Why There Has Been A Trump Stock Market Rally

January, 2017
S&P 500: 2239

OUTLOOK MEMORANDUM
Why There Has Been A Trump Stock Market Rally

Donald Trump was not most people’s first choice for President, and it has been surprising that the stock market has rallied strongly on his victory. The markets feel, however, that despite his many shortcomings, his proposals address things that need to be changed in our economy. The decline in Middle Class incomes over the past 15 years and the populist pressures this decline has fostered reflect a sharp rise in employer-based health insurance premiums and a significant deceleration in productivity growth that itself is due to a slowdown in business investment. Trump’s intention to reform the Affordable Care Act, support tax reform, and reduce governmental regulations are viewed as addressing these critical problems. Investors also support his desire to place more emphasis on fiscal stimulus and less on monetary policy, though the amount of fiscal stimulus he advocates would likely cause the economy to overheat. Trump insists he supports international trade, but investors must watch whether his bluster can result in improved trade deals for the US or a damaging trade war. On balance, we expect the bull market to continue through 2017, although it will be a volatile year as the new administration finds its legs, as populist elections occur in Europe, as the recent strength in the dollar is assessed, and as China counters Trump’s moves.

It is safe to say that Donald Trump was not the first choice for president of many people, and his presidency is viewed with fear and apprehension by others. How can it be, then, that the S&P 500 advanced by 6% following his surprising victory when so many thought stock prices would plunge in the unlikely event that he won? Surely, he comes to office with many serious shortcomings, and our objective here is not to endorse him, but to explain why the markets have chosen to react optimistically to the prospect of this change in Washington and his potential impact on the U.S. economy.

Trump will address real grievances like the need for healthcare reform. It is universally acknowledged that Trump’s election reflects a populist wave that is sweeping the U.S. as well as western Europe as Middle Class incomes have stagnated and living standards have declined. Last April, our Outlook Memorandum titled “Exploring The Problem Of Income Inequality” detailed how real Middle Class incomes have declined since 2000 for two primary reasons. The most important has been the huge increase in the cost of employer-paid health insurance over the past sixteen years that has absorbed much of the money that otherwise would have been used to increase wages and salaries. In addition, as the cost of health insurance premiums rose, companies have attempted to slow the cost rise by increasing deductibles and co-pays. These have imposed an estimated $2,000 per year of additional costs on the average family that had to be paid from its shrinking real paychecks. Thus, the sharp increases in health insurance premiums, especially the recent large increases associated with the Affordable Care Act (ACA), have been an important cause of the populist revolt.

Trump has promised to immediately have the ACA repealed. But, it already is clear that while the repeal will occur early in 2017, it will not be effective for at least two years. This will provide time to recraft this legislation to retain its benefits (20 million more with health insurance; elimination of pre-existing conditions, coverage of children to age 26), while correcting the legislation’s provisions that have resulted in spiking health insurance premiums. At least that is the hope.

We need to increase productivity growth if we are to return to more acceptable rates of real economic growth. The three primary engines of economic growth are increases in the size of the workforce, increases in the average number of hours worked each week, and increases in worker productivity. Due to the large number of retiring Baby-Boomers, U.S. workforce growth has slowed from about 1.5% per year to about 0.5% forecast for the next ten years. Thus, the U.S. might benefit from increased immigration. On balance, workforce growth will contribute little to economic growth in the years ahead, especially if immigration is restricted. The average workweek has been trending down for decades, and it will not contribute to economic growth in the future. Productivity is the amount of goods and services produced by an average worker per hour worked. From 1967 through 2010 productivity rose at a 2.5% average annual rate. But since 2010, productivity has increased at a mere 0.5% rate, and over the past year, there has been virtually no growth in it. Clearly, productivity growth must be restored to about a 2% rate if U.S. real economic growth is to return to a 2-3% rate. Moreover, real wages and salaries historically have increased as productivity has risen since it is this extra production that enables employers to increase the real pay of workers. Thus, the slowdown in productivity growth has been an important underlying cause of stagnant incomes and the populist revolt.

