Eye on the Market

Orange is the New Tack: domestic and foreign policy implications of President Trump

by Michael Cembalest
Chairman of Market and Investment Strategy
Nov 10, 2016

I’m not a sailor but am familiar with “tacking”, which is when you maneuver a boat through stiff winds.  A decisive number of US voters have tacked in a different direction: away from unfettered free trade and open borders, with demands that gains from globalization be more evenly shared.  Some explanations for Trump’s Midwestern victories are ascribed to dark thoughts in the American psyche, but to me the economic data is the more powerful one.  As shown below, the post-war “labor vs capital” balance was blown apart by China’s entry into the World Trade Organization1, and accompanied by accelerating losses of manufacturing jobs, something I first wrote about in December 2012.

Where to from here? For investors, there’s uncertainty since for the first time in the history of the republic, the President has no prior experience in governing or in military leadership. In this Eye on the Market, we walk through initiatives that Trump may pursue, based on his speeches and published materials (some of which were vague).  The general theme: increased government spending, lower taxes and a rollback in the pace of government regulation.  It’s a pro-growth agenda, with the primary risk that higher interest rates from deficit spending and rising tariffs derail it.  As a reminder, this note is about our role as money managers at a time of a Trump Presidency, and is not about the man himself or his campaign.

We conclude with a geo-political issue Trump will face: the interconnection of Syrian emigration, European politics and the unraveling of the US-Russia relationship, with observations from a conference we held in Paris with two former US Secretaries of State.

In the interest of brevity, some of this week’s charts are linked; just click on the highlighted, underlined text to see them.

TRADE

While the President has unilateral ability in general terms to withdraw from trade agreements, each trade deal has an “authorization trigger” which has to be hit first.  Examples: large balance of payments deficits, war and national emergencies.  The weakest trigger by far applies to NAFTA, which Trump has already promised to leave or renegotiate. Trump’s election comes at a time of all-time lows in global tariffs, a rise in trade protectionism and a global economy in which trade peaked in 2010.  This is potentially the most disruptive part of Trump’s agenda for global markets, and both the US economy and multinational companies could experience slower growth if a trade war erupts.  One example: a full-blown trade war could cost the US 5.0 million jobs by 2019, according to the Peterson Institute.

There might be room for Trump to claim victory on trade by simply terminating TPP discussions and trying to negotiate better deals with existing trading partners, without actually withdrawing the US from an existing treaty.  However, I’m not as sanguine as those who believe that Trump will be completely constrained by Congress on trade; I expect him to act on his mandate (promises to label China as a currency manipulator, impose import tariffs on goods from China/Mexico and impose US content requirements on consumer electronics), which could result in higher inflation and higher interest rates by the mid-term elections.

TAXES

Trump’s intention to lower personal and corporate tax rates is another controversial part of his platform.  Most economists agree that tax cuts help growth, but do not believe that tax cuts pay for themselves (i.e., tax revenues from higher growth do not offset the loss in revenue from lower tax rates).  The Tax Policy Center and the Tax Foundation came to similar conclusions regarding the impact of Trump‘s plan on the deficit: a massive increase of $6 trillion over ten years, and a new all-time high in the US Federal debt/GDP ratio (even above WWII levels).  Possible result: much higher interest rates and another spike in the dollar, which could hurt manufacturing and result in another US debt ratings downgrade.

GOP members in Congress may end up in conflict with the administration, since stated GOP policy is that tax changes must be deficit-neutral (or maybe this is a policy that the GOP only applies when Democrats are in charge?)  Our best guess is that some tax cuts occur, but not to levels Trump outlined during his campaign.  Note that if US corporate tax rates were reduced closer to international levels2, the pace of US “tax inversions” would probably slow as well, since the gap is what drives them.

