rate cuts and mitigate to some degree the impact on the federal deficit, all else being equal. Whether that expectation will be met remains to be seen, and some economists have forecast that higher deficits could be a negative for credit markets, will raise interest rates, and weigh on long-term growth. Bottom Line: The pro-growth Trump agenda of corporate and individual tax reform, infrastructure investment, and regulatory reform all appear likely to provide some near-term boost to economic growth in the United States, although any quantitative forecast is subject to a high degree of uncertainty. The long-term impact is less clear. Impact on fixed income markets In the immediate aftermath of the election, long-term interest rates moved sharply higher. The yield on the ten-year Treasury was 1.88% at the close on November 8, but by the end of the next day, it had moved up to 2.07%. In the weeks that followed, that general trend higher continued, with the ten-year Treasury yield now near 2.60%. On the back of stronger economic data, tightening labor market conditions that have pushed the economy into the full employment range, and a variety of reflationary tailwinds, including higher energy costs, rising wage pressures, and stabilizing import prices, the Fed already appeared poised to raise the funds rate by a quarter point in December. When the Trump victory became clear, the futures market pointed to an even higher probability of a rate hike not surprisingly under the assumptions outlined above. Stronger growth and job creation catalyzed by fiscal stimulus and additional inflation as a result would all be expected to nudge the Fed to move sooner rather than later.

6 6 Moreover, inflation expectations have also moved notably higher in the post-election period. Five-year and ten-year breakeven inflation (when comparing nominal Treasuries and Treasury Inflation Protected Securities) surged by twenty to thirty basis points ( %) a significant move in such a short timeframe. The shortend of the yield curve tends to be highly correlated by changes in the Fed s policy rate. Long-term yields, however, are established by market forces, and are influenced by a host of factors, with long-term growth and current and expected future inflation (and changes in both) having a critical impact on rates. As those moved higher, long-term rates moved in tandem. Even before the election, inflation expectations were creeping upward as labor markets tightened and the economy reached full employment. The addition of fiscal stimulus in the form of infrastructure spending and tax cuts has been projected to further boost growth into 2017 and Further tightening of labor market conditions, rising energy costs, and stronger growth would all be reflationary, although some relief could come from productivity gains. Dollar strength could help at the margins by keeping a lid on import prices. In totality, however, most signs point to higher inflation ahead. One year after the Fed raised short-term rates for the first time in nearly a decade, the central bank took another 0.25% last week as widely expected. The Fed s published expectations call for three additional rate hikes next year, taking the target Fed funds rate to %. This assumes that the Fed s projections for GDP growth (2.1%), the unemployment rate (4.5%), and personal consumption expenditures (PCE) inflation (1.9%) are met. Should growth and inflation accelerate and the jobless rate decline more than they expect, as many economists are now projecting, the Fed may be pushed to tighten more quickly than it is currently forecasting. Fixed income investors may be concerned about the impact of rising Treasury yields on bond prices. Rising rates are a negative for bond performance as it is happening. However, over the long-term, higher rates will improve the returns of bond investors in the form of higher income. The transitionary period can be difficult, but the long-term benefit is real. Certain sectors of the bond market may provide some protection to investors against interest rate risk. Mortgages, high quality corporates, and high yield are sectors that typically pay a higher yield and thus can buffer against higher rates. Maintaining a duration positioning below that of a portfolio benchmark can also provide some incremental protection on a relative basis. Perhaps most importantly, even in a rising rate scenario, bonds can serve as an effective diversifier to a portfolio of stocks, reduce portfolio volatility, and provide a source of income. Bottom Line: With the Fed expected to raise rates another three times in 2017, short-term interest rates appear likely to edge higher after being stuck near zero since Market forces have started to push longterm rates higher as well on the back of rising inflation expectations and optimism that fiscal stimulus will drive stronger economic growth in the U.S. As the yield curve moves upward, interest rate risk could create a headwind to the performance of already low-yielding Treasury securities. Impact on equity markets The policies that President-elect Trump has put forward as critical elements of his domestic economic agenda are expected to be pro-growth and thus positive for stocks. Given the tepid trend growth of about 2% annually since the expansion began in 2009, fiscal stimulus in the form of infrastructure spending, corporate tax cuts, and targeted individual income tax cuts should if ultimately implemented provide a much-needed shot in the arm to growth. Unsurprisingly, equities should be supported by stronger nominal growth (real growth plus inflation), which should support stronger corporate revenue and earnings growth. The Global View Over the long-term (typically defined as a market cycle or longer), equity market returns tend to be driven by just a few key fundamentals:

