2016 Election Commentary
by: R. Samuel Fraundorf
Don’t Lose Focus
It is early Wednesday morning after an election night that almost no one predicted. Given the fact that the unexpected happened, we are seeing a large number of initial commentaries on what it means and why it happened. But we are forcing ourselves to spend little time on that right now and rather pushing our focus out to mid-2017 and beyond. As long-term investors, the immediate what and why are more distractions than useful information. Let’s instead spend some time focusing on what is relevant.
Financial markets will have an initial period of volatility, which was to be expected regardless of the outcome of the US elections. When President Obama won his first term, also carrying the House and Senate as Mr. Trump did last night, equity markets reacted by falling 5%. In fact, they fell when he won his second term, a widely predicted election outcome. The current initial reaction is both a digesting of new information as well as behavioral trading reacting to an unexpected result. We are already seeing some recovery in early trading as markets trim their knee-jerk reactions to the news. However, we do think there is the potential for further volatility as buyers and sellers try to divine the policy impacts of the newly elected president.
Monetary policy moves markets much more decisively than fiscal policy, and fiscal policy will have many months to wait before it becomes anything close to clear. The near-term event is the Federal Reserves’ intentions related to a December rate hike. The economic data we have been seeing prior to the election has been improving, leading investors to believe a rate hike was imminent. Higher interest rates tend to lead to downward pressure on stock prices, and the S&P 500 had been on a losing streak up until Monday in reaction to the expected increase in short term rates. Given the payroll increases and tightening labor markets, we believe the probability of a December rate hike by the Fed is greater than the current futures level of 50%. However, a delay would be considered a positive event for stocks.
Historically, a Republican Capitol Hill and White House has tended to experience the strongest stock market results with the expectation that conservative and corporate friendly policies are good for equities. While we have a number of questions about both the policies the new president will push and the specifics related to them, we do believe there are some fairly good bets as to what gets initial priority. Corporate tax reform and the Affordable Care Act repeal will certainly be high on the new agenda. Taxes will include some opportunity for multi-nationals to repatriate earnings that currently sits overseas, most likely at lower rates. This was last accomplished in 2005 and proved positive to earnings and earnings growth in the near term. Changes to the healthcare law will be a complicated affair, but will tend to be beneficial to a large part of the healthcare sector. We think these will take some time to get done, with the former perhaps seeing the light of day in late 2017 and the latter most likely waiting until 2018 or beyond. We also see infrastructure and energy receiving a fiscal tailwind, which could also help boost overall GDP growth rates in the U.S.
It is not necessarily all good. Trade actions are a big unknown and the president has the power to act unilaterally to exit current deals, such as NAFTA. Discussions during the election race of sizeable tariffs on Mexico and China and the overall protectionist attitude of the incoming administration does not bode well for global free trade and could slow already anemic economic growth. This could be followed by additional protectionist votes in Europe in the coming year. Aspects of Mr. Trump’s tax plan have serious consequences to the budget deficit and the overall debt to GDP level in the US and could find very tough sledding with the Tea Party conservatives in Congress. Finally, the filibuster tool the Democrats have maligned in recent years well could be their friend in the upcoming Congress.
While we were certainly not predicting a Trump victory or a Republican sweep, we don’t think the outcome materially changes our current portfolio positioning. We still believe the positive economic growth of the U.S. supports a full allocation to equities, though our slightly defensive positioning within equities is still warranted given the fiscal uncertainty and expected continued volatility, as well as the current valuations being extended. The labor markets’ strength and potential for inflation still anchor our slightly less than benchmark duration in our fixed income portfolios. We still believe there is ample support for the Fed to move rates higher and a general desire among the Governors to do so. This will remain at odds with much of the developed world continuing to consider easing and will support increased non-U.S. exposures in our portfolios. Change seemed to be the mandate by the American people last night, but it will take time for that to arrive in implemented policies capable of moving the U.S. economy.