Key takeaways
- Republican victories at the national level make it likely that the Trump growth agenda can move forward without obstacles in Congress.
- The outlook for equities is bullish for the next several months, in our view, as the transition takes place and work begins on extending the low tax rates of the Tax Cuts and Jobs Act, with additional tailwinds from lighter regulation.
- Key risks to the outlook include geopolitical uncertainty and the potential for higher interest rates if the bond market expresses concern about higher deficits, making fixed income duration less attractive as an investment strategy.
From uncertainty to post-election rally
Donald Trump and the Republican Party achieved a more decisive victory on November 5 than polls had indicated. Heading into Tuesday, the chief concern was the potential that extremely close vote totals would take days to tally, potentially allowing for political protests or objections from one or both campaigns. Instead, by Wednesday morning the voters’ choice was clear, and Republicans could claim both the presidency and the Senate, with the House also likely to be in their control (as of this writing, control of the House remains undecided).
With the outcome resolved, our discussion focused on transition and what the election would mean for key policies of taxation, regulation and trade.
The Trump team appears to be prepared to move quickly on the transition, enhancing the likelihood of timely appointments. Even in the first days since the election, there is already some talk about potential candidates for key positions in important departments such as Treasury and Commerce, as well as regulatory bodies.
As we get closer to the holiday season and into winter, the agenda will take shape, with tax policy likely at the top. Extending provisions of the Tax Cuts and Jobs Act of 2017 appears all but certain, but it is best to be cautious about timing because Congress will likely hold hearings before making any decisions. Some of the campaign ideas were quite new, such as a proposal to exempt tips for restaurant and service workers from income tax. Newer proposals like this are less likely to be in final legislation.
Overall, the drive for lower taxes will run up against budgetary issues, as the deficit is already quite high. Expansionary fiscal policy could cause bond markets to push yields higher.
Tariffs and trade negotiations
One of the rare areas of agreement for both political parties is the question of considering tariffs on exports from China. In his first term, President Trump took a hard stance to negotiate a trade agreement that would require China to increase its purchases of US exports. However, this agreement has not been fulfilled as anticipated. One plausible explanation for this shortfall is the downturn in the Chinese economy, which has stifled demand for US products. Consequently, it could be argued that, when Trump returns to office, immediate penalties in the form of tariffs could be imposed on China for not meeting its earlier commitments. These tariffs, in my opinion, would be at the level of 10% to 20%.
There has also been talk of much higher tariffs—as much as 60%. This is likely an example of campaign promises and policy implementation being quite different. This proposed higher level might be used as leverage for trade negotiations. Trump will be able to implement some tariffs without needing Congressional approval, though it appears likely he could get that approval if necessary.
Investors have real questions about the inflationary impact that tariffs could have, especially just after the Federal Reserve (Fed) made a sustained effort to bring down price pressures. In my view, although tariffs lift prices to a new level, they do not become a sustained source of inflation.
A difficult balancing act
Even though Trump emerges from the election with a strong win, he still faces a complicated balancing act. Heating up the economy with growth policies could be inflationary. Lower taxes could increase the fiscal deficit, which could be inflationary. Trying to offset the revenue impact of lower taxes with tariffs would lift prices, although it is unlikely to cause sustained inflation.
Taking these possibilities together, the obstacle facing Trump could be the Fed. With inflation currently falling, the Fed has begun cutting rates, but if it sees price pressures are returning, it could reverse course and raise rates again.
Aside from new appointments to the administration, Trump might put pressure on Fed Chair Jerome Powell to resign. This is not a consensus view, but some hints are already there. Another idea floated by the Trump camp is for the president to have a greater role in voting on interest-rate policy. This change is unlikely, as the Fed would probably fight to preserve its independence.
Keeping an eye on risk
The US economy has shown great resilience, and we think it will continue to do so. Geopolitics is another matter. The conflict in the Middle East continues to be an overhang, especially if Iran is able to develop a nuclear weapon. However, historically, markets struggle to accurately price geopolitical risk.
Another issue that could eventually stand in the way is that bond vigilantes might reappear and respond to greater Treasury issuance by pushing rates higher. A rise in the 10-year Treasury yield to 5% could interrupt a stock market rally.
And remember that policy shifts do not always translate to better returns. In 2016, Trump entered office expressing support for the energy sector, while criticizing the technology sector, especially the big tech firms. However, during his administration, technology was the best performing sector, while energy lagged behind.
Bullish outlook
The outlook for the economy and the stock markets was quite positive before the election. In addition, gains often come in the wake of elections. Historically, looking back over the last 40 years, the market has typically shown strong positive returns in the year following an election.
This election seems particularly bullish, signaling a shift to a risk-on environment. We consider this sentiment likely to continue through the inauguration and well into next year. Broad exposure to stocks is warranted rather than picking sectors to favor based on the policy outlook.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Active management does not ensure gains or protect against market declines.
Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. Large-capitalization companies may fall out of favor with investors based on market and economic conditions.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
Focusing investments in the health care, information technology (IT) and/or technology-related industries carries much greater risks of adverse developments and price movements in such industries than a strategy that invests in a wider variety of industries.
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