INFRASTRUCTURE and DEFENSE

The topic that the GOP and Democrats agreed most on during the campaign was the need for greater infrastructure, and the idea of paying for it through a “deemed repatriation” tax on accumulated, untaxed offshore corporate profits.  For the S&P 500, such profits are estimated at $2.4 trillion.  Clinton’s plan was designed to raise $250 billion (implying a 10% deemed repatriation tax), so it’s unlikely that repatriation taxes alone could generate Trump’s target of $1 trillion.  Trump claims that his infrastructure plan is revenue-neutral since projects would be done through public-private partnerships and direct private investment.  One example of the latter could be energy infrastructure from the expansion of oil and natural gas pipelines.  There’s no way of knowing how much money will end up being spent, and some Senate GOP leaders have already described it as not being a major priority, but infrastructure spending is probably the clearest bipartisan winner in 2017 and beyond. From a growth perspective, this is helpful; according to CBO data, fiscal multipliers from direct purchases of goods and services by the government and infrastructure have the highest growth multipliers (e.g., much higher than tax cuts).

Trump also has aggressive plans to grow the Air Force (+59%), Marine Corps (+50%), Navy (+29%) and Army (+14%).  Trump claims that he will pay for this by eliminating incorrect payments, reducing duplicative bureaucracy, collecting unpaid taxes, etc.  But I cannot remember a single instance in history when programs were actually funded in this manner.  The implication: a spend-now, figure-it-out-later approach could increase the deficit by even more than his tax cuts already would.  Would Trump pay for part of this increase by requiring NATO countries spending well below agreed-upon targets to make payments to the US?  I’m not holding my breath.

HEALTHCARE

The decline in the number of uninsured individuals is what the Affordable Care Act was aiming for.  But given rising premiums, rising deductibles and falling insurer participation on state exchanges, the ACA reminds me of the wobbling equilibrium of the Tacoma Narrows Bridge.  Proposed “fixes” I have heard for the ACA are not comprehensive enough to change these dynamics, unless the premium differential guidelines (a core part of the ACA) were substantially changed.

Trump and the GOP want to repeal the ACA, but they’ll need another plan first.  Trump has discussed health savings accounts, interstate insurer competition and state grants as the building blocks in a new system.  Assuming Trump and the GOP craft this into a viable replacement, how would they try and repeal ACA?  A standard Senate repeal would require a filibuster-proof 60 votes. However, if the House and Senate pass a budget resolution that includes “reconciliation” instructions to produce healthcare legislation that is revenue-neutral, the House and Senate could consider legislation that would be protected against filibuster rules in the Senate, and only a simple majority would be needed. 

For anyone surprised at the undying vigor with which the GOP is opposing the ACA, consider this.  In 2013, we looked at major legislation since the early 1900’s and computed the partisanship gap between both parties in both houses of Congress.  The Affordable Care Act had the greatest partisanship gap in history, which in retrospect is the “Original Sin” of the Act.  Without any support from the opposing party, the bill was always subject to repeal when/if the GOP controlled the legislative and executive branches of government.

Even if the ACA were not repealed, there are benefits for parts of the healthcare sector from a Trump presidency.  In the wake of Turing’s price increase on Daraprim, biotech stocks plummeted since Clinton indicated that she would create a drug pricing oversight committee with the ability to impose fines, accelerate FDA generic approvals and approve emergency imports.  Trump has also talked about fostering more competition by clearing the FDA backlog (in 2015, pending FDA approvals were 9x the rate of actual approvals), and there is bipartisan concern about drug price increases.  Even so, the sector will likely recover some of what was lost in the prior couple of years now that biotech valuations have converged to large cap pharma, and since healthcare valuations are close to the lowest levels since 1990.

ENERGY

Climate change will take a back seat to growth and the goal of energy independence in a Trump administration. But while Trump might jump-start offshore and arctic drilling, neither will eliminate the US net crude oil deficit.  The US produces and imports around 8 million barrels per day of oil, and if anything, the oil price decline has driven up imports at the expense of domestic production.  Our October 18 Eye on the Market went into more detail on the US energy deficit.

The big debate will be about coal.  To be clear, there’s no such thing as “clean coal”, since carbon capture and storage does not exist in any meaningful way as a commercially available technology.  EPA rules may be relaxed in order to slow coal’s decline, but the transition from coal to gas will probably continue.  The other EPA issue to watch: hydraulic fracturing.  While scientists continue to accumulate evidence demonstrating the need for improved treatment of above-ground wastewater from hydraulic fracturing, the EPA has taken a more benign view.  In June 2015, the EPA concluded that while there are mechanisms through which fracturing can impact groundwater, they could not find evidence of widespread, systemic impacts; while they did find instances of contamination, they were reportedly small compared to the number of hydraulically fractured wells.  Trump’s EPA will almost certainly emphasize these findings, even though the EPA’s own advisory board had some reservations about them.