7 7 Revenue growth (which correlates strongly to nominal economic growth) Profit margins expanding margins contribute positively to earnings while contracting margins put a ceiling on profit growth Dividend yields the cash flow paid out to investors holding the stock, and Contraction or expansion of the price/earnings (P/E) ratio a rising P/E ratio boosts the return to investors, while a falling P/E reduces the return Over shorter periods, the greatest effect on stock prices tends to come from contraction or expansion of the P/E ratio, as investors react to the daily flood of information about the global economy, monetary and fiscal policy, corporate fundamentals, and exogenous events long before these factors affect dividends, revenue, or profit margins of companies. In the aftermath of the election, the expected shift in policy direction also caused equity markets to recalibrate expectations related to several specific factors that are expected to influence equity market returns over the next few years, assuming that the President-elect is successful in adopting the policies that have been proposed. These include: Stronger economic growth Fiscal stimulus through tax cuts and increased government spending are projected to provide a temporary boost to growth that could extend out through Rising inflation With inflation already showing signs of picking up, stronger economic activity and tighter labor markets are likely to push inflation higher as well. Tighter monetary policy The Fed appears positioned to accelerate the pace of rate increases, although rates are likely to remain supportive for some time to come. A continuation of the dollar bull market Stronger growth coupled with higher inflation and interest rates, particularly against a backdrop of limited growth, monetary easing, and low (or negative) interest rates outside the U.S. may support further dollar strength for longer than previously anticipated. Broadly, these factors could favor U.S. equity markets over foreign markets and smaller companies over larger companies over the intermediate term. From a capitalization perspective, a continuation of the cyclical strengthening of the dollar relative to other major currencies is a factor that should not be overlooked. The direct effect of a stronger dollar is that it makes foreign goods cheaper for U.S. consumers, while making goods produced in the U.S. more expensive for foreign buyers. From the perspective of a U.S.-based investor, a strengthening dollar affects the outlook for global equities in a few different ways: Impact on foreign-sourced revenue and earnings for U.S. companies As the dollar strengthens, U.S. companies that operate in foreign markets will experience weaker earnings growth in dollar terms. Impact on performance of international equities A strengthening dollar directly reduces the return on foreign stocks for U.S. investors. For example, if Japanese stocks return 3% in local (yen) terms, but the dollar strengthens by 2% during the same period, U.S.-based investors will achieve a net return of just 1%. When the dollar rallies, there is a direct negative impact on the returns of both foreign developed and emerging market stocks, but the effect of a stronger greenback on equity investors doesn t end there. Today, S&P 500 companies as a whole derive substantial revenue (estimated at about 44%) from outside the United States. The stronger dollar has contributed to the softening in both revenue and earnings growth for U.S. multinationals in recent years, and could present a continued challenge moving forward. A dollar headwind isn t universally negative for all equities; in fact, it could be a relative boost for small company domestic stocks. Because so many small U.S. companies are predominantly focused on a domestic customer base, they are not as likely to be affected by a strengthening dollar. As such, small caps are likely to be better positioned to defend their bottom line if the greenback continues to strengthen over time. This has the potential to be particularly beneficial if domestic economic growth accelerates while other major

8 8 economies muddle along. That additional boost to revenue and earnings will be magnified for companies operating predominantly in the U.S. Bottom Line: A stronger U.S. economy should provide a more favorable backdrop for corporate America. While rising interest rates could at the margins raise the cost of debt capital, periods of slowly rising interest rates accompanied by moderate growth have typically provided favorable conditions for U.S. equities. The potential for a continuation of the strong dollar trend and stronger relative growth in the U.S. creates an environment that may favor domestic stocks over foreign equities, and small companies over the large cap multinationals. Conclusion Until the evening of November 8, the June Brexit vote in the UK seemed like a lock to be the surprise global political development of The outcome of the Presidential election, however, may have Trumped that. Equally surprising was the rally in stocks that followed, in stark contrast to expectations for a more volatile path for equities should Mr. Trump emerge the winner. It is a great reminder of the challenges associated with forecasting, particularly when the range of outcomes as is the case with the specific policies related to tax reform, stimulus spending, and regulatory overhaul are so broad. No one including those in Washington can say with certainty what will be contained in the legislation that will be proposed, negotiated, adjusted, amended, and ultimately passed on to the President for his signature. Nonetheless, the overall direction of policy in the next administration is relatively clear. The questions revolve around the specifics of what the President and Congress will be able to agree to and implement. Disclosures Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree. Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.