Trump’s agenda also addresses some of the underlying causes of slowing productivity growth. The reasons for this productivity slowdown have been widely debated by economists. While our aging workforce and the distractions of smartphones may be involved, most agree that a sharp slowdown in business capital spending has been a primary factor. Business capital spending affects productivity because, while knowledge and experience enable workers to produce more, the real differentiator is the quantity and quality of the machines, tools, and other equipment with which workers are provided to do their jobs. Sadly, despite historically-low interest rates during recent years that have made borrowing cheap, U.S. companies have opted to use more of their cash to pay dividends and to repurchase their own shares than to invest in new plant and equipment. The U.S. Bureau of Labor Statistics estimates that the ratio of capital employed to hours worked (e.g., capital intensity) of U.S. business has been so weak that it actually subtracted from worker productivity during the 2010-2014 period studied. Thus, it appears that a marked slowdown in business capital spending has played a major role in the stagnation of productivity that has contributed to weak Middle Class incomes and the populist movement.

Trump’s tax reform will incentivize capital investment. The high U.S. corporate tax rate relative to most other countries has discouraged capital investment in the U.S. Businesses make investment decisions based on expected aftertax rates of return on the capital invested. Our high corporate tax rate reduces this return and discourages investment, costing jobs and contributing to the slowdown in productivity growth. Tax reform is intended to result in increased capital spending that will boost growth and raise productivity.

Excessive government regulation also has damaged productivity. While experience has shown that some regulation of business is useful and necessary, the pendulum seems to have swung too far. Increased government regulation has a couple of negative effects. First, it reduces productivity as more time, effort, and resources must be devoted to meeting them and monitoring compliance. We see this in our own dealings with the banks and brokers on our client’s behalves as the huge increase in regulations stemming from the Dodd-Frank legislation force every request, regardless of how minor, to require additional authorizations and demands for documentation. Another damaging effect of excessive regulation is that it encourages businesses to do their capital investing elsewhere in the world, thereby further contributing to the slow productivity growth here. By incentivizing increased capital spending through tax reform and cutting excessive regulations, Trump hopes to raise productivity and stimulate growth that will benefit both Middle Class incomes as well as investors.

Fiscal stimulus is replacing monetary ease. A change in attitudes toward monetary policy also is at play here. Since the 2008 financial crisis, the developed economies have pursued monetary policies of zero, or near-zero, interest rates to stimulate growth and economic recovery based on the concept that low interest rates would induce increased consumption and investment. With our economy having recovered from that crisis, these monetary policies clearly have had some meaningful success. Nonetheless, deflationary forces have persisted and monetary authorities have found it difficult to raise, or “normalize”, interest rates. The Fed Funds rate that rarely has been below 2% since 1945 recently was at only 0.50%, and the 10-year US T-bond yield, historically above 3.75%, was 2.50%. As we discussed in October, a feeling began to develop in the markets during 2016 that the negative effects of zero interest rates were becoming more significant than their positive effects. Low rates hurt savers and retired households, and encourage the excessive use of debt that can cause dangerous bubbles in some parts of the economy. Perhaps more importantly, it is becoming recognized that such abnormally-low interest rates send a subtle message to businesses that all is not right, and thereby discourage investment. This has led to the counter-intuitive notion that raising interest rates toward more normal levels might increase business investment and economic growth.

Trump wants to shift the focus of economic stimulus from such monetary policies to fiscal policies that include increasing federal infrastructure spending and financing it with debt. As noted above, this policy shift is in line with the market’s current desire for interest rate normalization and more reliance on fiscal policy. Trump talks of a $1 trillion infrastructure rebuilding program over ten years. When combined with the tax cuts he advocates, such a mammoth spending plan would likely increase the federal deficit by far more than the Tea Party faction would accept. In addition, with the U.S. economy currently operating near its non-inflationary potential, and with inflation beginning to rise, such a large amount of fiscal stimulus would likely overheat the economy. This would force the Federal Reserve to raise interest rates quickly to slow the economy to keep inflation from getting out of control. Thus, we think a smaller amount of fiscal stimulus is likely; enough to modestly boost economic growth while not pushing either the economy or the deficit too high. Nonetheless, the prospect of increased fiscal stimulus has caused interest rates to rise since the election and this has been viewed as constructive by the markets in that rates finally are moving toward a more normal level.

