Opinion: Potential Consequences of Trump Presidency
Given the unpredictable nature of Donald Trump and the lack of a well-articulated platform and ideology that he adheres to, it has become a cottage industry to predict how the US government over the next several years--at least until mid-term elections in 2 years--will behave. I don't like Donald Trump, his policies or the people he surrounds himself with--Steve Bannon, the ex-Goldman Sachs banker/ex-film producer and almost-far-right proponent, and Bill Walton, the former Allied Capital CEO who some of you may recall being profiled by David Einhorn over a decade ago with some employees eventually being convicted of fraud come to mind (it's almost farcical that Trump would put Walton in a role to influence the policies of the SEC and SBA when those two agencies contributed to the conviction of wrongdoing by Walton's firms)--but as I have mentioned in the past, unlike most other countries, the US President has far less power than many imagine. Having said that, since the Republican Party controls the House and the Senate, and will likely pick key justices for the Supreme Court, Trump will likely get through quite a number of his policies (unlike the Obama presidency where he couldn't get the Republican House to agree to anything substantive (except foreign wars)).
If you are a pure value investor then you should just ignore what is happening in econopolitics and focus on companies. Otherwise, if you are more macro-oriented like I am, it's worth contemplating some scenarios.
The market has rallied strongly over the last couple of weeks but I see all sorts of conflicting behaviour. For instance, I think the movement in the US$, equity prices and inflation expectations are contradictory with each other to a large degree. I think one of these elements will overpower the others.
Some have suggested the market is starting to price in high inflation. It's not clear to me that this is the case. There is definitely more inflation being priced in but not "high" inflation. If you look at the TIPS breakevens (10yr here; 30yr here), it doesn't look like a drastic change. The chart below of the 10yr breakeven:
For those not familiar, this is essentially a plot of the 10yr Treasury minus 10yr TIPS bond (which is inflation-indexed). Both bonds are issued by the US government and have the same risk profile and the same maturity so the difference is yield should be largely due to the extra inflation risk the normal bondholders take (technically, some of the gap is also due to other issues like liquidity (normal bond more liquid I believe) but these are minor issues and ignored). This breakeven is used by many to gauge inflation expectations. Many, including me, like using it because it is set by the market as opposed to many other inflation items which involve estimates and can be manipulated.
You can easily see the increase in breakeven in the last month or so. However, from a longer term perspective, it hasn't gone up much. I mean, it's just back to what it was in 2015. Even if it goes to the peak in 2013 or 2004-2006, it is only at 2.5%. In the very-long-run, US inflation has been about 3%. So we still won't be at the long-term average (some argue we will never see inflation like the past because of demographic reasons but I don't believe that--shrinking populations is more of an issue in Japan and Europe, not America or Canada).
If I had to guess, I would say that we will still be below long-term inflation for a while, Trump or not.
Having said all that, bonds are definitely selling off (10yr below):
On this chart, you can easily see on the far-right the huge losses bond investors have suffered in the last few months. Yields have certainly gone up quite a bit within a few weeks. Many thought bond yields hit a bottom during the financial crisis but they ended up being wrong but we may have set a bottom in yields (i.e. peak in prices). If so, it is something investors need to watch out for. In particular, leveraged companies are going to be more dangerous than they have been for the last three decades. For the last 30 years, companies have been able to roll over debt and actually pay less in interest by doing so. Now it is going to reverse. If bonds did enter a bear market, I think private equity (what used to be called LBO in the 80's) will probably run into trouble. Similarly, many companies that issued debt to buy back stock or pay dividends may perform worse than those that did not take on the debt.
A lot will depend on how fast rates rise: I expect it to be very slow and maybe take 20 years to peak out.
With all that said, there are some scenarios under which inflation could get out of control (sort of). For this to happen, I think some of Trump's other policies need to be executed (particularly the whole protectionism/nativism). Anatole Kaletsky--long-time readers may recall him as being one of the founders of GaveKal--sees some good in the Trump administration and some bad (he isn't always right but it's worth thinking about his ideas). Overall, he expects strong economic growth (more than the approx. 2% we have seen for the last few years). On the negative, he says (source: Project Syndicate; h/t Advisor Perspectives):
I think Trump, and to some degree the Republican Party, will be forced to execute on some of their outlandish policies they promised during the election. They will probably kill most of so-called Obabmacare health reform. But they need to do one other thing or else they will probably lose the mid-terms in a few years and possibly the presidency the next time around. It's hard to say what will happen but one should be prepared for the possibility of a trade war with China and protectionist policies in general. If such a situation arises, the entities that profited well in the last decade will probably suffer the most (Kaletsky suggests it might be emerging markets and multinationals). It is quite possible that the extremely-high-profit corporate profit margins may finally decline if profitability of multinationals worsens.
What happens with the dollar is a big mystery to me. One needs to watch and see what happens on this front.
I think any sort of protectionism will make life difficult for most emerging markets. Many of them depend on FDI (foreign direct investment) and portfolio investment for their growth. Although emerging markets have a higher long-term expected returns, one should consider what happens if the Trump administration goes protectionist (already there are some stories that Trump is pressuring American companies not to relocate outside the country).
We are just in the first few pages of the story. A lot is yet to come. I think one shouldn't really change their investments because of what may or may not happen. However, one should consider the different scenarios and be prepared if something starts to materialize.
