Eye on the Markets - 2017

What is Trump Trade?

By Ketu Desai

The election of Donald Trump marked an important turning point in financial markets. The election also resulted in a new phrase that has driven the markets, “Trump Trade." The “Trump Trade" is a set of asset classes, sectors, and market drivers that are expected to do well with the new President's policies.

The policies generally center around three items: tax reform, deregulation, and infrastructure spending. Let's examine each of these, describe the specific market movements, where we are currently economically, and the risks.

President Trump and Congressional Republicans agree that there should be lower rates and a broader taxable income base. Trump wants to reduce the number of tax brackets to about three from seven, and reduce the highest rate from 39.6% to 33%. They would also look to simplify the process and deductions. For corporate taxes, he wants to reduce the rate from 35% to 15%, and also simplify the process. Trump has said that we should get more specifics over the coming weeks. The question many will ask is how do we make up the revenue difference?

Deregulation and infrastructure will be ongoing. President Trump has said he wants to cut regulations by 75%. Further, he has said that for every new regulation, two must be eliminated. He has already started with certain financial deregulation and will likely focus on some deregulation related to the EPA. Over time, President Trump wants $1 trillion of investment in infrastructure. He campaigned on spending to improve our roads, hospitals, bridges, tunnels, airports, etc.

The objective of these policies is to stimulate economic growth. If taxes are lower, consumers and businesses have more capital to spend and invest. If there is less regulation, it is easier to conduct business, get new projects approved, and most likely cheaper to do business. Infrastructure projects are job creators. All of these items are positive for economic growth, and that is what the market has been reacting to.

The “Trump Trade" for the economy means higher economic growth, higher inflation, higher interest rates, and stronger U.S. dollar. The policies above are aimed at higher economic growth, however, with higher economic growth comes higher inflation due to higher demand for goods, services, and labor. As inflation increases or is expected to increase, the Federal Reserve increases interest rates to prevent overheating of the economy. Further, investors sell bonds, which has the impact of increasing interest rates. Lastly, the U.S. dollar appreciates because global investors invest in the U.S. because of its higher growth rates and interest rates, relative to other developed markets.

What does the “Trump Trade" mean in terms of markets? The “Trump Trade" has meant investors favoring assets that perform well with these policies. More specifically, it has meant equities over fixed income. It has meant investors favoring domestic over foreign. It has meant investors favoring growth over yield. It has meant investors favoring cyclical over defensive. It has created a market environment where there are certain asset classes, sectors, and companies that are winners and others that are losers, many of which in a bifurcated way.

Where does the economy stand currently and does it need this boost? Let's examine, starting with the consumer, as the consumer is nearly 70% of U.S. Gross Domestic Product (GDP). The unemployment rate is 4.7%, a level we have not seen since pre-crisis.

Wages are also growing, wages have grown north of 3.5% in recent months, according to the Atlanta Fed, also numbers we have not witnessed since the crisis. Approximately 4.3 million workers across the country will see an increase in the minimum wage early this year. A recent payroll number was 80k higher than expected. Consumers with wage and job growth are confident. Consumer confidence is at a 13-year high, a 7.1% increase from January last year.

From this and other data, the consumer appears to be healthy. Moving onto corporate health, earnings have not grown for the previous seven quarters. That said, fourth-quarter earnings that have been released are pretty good, earnings have grown approximately 5%. Further, earnings are expected to grow this year by high-single digits. Businesses do appear confident.

Anecdotally, many CEOs have expressed cautious optimism on the economy and their outlook on earnings' calls. Small business confidence is also at the highest level since 2004. The latest GDP report showed that business spending, which hasn't been a major factor post-crisis, is improving, growing 2.4%, lifted by rising spending on equipment and research-and-development projects. All these data points would suggest that the economy is in pretty good shape, and further stimulus would augment the economic outlook, but there are risks.

One of the clear risks to these pro-growth policies at this point in the economic cycle is that the economy overheats causing rapid inflation. This could potentially cause a decrease in purchasing power for Americans, if wages do not keep up with inflation. Further, the Federal Reserve would have to act more aggressively in increasing interest rates, which could lead to a crash in the market. There is also much risk in how the policies are implemented and often with such policies the devil is in the details. There are other risks such as having too strong of a U.S. dollar that hurts in trade. Unforeseen risks are also worth being cognizant of with such drastic changes in the outlook.

There is a lot going on in financial markets with much to be gained and lost. Stay tuned!