Donald Trump Wins!

There is an old saying on wall street “that nobody rings a bell at the top or the bottom of a market”. With the surprise Trump victory it's almost like the bell has rung as we are witnessing one of the most significant market pivots in history. Irrespective of your personal thoughts of President-elect Trumps environmental policies, his attitudes to women and minorities and his behaving like a bully, the recent election is positive for the US stocks.

President-elect Trump promises to lower taxes and reduce the regulatory burden on companies. The hope is that these actions will boast economic growth and unleash pent up consumer demand. Trump has reinforced his commitment to reducing regulations with his initial cabinet choices. Selecting Rex Tillerson as Secretary of State, former Texas governor Rick Perry as Energy Secretary and Oklahoma attorney general Scott Pruitt as head of the EPA signal a friendlier regulatory environment. Strategas Research estimates that there is $48 billion in energy projects languishing due to environmental concerns. These projects should now move more quickly through the approval process.

The banking industry has also faced a progressively onerous regulatory burden as it has been sued for both real and imagined misdeeds. With the US government continuing to levy fines on the banks, banks are effectively being treated as the governments piggy bank. This has become an expensive cost in the financial sector. The government has sued J.P. Morgan for the errors of Bear Stearns, after J.P. Morgan rescued Bear Stearns at the behest of the government and immunized (from lawsuits like this) J.P. Morgan for the violations of Bear Stearns that preceded the rescue. Regulatory over reach has resulted in banks reducing their balance sheet risk by not making loans thereby limiting their typical role of financing economic growth.

The Dodd frank bill of 2010 as originally envisioned was supposed to be a six-page document. It was passed as a 2,000 plus page law with few people having read it prior to its passage. This law has fuelled growth in non-productive (from an earnings perspective) compliance departments. The newCommerce and Treasury secretaries are more pro-business and less ideological than their predecessors. Even if the new government does not reverse President Obama's executive orders, the psychology has shifted as banks will be less fearful of doing the wrong things.

Blackrock’s CEO Schwartzman says that the Trump administration will usher in the most profound regulatory and tax changes that he's seen in 45 years. He says “the changes as a result (of the election) are going to be very substantial in many areas, but particularly in the business community and the financial area. You’re going to have a very substantial reversal in regulations of all types… if you look at the architecture of the financial world, it’s going to change substantially…this is as big a change happening all at once. I’ve been in finance for, I don’t know, 45 years? This will be the biggest. When you have changes like this that are so profound, it’s going to drive higher GDP. It’s going to make the US a friendlier place for foreign capital. And it’s going to have significantly accelerated growth not just for the financial institutions but for the country as a whole. So, this is like very important. It’s very important. And it’s not just about some stocks for financial companies, although that would be a nice thing. It’s much bigger and more impactful over a much longer period of time.”

The US election provided more surprises than just Trump winning the presidency. As expected, the Republicans (GOP) retained their majority in the house but the big surprise was their maintaining
more than half of the seats in the Senate. The GOP senate majority is not filibuster proof, meaning the GOP will need to get some Democratic votes to enact legislation. This should not be arduous if the GOP understands that the key to constructive government and passing sustainable legislation is negotiation and compromise.

One of the meaningful changes that is rarely discussed is the transition in the senate leadership. Harry Reid, the outgoing senate minority leader was an obstructionist, “my way or the highway” type of guy. He was replaced by Chuck Schumer, who is more open to negotiations and getting things done when the two parties are generally in agreement (like tax reform).

During the recent election, the Republicans had the most at risk senators up for re-election. In two years’ time, it will be the democrats who will be most vulnerable to losing seats. (As senators terms are six years, they only run every six years, meaning that only 1/3 of sitting senators are running to retain their seat during an election cycle). The Democrats cannot afford to be obstructionist as the Republican's might pick up enough seats to have a 60 seat, filibuster proof majority. One of the big issues Democrats had in the last election was that Harry Reid brought so few bills to the senate floor for a vote. Democratic senators in swing states were not able to vote on important local issues and demonstrate to voters how their views were differentiated from the leadership of the party.

President-elect Trump will be a president like no other. While President Obama had his blackberry, Trump has his twitter account. This allows him to berate company managements (United Technologies, Ford) or negotiate in public (Boing or Lockheed Martin). We have also seen that the President-elects’s policies can be fluid. This will increase volatility as stock market movements can now be triggered by presidential tweets and increased policy uncertainty.

GDP growth has averaged only 2% during the Obama presidency. The economy is in year eight of a tepid expansion and there is currently no obvious reason to expect an expansion ending recession. The economic cycle has not been overly robust, but it is enduring. Growth should accelerate in 2017, due to lower taxes and a pro-growth environment.

President-elect Trump has discussed corporate tax reform as a primary goal for 2017. There is a high probability this will happen as both parties have agreed it’s a priority. Trump has discussed a 15% rate, while the house GOP plan is closer to a 20% rate. Assuming the new rate is closer to the house version, this would translate into an almost 10% boost to corporate earnings. Repatriation of foreign earnings, increased defense spending and deregulation (especially in banking, energy and healthcare) would all be additive to earnings.

Equity upside will be linked to improving earnings. Current policy neutral earnings (meaning we do not consider potential economic, taxation or regulatory policy changes due to Trump’s victory) growth for 2017 is forecasted to be 6 – 8%. This assumes accelerating revenue growth, neutral margins, and continued stock buy backs. Stocks are not cheap, especially with the move since the election. If the Republicans are successful in making a fraction of their proposed changes, we would expect acceleration in economic growth and corporate earnings. On this basis, the stock market will appear cheap fuelling another increase in stock prices.

The caveat to this rosy scenario is if President-elect Trump is not successful in passing his pro-growth agenda. Growth would then continue along at its recent tepid pace and the stock market would languish at current levels. While both parties have incentives to move proposed legislation forward, passage of these changes is not guaranteed.

While pro-growth policies are positive for US equity markets, they are bearish for bonds. Since the election, there have been record outflows out of bonds into equities. The interest rate on the ten Year US Government bond has risen almost 1.0%. The Federal Reserve Board is discussing two to four interest rate increases in 2017. For the first time since the great recession, investors believe that there is a high probability that this will occur.

Here in Canada, economists continue to forecast an anemic expansion (sub 2%). There are few expectations that the Bank of Canada will raise short term interest rates during 2017. Rates for five and ten-year Canadian government bonds have recently increased, but that is in response to the rate increases seen for similar maturities in US bonds. As US rates increase, Canadian mid to long term bond rates (which are set by the market and not by the Bank of Canada) should also continue to rise. This does not auger well for bond returns in 2017. We have already seen the negative effects rising rates have on bonds, with Canadian bond returns being negative for the latter half of 2016. Bond coupons were not high enough to offset the decline in bond prices due to the rise in rates.

With US economic growth accelerating, and the expected increase in both earnings and interest
rates, we continue to prefer equities over bonds. Those bonds that clients hold are short term in nature and not materially impacted by the recent rise in rates. US equities overall should perform better than Canadian stocks due to better growth dynamics. We expect a heightened level of volatility due to elevated valuations, the uncertainty related to the passage of the new administrations pro-growth agenda and the President-elect being more unpredictable than any preceding president.

Contact us to discuss how to navigate the opportunities and pitfalls.