If you are a pure value investor then you should just ignore what is happening in econopolitics and focus on companies. Otherwise, if you are more macro-oriented like I am, it's worth contemplating some scenarios.
The market has rallied strongly over the last couple of weeks but I see all sorts of conflicting behaviour. For instance, I think the movement in the US$, equity prices and inflation expectations are contradictory with each other to a large degree. I think one of these elements will overpower the others.
Some have suggested the market is starting to price in high inflation. It's not clear to me that this is the case. There is definitely more inflation being priced in but not "high" inflation. If you look at the TIPS breakevens (10yr here; 30yr here), it doesn't look like a drastic change. The chart below of the 10yr breakeven:
(source: St Louis Fed Res FRED, downloaded Nov 29 2016)
For those not familiar, this is essentially a plot of the 10yr Treasury minus 10yr TIPS bond (which is inflation-indexed). Both bonds are issued by the US government and have the same risk profile and the same maturity so the difference is yield should be largely due to the extra inflation risk the normal bondholders take (technically, some of the gap is also due to other issues like liquidity (normal bond more liquid I believe) but these are minor issues and ignored). This breakeven is used by many to gauge inflation expectations. Many, including me, like using it because it is set by the market as opposed to many other inflation items which involve estimates and can be manipulated.
You can easily see the increase in breakeven in the last month or so. However, from a longer term perspective, it hasn't gone up much. I mean, it's just back to what it was in 2015. Even if it goes to the peak in 2013 or 2004-2006, it is only at 2.5%. In the very-long-run, US inflation has been about 3%. So we still won't be at the long-term average (some argue we will never see inflation like the past because of demographic reasons but I don't believe that--shrinking populations is more of an issue in Japan and Europe, not America or Canada).
If I had to guess, I would say that we will still be below long-term inflation for a while, Trump or not.
Having said all that, bonds are definitely selling off (10yr below):
(source: St Louis Fed Res FRED, downloaded Nov 29 2016)
On this chart, you can easily see on the far-right the huge losses bond investors have suffered in the last few months. Yields have certainly gone up quite a bit within a few weeks. Many thought bond yields hit a bottom during the financial crisis but they ended up being wrong but we may have set a bottom in yields (i.e. peak in prices). If so, it is something investors need to watch out for. In particular, leveraged companies are going to be more dangerous than they have been for the last three decades. For the last 30 years, companies have been able to roll over debt and actually pay less in interest by doing so. Now it is going to reverse. If bonds did enter a bear market, I think private equity (what used to be called LBO in the 80's) will probably run into trouble. Similarly, many companies that issued debt to buy back stock or pay dividends may perform worse than those that did not take on the debt.
A lot will depend on how fast rates rise: I expect it to be very slow and maybe take 20 years to peak out.
With all that said, there are some scenarios under which inflation could get out of control (sort of). For this to happen, I think some of Trump's other policies need to be executed (particularly the whole protectionism/nativism). Anatole Kaletsky--long-time readers may recall him as being one of the founders of GaveKal--sees some good in the Trump administration and some bad (he isn't always right but it's worth thinking about his ideas). Overall, he expects strong economic growth (more than the approx. 2% we have seen for the last few years). On the negative, he says (source: Project Syndicate; h/t Advisor Perspectives):
Now for the bad news. For the first time since the 1930s, the US has a president who views trade as a zero-sum game. Trump’s protectionist campaign rhetoric may not have been meant literally, but if he fails to deliver any of the trade curbs that he promised, Republicans will suffer a backlash from what is now their core voter constituency, voters in declining industries and regions...negative for emerging economies and multinational companies, whose development models and business strategies have assumed free trade and open capital flows.
I think Trump, and to some degree the Republican Party, will be forced to execute on some of their outlandish policies they promised during the election. They will probably kill most of so-called Obabmacare health reform. But they need to do one other thing or else they will probably lose the mid-terms in a few years and possibly the presidency the next time around. It's hard to say what will happen but one should be prepared for the possibility of a trade war with China and protectionist policies in general. If such a situation arises, the entities that profited well in the last decade will probably suffer the most (Kaletsky suggests it might be emerging markets and multinationals). It is quite possible that the extremely-high-profit corporate profit margins may finally decline if profitability of multinationals worsens.
With the US economy growing faster than expected and long-term interest rates rising, excessive strengthening of the dollar is a third major risk. Even though the dollar is already overvalued, it could move into a self-reinforcing upward spiral, as it did in the early 1980s and late 1990s, owing to dollar debts accumulated in emerging markets by governments and companies tempted by near-zero interest rates.
What happens with the dollar is a big mystery to me. One needs to watch and see what happens on this front.
Fourth, the combination of a dollar squeeze and protectionism spells big trouble for developing countries, with the possible exception of some relatively closed economies such as Brazil, Russia, and India, whose development strategies are less reliant on free trade and foreign financing.
I think any sort of protectionism will make life difficult for most emerging markets. Many of them depend on FDI (foreign direct investment) and portfolio investment for their growth. Although emerging markets have a higher long-term expected returns, one should consider what happens if the Trump administration goes protectionist (already there are some stories that Trump is pressuring American companies not to relocate outside the country).
We are just in the first few pages of the story. A lot is yet to come. I think one shouldn't really change their investments because of what may or may not happen. However, one should consider the different scenarios and be prepared if something starts to materialize.
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