Rising interest rates will raise stock Price-ToEarnings ratios (P/E) in 2017, not hurt them. Since the Great Recession, we have argued that while rising interest rates generally depress stock market valuations and falling interest rates boost valuations, history has shown that the unusually low interest rates associated with deflation fears significantly depress the valuations of stocks. With bond yields still far below normal levels, we see this new interest rate normalization process as bullish for stock valuations whereas many think it will cause valuations to fall. On November 9th, the 10- year U.S. Treasury bond yield was 2.05% and the S&P 500 stood at 2139.56, 16.1 times consensus 2017 earnings of $132.71. Since then, the 10-year U.S. Treasury bond yield has risen to 2.54%, and the S&P 500 P/E ratio has risen to 17.1. This is consistent with our view that normalizing bond yields will increase the P/Es of stocks rather than shrink them.

Investors will be watching Trump closely on trade policy. During the campaign, one of Trump’s primary populist messages was antitrade, focused particularly against Mexico, China, and the recent Trans-Pacific trade legislation. Most economists agree that international trade results in faster overall economic growth and improved living standards, and Trump’s protectionist rhetoric raises fears of the kind of misguided policies that led to the Great Depression. These fears have been further stoked by his naming economist and China-hardliner Peter Navarro as his Director of Trade & Industrial Policy. Navarro has explained, however, that Trump actually supports international trade, but opposes trade deals that hurt the U.S., pointing specifically at China’s continuing to subsidize their exports to the U.S. and to steal U.S. intellectual property in violation of the rules they agreed to follow when they joined the World Trade Organization. He further says that Trump’s calls for punishing 45% tariffs are intended to bring the offending nations to the bargaining table to obtain fairer deals for the U.S., and that such tariffs hopefully will never be imposed. Trump sees himself as a good negotiator, but the markets will be watching whether this tactic produces its desired result or provokes a harmful trade war.

We think 2017 can be another decent year for stock investors, …. The current bull market is approaching its eighth anniversary. We have been consistently bullish during this period, notwithstanding our having correctly anticipated the 2015 market correction associated with the Fed’s initial rate hike. The fundamental tools that have guided us during this market run continue to point to an extension of this trend in 2017. The outlook for economic growth is favorable, S&P 500 earnings are forecast to rise by about 12%, and there continues to be ample money and credit available to finance this growth. In addition, as discussed above, we think the P/E ratio of the S&P 500 can rise to about 18.5 times during the coming year as bond yields continue to normalize. This gives us a yearend 2017 price target for the S&P 500 of 2460 (18.5 X $133), which would represent an increase of about 10%. When a 2% dividend is included, we think the S&P 500 could return about 12% this year.

… but, market volatility seems likely to increase. Of course, our expected stock market gain is unlikely to develop smoothly. Trump’s agenda will be contested, and we should expect much controversy, especially surrounding the anticipated repeal of the ACA. And surely, the Chinese will strongly resist Trump’s efforts. In addition, the dollar has risen sharply since the election, and we may see some renewed fears about how this will affect our growth and corporate earnings. If the prices of oil and other commodities continue to rise, however, we could see the dollar weakening during part of this year as it did during much of 2016. We also should expect renewed international turmoil regarding the terms of Brexit and the upcoming elections in France, Germany, and the Netherlands. Fears that populist victories in these countries could tear the Euro community apart are likely to create market volatility. Thus, the year may again be stressful, but we think that investors can earn a positive return for bearing the stress.

Happy New Year!