Market Memo: Back to the secular bull; adding to equities

11-10-2016

We and the rest of the world have been spending much of the last 48 hours parsing the impacts, near and longer term, of Tuesday’s spectacular presidential election vote. With the almost equally surprising victory of the Republican party in the Senate, we stand here today with the prospects not only for a dramatic turn in government policy toward a pro-growth agenda, but also with a higher probability of that agenda being adopted into law by a unified Republican Congress, highly incented to positive action.

As we noted in our post-election-morning piece, the economic future is surely brighter, with the three of the five key components of President-elect Trump’s policy agenda heavily skewed toward growth reacceleration. The potential impact of the last two elements, trade and the Fed, is more controversial and could cause some bumps in the road ahead, for sure. On balance, though, we think the future policy mix out of Washington is now growth supportive rather than growth subtractive, and as such adds an important tailwind for equity investors.

To acknowledge this, Federated’s PRISM committee today raised its equity weighting to 52%, our neutral point, with a bias to add further on any dips caused by the series of remaining unresolved issues we’ve been citing for some time. (See Phil Orlando’s companion piece for details.) Here’s how we see the Trump policy mix unfolding ahead:

  • Roll back excess regulation A key drag on growth has been the thousands of new regulations and regulators pouring out of Washington over the past eight years, choking off risk-taking and investment decisions in nearly every sector of the economy. Many of these regulations are well intentioned but few if any weigh the costs and benefits of implementing them the way a hard-nosed business person such as Trump might think is appropriate. We expect the new president to freeze new regulatory edicts coming out of Washington on Inauguration Day, setting the tone immediately that regulatory overreach will not be welcome. Over time, we expect a more thorough review of the Obama-era regulatory apparatus, with the most growth-negative of these being rescinded. These changes should almost instantaneously produce a wave of renewed business confidence and optimism. We estimate deregulation alone could boost U.S. economic growth by 0.5%.
  • Cut & simplify corporate taxes The second key component of Trump’s plan is to simplify the corporate tax code. Importantly, his goal is to cut the tax rate to a level more competitive with the rest of the world. Bundled with this is a plan to cut and simplify personal tax rates. This represents a big and complicated project for sure, and some would say, an impossible achievement. We think in the present post-election environment, it might prove easier than expected. Trump is not a policy wonk, and will focus attention on bottom-line numbers like the max rate, the closing of loopholes, etc. Paul Ryan’s House Republicans have already constructed a fairly well thought-through plan, and our guess is Trump will work with some version of this to get a plan approved quickly. All of this would be growth supportive, similar to the way Reagan’s tax cuts were back in the 1980s. With details still to come, it’s hard to guess the impact of these changes to growth, but we think, eventually (2018 or 2019), it could raise potential growth by another 0.5% per year.
  • Increase infrastructure spending Obviously this was a significant campaign promise. We are looking for Trump to go for something big, in the hundreds of billions, and to fund it in a growth-supportive way, such as a repatriation holiday that brings hundreds of billions of dollars back home. This is likely to spur additional economic activity over the next three to four years, and have some modest positive impact on growth, possibly 0.1 to 0.2% per year.
  • Negotiate “Better Trade Deals”/“Build a Wall,” etc. Here’s where things get tricky. Markets until recently have worried about Trump’s stance here, concerned that if his threats to scale back Nafta or renegotiate terms of trade with China are implemented, they could impact economic growth severely. Our take is Trump might go for a combination of select, headline-grabbing concessions such as higher tariffs on Chinese steel imports, while at the same time embark on trade negotiations with our key partners in a way designed to improve the terms of trade to make them more balanced for both parties while keeping markets open. This approach would be far less growth negative than markets expect. We shall see. At a minimum, there is headline risk here, for sure.
  • Pressure the Fed toward a more hawkish policy Trump did not highlight this as much during the campaign, but we think it is probable that he replaces Chair Yellen in 2018, or sooner if she were to resign early, with a more hawkish economist who sees quantitative easing and zero rates as economically repressive rather than stimulative. We agree with this stance. The Fed’s prolonged low-rate policy has probably outlived its usefulness and at this stage is mostly discouraging bank lending by making such lending less profitable, and discouraging consumption by suppressing the retirement income of millions of baby boomers. On the other hand, a shift might cause some near-term uncertainty for the markets, particularly as levered players (read, hedge funds) have come to rely so heavily on low interest rates to fund their trading strategies. Net net, we have a shift at the Fed as a short-term negative and a long-term positive.

On balance, we see the likely policy actions ahead as supportive of the economy  and are raising our outlook for U.S. economic growth in 2017 and 2018 by 0.5% and 1.0%, respectively. We think this should translate into better earnings growth by the back end of 2017 and especially 2018, materially raising the probability of hitting our long-standing S&P 500 target of 2,500 by 2018. This represents 15% upside over the next 18 to 24 months, better than investors are likely to achieve in bonds. With our eyes on this prize, we are advising investors to begin edging their equity weightings higher; in our case, we added 200 basis points to equities today in our PRISM stock-bond model, taking the total up to 52%, our neutral point. 

Buy the dips, not sell the rallies
Inevitably, there will be volatility ahead. Although we’ve gotten past our single largest remaining hurdle for 2016, we have long cited multiple others, such as the Brexit negotiations, the coming Italian election in early December, the likely Fed rate hike in December, the November OPEC meeting, and the gradual grind down in near term (2017) earnings estimates to our $125 forecast. Our plan, and advice to our clients, is to use the likely bouts of volatility ahead to add to positions. Said differently, after 18 long months of going virtually nowhere in equities, with occasional and sudden “thunderstorms” of -5% to -10%, we now think we are moving back into secular-bull-market mode. Going forward, it’s buy the dips, not sell the rallies.