FINANCIALS

While the regulatory oversight on banks may lighten, the largest factor driving bank stocks higher has to do with expectations of higher interest rates.  From 1929 to 2008, bank stocks were positively correlated with US Treasuries.  Starting in 2009 with the Fed’s monetary policy experiment, these correlations turned negative, and by 2013, they had reached -80% (e.g., rates rally, banks stocks fall).  With the prospect of higher interest rates, the net interest income dynamics latent in bank balance sheets could resurface, and right now, bank valuations are on the low side at around 1.0x book value.   Conversely, I’m adding “bond proxy stocks” to the endangered species list, given their high valuations and the eventual likelihood of higher interest rates.  Clearly, domestic growth stocks should also benefit vs value stocks.

THE BIG PICTURE: FROM MONETARY EXPERIMENT TO FISCAL EXPERIMENT

We have just lived through an unprecedented monetary policy experiment which drove up financial asset prices, but whose contributions to median household income were more modest.  The Trump version: forget about monetary policy, cut taxes, spend more, slow the pace of regulation, protect US workers with tariffs and watch the economy soar.  In the short term, it’s a market friendly policy if adopted in moderationBut moderation is not something I generally associate with Trump, who is untested and whose party controls both chambers.

We’ll be watching long-term interest rates, since that will be the ultimate arbiter of whether Trump goes too far on government spending or protectionist trade policy. The quality and perceived competence of Trump cabinet appointments may also have a substantial impact on how financial markets respond to his administration’s policies.

All things considered, the election doesn’t radically alter the market environment we had anticipated all year: mid-single digit returns on diversified portfolios at a time of low GDP and corporate profits growth:

  • Q3 revenues and earnings growing at 1%-2% in both the US and Europe (a little better ex-energy).  We expect mid-single digit earnings growth in 2017 as dollar/oil impacts fade. Depending on the degree of corporate tax cuts and deficit spending, earnings growth could rise further by late 2017
  • Rising US wage inflation that may force the Fed to tighten faster than what’s priced in (markets are assuming only 3 Fed hikes by the end of 2018); in addition to rising wages, the most recent BLS data show a record low in layoffs and a high level of job openings
  • A modest recovery in China fueled by substantial stimulus
  • A recent pick-up in global business activity that points to 3% global GDP growth

What about a Clinton Presidency?

The outcome was a surprise to me, and in all candor, I had first prepared a Clinton victory Eye on the Market.  That document welcomed presumed continuity for markets, but also wondered about the following: how would a Clinton administration deliver a positive jolt to an aging, highly indebted US economy that has lost its productivity mojo, and whose entitlement payments consume a greater and greater share of government spending?  Clinton’s agenda included high frequency trading fees and risk fees on financial institutions; a drug pricing oversight committee; regulations on a variety of niche for-profit industries; Federal support for labeling guidelines and soda/sugar taxes; further Medicaid expansion; new regulations on paid leave; revised energy efficiency and extraction standards; and expansion of insurance coverage requirements. 

While each has its merits, there’s an unmistakable theme: continued expansion of the regulatory footprint of the Federal Government.  Compared to Bill Clinton and George W. Bush, the pace of Obama regulation was considerably faster, a trend which has been affecting small business, and which Hillary Clinton appeared poised to maintain. In the piece, I struggled to connect these initiatives with a rebound in growth.

TRUMP’S FIRST FOREIGN POLICY TEST: SYRIA, RUSSIA and THE STABILITY OF EUROPE

For investors, one potential landmine is a dramatic change in Europe’s political landscape just as the continent is finally posting positive growth again.  Why would anti-establishment parties be rising when its economy is improving?  At our JP Morgan Asset Management Global Investor Summit and International Council meetings in October, we discussed this issue at two client sessions, one with Condoleezza Rice and the other with Henry Kissinger.  The charts below are a synopsis of those discussions.  Like Harold Pinter’s play Betrayal, this story is best told backwards; starting with what’s happening now, and finding our way back to root causes.

