The Bull Market Should Survive Trump’s Healthcare Failure

April, 2017
S&P 500: 2363

OUTLOOK MEMORANDUM
The Bull Market Should Survive Trump’s Healthcare Failure

Investors have bid up the S&P 500 by 10% since the election partly in anticipation that President Trump’s agenda of tax cuts, deregulation, infrastructure spending, and reforming healthcare will result in a healthier, higher growth, and more profitable economy for U.S. companies. The Republicans’ dramatic failure in lateMarch to replace the Affordable Care Act caused stock prices to weaken as investors reassessed the prospects for the rest of the Trump agenda. We think it is important to understand that the current leg of this bull market in U.S. and other global stock markets began in early-2016, well before the election, as the 2014-2015 period of deflation fear was replaced with expectations of a new reflation cycle. While Trump’s election increased investor confidence in the new reflation trend, the trend is unlikely to reverse even if Trump continues to have difficulties enacting his program. Liquidity continues to be favorable, the Leading Economic Indicators are strong, and both consumer and business confidence are at multi-year highs globally. Moreover, while the Trump healthcare defeat was damaging, his failure makes it imperative that the Republicans enact the rest of his economic program if they wish to continue governing.

Since election day, the S&P 500 has risen by 10%. As we anticipated in our January Outlook, much of this advance has reflected investor optimism that economic growth, middle class incomes, and corporate profits would benefit from the new Administration’s program of tax reduction, deregulation, fiscal stimulus, and healthcare reform. We think most investors recognized that an energized Democratic opposition and a Republican party that was far from unified would pose many challenges to translating Trump’s program into legislative reality. This is why we wrote in our January Outlook, “Trump’s agenda will be contested, and we should expect much controversy, especially surrounding the anticipated repeal of the ACA”, and, “…, our expected stock market gain (for the year) is unlikely to develop smoothly.”

Speaker of the House Paul Ryan introduced the Republican healthcare plan in early March, and since then the stock market has lost its upward momentum as investors assessed its prospects. The lead-up to, and eventual collapse of this legislative effort on March 24th were serious blows both to the Republican Congress and to President Trump. Understandably, it also shook investors’ confidence in Trump’s prospects for success. In fact, the S&P 500 declined for seven of the eight days surrounding this development, and its 1.2% decline on March 21st was its largest one-day drop since the election. While the Republicans made a mess of their first attempt at governing, we think this failure is unlikely to keep the stock market from having another good year in 2017 because the market advance primarily is reflecting a trend change that began last year.
Our view rests on two key assumptions. The first is that the current “reflation” leg of the bull market has a more fundamental foundation than just the Trump program. Reflation is a term used to describe an environment in which the economy moves away from deflation as inflation rises toward a more normal level. This leg of the bull market began more than a year ago as the prospects for an acceleration in economic growth brightened and fears of deflation began to give way to expectations that moderate inflation would return. If anything, in recent months there has been increasing evidence around the world that this, indeed, is happening. Our second assumption is that Trump and the Republicans know that they must produce results, and that they will have learned enough from their painful experience with Ryan’s healthcare reform bill to do better on the rest of their agenda. Although healthcare reform is a high priority, the economic benefits from tax reform, deregulation, and fiscal stimulus are more significant to investors than repealing Obamacare.

The reflationary trend preceded Trump. The chart below illustrates the switch that occurred early last year from a deflationary to a reflationary environment. It shows the Commodity Research Bureau’s Spot Industrial Commodity Price Index declining through 2014-2015 before rebounding sharply since the start of 2016.

This important trend change clearly preceded Trump’s election and is supported by expectations of accelerating economic growth. The November spike in this index after the election reflects the boost to growth expectations provided by the election. The uptrend, however, was strongly established prior to the election.

The U.S. economic expansion that began almost eight years ago continues to look healthy. The financial system remains relatively flush with funds and there is plenty of liquidity to finance economic growth even as the Fed slowly tightens monetary policy. This is reflected in our Liquidity Index trending far above the 98 (red line) level that historically has preceded recessions by roughly a year

The Index of Leading Economic Indicators made a new cyclical high in its latest posting, confirming the favorable outlook. The fading economic headwinds from the 2014-2015 plunge in oil prices and strength in the dollar also are favorable for accelerating U.S. growth.

In addition, with an above-trend monthly average of 194,000 non-farm payroll jobs having been created over the past six months, real incomes continue to rise, fueling an increase in the Conference Board’s Consumer Confidence Index to its highest level in 16 years. Here, again, one can see the upward spike that has occurred in confidence after the election, but the acceleration really began during the first half of last year.

This, and ample liquidity, is keeping the housing industry strong, with private housing starts in February near their best levels since 2007. Business confidence similarly has spiked, with the widely-followed Purchasing Manager’s Manufacturing Index near its highest level in more than five years.

