What effects might the incoming administration of President Donald Trump have on portfolios going forward? Having had time to digest the 2016 U.S. Presidential election results, markets have reacted and may be showing some signs of what could be anticipated in the near future. However, in addition to market movements, there are other mitigating factors that advisors and their clients should consider as they contemplate President Trump’s potential influence on capital markets.
Caution: Growth Indicators
It looks as though many investors believe that a Republican White House under Trump – with both houses of Congress also under Republican Party control – could be a boon for U.S. growth, driven by a large infrastructure spending program and tax cuts for individuals and corporations. On the other hand, huge tax cuts and increased government spending without other fiscal offsets could increase the budget deficit. By extension, stronger growth coupled with larger deficits may stoke inflationary fears. As if on cue, pro-cyclical stocks have rallied and break-even inflation rates1 skyrocketed after the election.
Nonetheless, a word of caution may be in order, as investors could be overestimating the potential effects of tax cuts and infrastructure spending. The wheels of fiscal policy turn rather slowly and straight-line projections ignore how other agents may react. Will U.S. economic growth turn marginally higher? It is possible – but there are mitigating factors.
Reflections on Trump the Builder
Let’s start with infrastructure spending. First, while many expect it to be high on both the presidential and Congressional agendas, a bill/law may not be ready until mid-year. Second, as is often noted, there are very few “shovel-ready” projects. Projects have to be designed and approved, so little will likely be spent next year, with most of the fiscal boost potentially coming in 2018–19. Third, conservative Republicans may seek to limit the size of any spending package given its likely deficit implications. Fourth, if a spending package materially widens the deficit, higher interest rates are likely to follow, which could counteract the stimulus to some degree.
Finally, and most importantly, simply throwing taxpayer dollars at projects may only provide a temporary boost to growth. Spending money on projects that do not have the potential to boost productivity can increase the risk of creating only temporary employment gains instead of lasting economic growth.
Accounting for Tax Breaks – for Whom?
On the tax side, lower income taxes could boost consumption. Yet Trump’s proposed cuts have thus far focused on the wealthy, who typically have a lower marginal propensity to consume. That’s a fancy way of saying that lower- and middle-class consumers spend virtually all their tax cuts while the wealthy tend to save a higher portion of them. In addition, lower corporate tax rates could mean that companies would be able to distribute more cash flows to investors – and maybe even workers – to spend. Tax cuts for corporations could also allow for greater capital reinvestment.
Potential Portfolio Implications
It is important to remember that while any tax cut or government spending proposals introduced by President Trump could boost growth — newer, more stringent U.S. immigration policies or policies that significantly alter existing U.S. trade relations with China and Mexico could damage it.
Yields on federal government bonds have gone up since the election, putting stress on bonds of all types as bond prices fall when yields rise. There is some worry that lower tax brackets will reduce the appeal of municipal bonds, but even at lower tax rates we believe the yield after taxes remains compelling. Meanwhile, corporate bonds could benefit from strong growth and/or somewhat higher inflation.
The outlook for modestly stronger U.S. growth argues for continued but slow improvement in corporate earnings. The longer-term outlook for U.S. stocks could be better if an infrastructure plan or corporate tax change yields meaningful productivity gains.
Valuations are a bit elevated in many cases, limiting the upside potential for stocks. In this environment, we believe that small-to-mid-cap stocks may be more attractive than large-caps over the near term as they have less sensitivity to changes in trade policy and the value of the U.S. dollar (USD).
Stocks overseas exhibit many of the same characteristics as U.S. stocks, driven by a slowly improving macroeconomic picture against somewhat elevated valuations – assuming no outbreak of trade wars or other significant market event. The performance of international equities is likely to be volatile and country-specific, varying by trade policy moving forward.
It remains to be seen whether or not recent growth trends continue in the months ahead. The potential for interest rate changes and increased volatility reiterates the importance of an investment process that puts risk first. Instead of attempting to package up the best performance, advisors have an opportunity to help clients manage risk and seek solutions that can meet their unique investment needs. An approach to portfolio construction that considers a variety of potential market conditions can help take the emotion out of investment decisions and may achieve better long-term results.
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1 Break-even inflation refers to the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of a similar maturity and credit quality.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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Discussing the potential policies and politics of President Trump and the GOP-controlled Congress.
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