Global equities have risen by 13.7% since the election of Donald Trump as the 45th president of the United States last November. Naturally, Trump couldn’t resist reminding the world of this fact as he addressed Congress.
“The stock market has gained almost three trillion dollars in value since the election on November 8th, a record”, he crowed. At Davy Asset Management, we went in to 2017 looking for “mid-to-high single digit” returns from equities and negative returns from bonds for the year ahead. In the first two months of this year, the MSCI World Index had returned 5.3%. Can equity markets maintain this level of performance?
The answer to this question will depend to some extent on a process that the president started. Trump arrived on Capitol Hill for a much-anticipated address to a joint session of Congress. Given all that he had said in the election campaign, there was much excitement and anxiety alike about the detail of the new administration’s tax and spending plans. These addresses are set piece occasions and are generally seen as the president’s opening gambit in a potentially long drawn-out budgetary process.
Ultimately, it is Congress that will set federal budget for the year, but the president had been making some big promises, particularly with regard to infrastructure spending. In the event, Trump gave very little detail regarding his tax and spending plans, merely restating his desire for a $1trillion infrastructure bill, lower corporate taxes and “massive tax relief for the middle classes”. He made no mention of the 'border adjustment tax'.
To see why the market got excited about the prospects of some fiscal details, it is worth looking at the drivers of the market’s post-election rally. As the headline index levels have been advancing, there has been a pronounced change in sector leadership within equity markets. Trump’s commitment during the election campaign to tax reform and infrastructure spending has turbo-charged a rally in cyclical stocks that began in July last year, just weeks after the Brexit vote, and continued up to the end of January. So, rising expectations of fiscal largesse have been a major support for US equity markets.
To be sure, cyclical stocks are natural winners in any sustained infrastructure upgrade. Early in his acceptance speech of 9th November, Trump made special mention of bricks and mortar:
“We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it."
Expectations of the announcement of a trillion-dollar infrastructure plan during the first 100 days of Trump's presidency were high on the night of the election victory- they have fallen consistently since then. In late February, Axios Media, citing Republican sources, reported that the Trump administration was pushing out any plans for a big spend until 2018. As if to underline the market’s dependence on public spending, cyclical stocks such as US Steel, US Concrete and Caterpillar bore the brunt of the sell-off that followed the report. Six weeks into the presidency, as he arrived on Capitol Hill, the reality of what can be achieved with Congress in a short space of time appeared to be dawning on the Trump administration.
What of the president’s other fiscal plans? We also noted in September that Trump had just aligned his proposals on personal tax rates with those of the House Republicans. He would reduce the number of individual tax bands from seven to just three: 12%, 25% and 33%. The proposals differ in terms of the income levels at which the rates kick in, but changes are set to benefit higher earners disproportionately. At the time, we regarded these personal tax proposals as a positive for consumer-facing companies, cyclical and non-cyclical. Given the alignment of interests, we think personal tax reform proposals may be among the first plans to emerge in the coming weeks.
Trump never mentioned the 'border adjustment tax' in his address. The basic idea is that the value of goods that are exported from the US will not be taxed, while the cost of imported goods that are sold in the US cannot be deducted from taxable profit. The aim is to incentivise companies to manufacture and export from the US. However, if you are a retailer like Walmart and you import most of what you sell from countries such as China, you are going to be squeezed and will have to raise your prices…."bigly"! Such price rises may undo much of the benefit to consumers of lower personal tax rates.
The only way the retailers and others can avoid the squeeze is if the currency which they use to purchase these imports appreciates to offset the new reduced 20% corporation tax rate. And, strange as it may seem to somebody who has worked in the currency markets, that is exactly what Paul Ryan and the House Republicans hope will happen. The stronger dollar will help importers and hinder the exporters, thereby levelling the playing field somewhat. Trump has vacillated on this proposal since his inauguration, at first calling it “too complicated”, but recently appearing to support it. This time he ignored it!
On the repatriation of overseas cash, there is a wide range of estimates as to how much cash US companies have squirreled away abroad in order to avoid a 40% tax. There is also some debate about how much the companies will want to bring home if Trump gets his plans for a reduced rate of 10% through Congress. But there is a general consensus that this money is unlikely to wind up in new green field factories. Rather, it is more likely to go back to shareholders as dividends or, more likely, share buybacks. This plan is supportive of equity markets.
Back in September we had expected that the Democrats would take the Senate and that a split Congress would crimp either candidate’s ability to get things done. The Republican clean sweep in the elections should make life easier for Trump. Although, In general, Republican congresses have not been as fiscally profligate as the self-described “King of Debt” appears to want to be. So, the idea that a combination of an increased Defence budget, a repeal of “Obamacare”, lower personal tax rates, a lower corporation tax rate, and a major infrastructure spend would all sail past Congress in a hurry, seems a little optimistic.
However long and complicated the fiscal process ahead turns out to be, the outcome should be a boon for many US companies and equity markets through higher domestic GDP growth, lower taxes and reduced regulation. Therefore the likely end point for equity markets and cyclical stocks is higher than where we are today. For bond investors, the journey may get a little rougher from here. It was notable that before Trump got up to speak, two prominent Federal Reserve governors, William Dudley and John Williams raised the prospect of a Fed rate rise at the March meeting. The pace of the equity advance may slow somewhat from here as the nitty-gritty of getting fiscal reform through gets underway. But the backdrop remains positive.
Source: All data is sourced from Davy Asset Management and Bloomberg as at market close 28th February 2017 and returns are based on price indices in local currency terms, unless otherwise stated.
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