Why is this happening now? And will Trump’s election amplify the confidence of such parties that a global anti-establishment movement will continue?

The rise in anti-establishment parties can be traced to low economic growth in Europe, but also to the growth in asylum-seekers and illegal migration, and concerns about terrorism.

The spike in asylum seekers can be traced to the war in Syria.  While local combatants have inflicted a lot of damage, the recent involvement of Russia has arguably worsened the situation for many civilians.  As shown, Syrian civilian casualties from Russian bombings are now roughly equal to ISIS inflicted casualties.

Why wasn’t Europe prepared to act more aggressively to counteract Russian involvement in Syria, given the impact of Russia’s involvement on Europe itself?  One answer: the gradual disarmament of Europe.

A second answer: weak growth in Europe (some of which can be traced to the adoption of the Euro itself), which detracts from its ability and willingness to meet NATO spending targets.

The third answer: growing European reliance on Russia for its energy needs (the chart incorporates both crude oil and natural gas), a stark contrast to the 1980’s when Europe produced more than 3x the amount of oil and gas imported from Russia.  Absent expanded European gas production and/or a shift from Russian pipeline imports to more expensive LNG imports from the US/Australia, European reliance on Russian energy will probably grow in the decade ahead.

Without sufficient economic or political leverage, Europe and the West have essentially acted as shock absorbers to Russian involvement in Syria.  There’s a line of thinking that goes something like this: if we do not have leverage, the next best option is a better working relationship with Russia, with the West’s best interests at heart [oddly enough, a generous read of Trump’s view on Russia could be interpreted this way].  At our conference, there was disagreement on this issue that involved the history of Russia and the West, the impact of the Iraq War on US willingness to use military force3, and the costs/benefits of NATO expansion to Russia’s borders.

Either way, both Secretaries of State agreed that the facts on the ground have eroded to Europe’s detriment, and that more European election surprises lay ahead. While Trump’s election may be bullish for US equities in the near term, it may be bearish for Europe, since if his success translates into more success for anti-establishment parties, that could raise the spectre of a disruptive dismantling of the Eurozone itself. These parties are also generally not in favor of the kind of deregulation and tax cuts proposed by Trump.

One last item.  Since August 2016, we have been posting brief updates on LinkedIn.  In case you want to see a recent history, refer to the posts below.

11/2/2016:    Why voter clustering matters and the battle for the House
10/26/2016: Electric cars: a 1% solution?  (with commentary on renewable energy)
10/12/2016: The tell-tale heart of the Buffett Rule
10/5/2016:    After the fall, own some emerging markets
9/28/2016:    Presidential debate chart-watch
9/21/2016:    The distant meteor of unfunded pensions
9/14/2016:    War on savers retirement kit
9/7/2016:      Worst moments from the Party conventions
8/30/2016:    China’s environmental mess
8/25/2016:    The high price of bond-like stocks
8/23/2016:    The limited impact of geopolitics on markets

Michael Cembalest
J.P. Morgan Asset Management

Acronyms: ACA Affordable Care Act; EPA Environmental Protection Agency; FDA Food and Drug Administration; LNG Liquefied natural gas; NAFTA North American Free Trade Agreement; TARP Troubled Asset Relief Program; TPP Trans Pacific Partnership; WTO World Trade Organization

1 Automation played a role as well, but after reading both sides of the debate, I find the trade argument more convincing given the suddenness of the decline in labor’s share of profits and in manufacturing employment.  In the Autor/Dorn/Hanson paper (MIT), detailed maps showing counties exposed to Chinese competition do a good job of explaining why Trump did unexpectedly well in North Carolina, Wisconsin, Ohio, Pennsylvania and Minnesota.

2 Based on an analysis we reviewed in 2014, effective US corporate tax rates (i.e., after taking deductions and offsets into account) are the highest in the OECD.

3 One of the saddest charts in the history of the Eye on the Market: a chart from December 2015 showing the $2 trillion cost of the Iraq War, money that could have solved two of the challenges mentioned in the 2016 Presidential campaign: US infrastructure needs, or free college tuition for a generation of college-bound students.

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