Not just in the U.S., but globally. Recent global economic data show the reflationary trend gaining strength around the world. Monetary policies remain accommodative in most economies. According to JP Morgan, business confidence in the developed economies began to rise last spring and has climbed to its highest level in six years. They see global manufacturing expanding at a 4.5% pace in the March quarter.

In Europe, business confidence is higher than it has been since 2011 despite the concerns about Brexit and potential protectionist actions from the Trump Administration. In China, consumer demand is exceeding prior expectations and investment spending is strong. The smaller Asian economies also are enjoying an acceleration in growth. Even in Japan, the most deflationary of the world’s economies, strong export demand from the rest of Asia has brought an acceleration in growth.

These points are only examples of the substantial evidence that an important reflationary global trend began in early-2016 that has been boosting stock prices since then. Recall that we have said repeatedly that even as our economy and our stock market have recovered from the financial crisis of 2007- 2009, lingering deflationary fears have continued to depress stock valuations. These deflationary pressures began diminishing before Trump’s election. While his agenda will reinforce the reflationary trend, the trend itself is not dependent on him.

Trump’s Agenda is down, but not out. The collapse of the long-promised effort to “repeal and replace” Obamacare has caused investors to question if Trump and the Republican Congress will be capable of delivering on the promised program of tax cuts, deregulation, and infra-structure rebuilding that investors have expected to reinforce the reflationary trend. Revenue-neutral tax reduction will be more difficult to achieve without the federal budget savings expected from replacing Obamacare. The new border-adjustment tax included in the Republican plan has the potential to be disruptive to our economy and is opposed by some important Republican constituencies. Without it, meaningful corporate tax reduction would likely result in larger deficits, something conservative Republicans might oppose. Moreover, the President and Congressional leaders like Paul Ryan wasted valuable political capital in the failed healthcare effort, and they will be less able to compel votes in the future. Thus, there are legitimate concerns that Trump’s healthcare failure reduces the odds for tax cuts this year, or means that even if tax rates are reduced, the reductions will be less meaningful.

The more optimistic view is that the healthcare failure makes it absolutely essential for the Republicans to come together to pass the other elements of the Trump agenda if they are to avoid huge losses in the 2018 elections. They will find a way to do it because they have to. This argument may not be intellectually satisfying, but we should keep in mind that we are talking here about politics, an area that rarely satisfies our intellectual side.

In summary, our view is that since early-2016 stocks have been benefiting from a global reflationary trend that is boosting economic growth rates and corporate earnings, in addition to raising stock valuations. Trump’s agenda generally is pro-growth and has been expected to strengthen this trend. Consequently, investors fear that the healthcare failure could make it less likely that other important aspects of his growth agenda will be enacted. Regardless, we expect the trend to continue for the rest of this economic cycle. Barring some unexpected development that causes the Fed to tighten monetary policy more rapidly than we currently anticipate, we expect this economic expansion to continue into 2019-2020, and we thus think the bull market can live on for at least another year or two.

Our portfolios are structured to benefit from the reflation trend. Because we expect this reflationary trend to benefit stock prices, most of our money available for stock investment currently is invested. Given that the stock market has advanced strongly over the past year, however, and that investors might have to reassess the prospects for the Trump Administration, we are holding a little more of our stock money in cash than we were at yearend. In portfolios that have bonds, average maturities are being kept short to minimize the capital losses that longermaturity bonds are likely to incur as interest rates rise.

Within our stock sectors, we have aboveaverage weightings in a number of sectors that should benefit disproportionately from the reflation. Energy is one such group where rising oil and gas prices along with a continued recovery in drilling activity are likely to produce above-average returns. Banks and other financial service stocks will benefit from the reflation as the Fed raises interest rates toward more normal levels. We are modestly over-weighted in Financials and are looking for opportunities to add to these holdings. The strong dollar and weak commodity prices that characterized the deflationary period of 2014- 2015 weakened stock prices in the Emerging Economies. Consequently, this sector also is likely to benefit from the ongoing reflation, and our Emerging Markets holdings have risen strongly this year. While homebuilders often are viewed as interest rate sensitive so that they might be expected to underperform when interest rates rise, we consider them to be more GDP-sensitive. During the past nine years, many Millennials deferred marriage and family formation due to the weak job market. With their prospects now much improved, the demand for newly-built “starter” homes is strong. Therefore, we see homebuilders benefiting from the reflation until mortgage rates rise to a much more painful level. Similarly, many of our Consumer stocks will benefit from the gains in personal income that will accompany the reflation, as will some of our Technology stocks as business investment accelerates. We think our having these direct exposures to the reflationary trend give our portfolios an excellent chance of performing well in the favorable environment we anticipate over the next year or two. With so many uncertainties, however, some volatility is likely to be appear occasionally.