Jan 31, 2017

Counting on Trump to Deliver

The Ten Surprises of 2017 have a generally constructive tone.  President Trump campaigned promising significant change to the American people.  He raised expectations, and that’s why he won.  Now he has to get his pro-growth agenda implemented.  The key elements are tax cuts for corporations and individuals, dismantling regulation and improving the country’s infrastructure.  If he is moderately successful in putting his plan in place, I believe we will see a better economy this year and the financial markets will reflect that improvement.  Investors are ambivalent because they are concerned that we won’t see the significant positives until 2018, but I think favorable results will appear before then.

The definition of a Surprise is an event that I believe is probable, having a better than 50% chance of taking place, while the average investor would assign only a one out of three likelihood of it happening.  Usually I get five or six of the Surprises more or less “right,” but I don’t compile the list to get a good score.  The objective is to stretch my thinking and, hopefully, the thinking of others. 

The first Surprise is that the President backs away from the more extreme positions he put forth during the campaign.  He talked about tearing up some trade deals and various other international agreements, like the Iran nuclear weapons deal, as well as some domestic legislation, including the Affordable Care Act, on his first day in office.  I believe he will move more deliberately on these policy shifts and that his wastebasket will be empty as he completes his first day of work.  I think he will find that some of our trade agreements actually create jobs rather than eliminate them.  In certain cases, like NAFTA, these involve many countries, and unilateral withdrawal would complicate diplomatic relations.  As for the Affordable Care Act, 20 million people have signed up for insurance, so repeal without a replacement would be very unpopular.  Repeal and delay is not a workable option.  In any case, his cabinet and many members of Congress oppose an abrupt termination of the existing healthcare program.

Trump has assembled a cabinet and set of advisors who are controversial and inexperienced in government.  I believe, however, they will work effectively to make sure that radical, disruptive and unsettling changes do not take place.  The new president will strive to maintain a high approval rating and he will try to establish confidence among the American people during his first few months in office.  As a result he may defer his more divisive agenda items until later in the year. 

In the second Surprise I said that a combination of pro-growth initiatives would result in a real GDP increase in the United States in excess of 3%.  Since the beginning of expansion in 2009, growth in this cycle at less than 2% has been slower than typical post–World War II recoveries. This is consistent with the observations of Ken Rogoff and Carmen Reinhart in their seminal book on 800 years of business cycles This Time is Different.  They concluded that when you have an economic recession and a financial collapse at the same time, the recovery is more prolonged than normal.  When business is improving, productivity usually rises because companies don’t hire as fast as the new orders come in.  In a slowdown the opposite is true: generally managers are reluctant to lay off workers.  As a result, I expect to see better productivity numbers as we move through the year.

In the third Surprise I believe Standard & Poor’s 500 earnings will be better than expected.  For the past several years earnings have been trapped between $115 and $120.  This year’s estimates by top-down analysts and strategists are between $120 and $125.  As a result of stronger GDP growth, a reduction in the corporate income tax and some regulatory relief, I believe earnings for 2017 will be closer to $130.  This would enable the market to move somewhat higher; my target is 2500 on the index, about 10% above present levels.  The possible negative in Trump’s economic plan is that the budget deficit would increase as a result of the tax reduction.  The Trump economic team employs the analytic tool of “dynamic scoring,” which is based on the concept that if economic growth and earnings for corporations and individuals improve, taxes collected will also rise.  I believe the concept is reasonable but I think the increase in government revenues may lag the reduced income from the tax relief.  I have another worry about Trump’s economic program.  If he slaps punitive tariffs on imported goods and other countries retaliate, that obviously will have a negative effect on business activity.  This is one of the extreme positions he talked about during the campaign that I believe he will modify.           

The fourth Surprise is that the strength in the dollar continues.  I have it going to 130 against the yen and 1.10 against the British pound, and the euro dropping below par.  The United States is slated to grow faster than any other major industrialized country except China in 2017 and that should attract investors, particularly if there is a perception that investments in other countries will not do as well.  The strong dollar is dependent on the Trump pro-growth agenda gaining traction.  If important parts of it do not get through Congress or do not stimulate the economy as I expect, the strengthening of the dollar may lose momentum.

We are unlikely to have continued growth without a pick-up in inflation.  The labor market is already tight.  In December, average hourly earnings increased 2.9% year-over-year compared to previous monthly readings of 2.5%.  With the unemployment rate below 5%, we cannot expect an increase in growth to take place without an inflation impact.  For the fifth Surprise I have the 10-year Treasury yield increasing to something above 3%, perhaps approaching 4%.  Clients have questioned how higher rates will affect the equity market.  I trotted out my dividend discount model concept from the 1980s and 1990s to gain an insight into that issue.  At current yields of around 2.5%, the equilibrium point where stocks and Treasurys are equally attractive, using $130 in earnings, is about 2800 on the S&P 500.  If yields rise to 3%, the equilibrium point drops to the present level of about 2250.  If the 10-year Treasury goes to 4%, equities would be in trouble, but knowing where the inflection point kicks in is difficult.  After Trump’s election the 10-year Treasury yield rose from 1.4% to 2.5% and the S&P 500 rose 10% because bonds were not viewed as competition for stocks at very low interest rate levels.

The sixth Surprise reflects my continuing concern that populism is spreading across the Western world.  We saw it first with Brexit in the United Kingdom, then with Donald Trump’s election here in the United States.  During 2017, with important elections in France, Holland and Germany, we will see how much further it goes.  I am worried that Angela Merkel will lose the election in Germany in September.  This could be significant because she is the putative leader of Europe and the stability of the European Union could be threatened if she loses her position as Chancellor.  There is no clear leader to take her place. 

Low oil prices and burdensome regulation have held back both production and profitability in the oil industry in the United States.  With the price of West Texas Intermediate above $50, I believe we will see more hydraulic fracking and an increase in production here at home.  I also expect Iran and Iraq to be stepping up production.  The result will be that the price of oil will rise more modestly than the consensus expects.  For the seventh Surprise I have it staying below $60 for most of the year.  I also anticipate that some members of OPEC will produce more than their reduced target amounts and this will have a dampening effect on the global price of crude oil.

In the eighth Surprise, I think Donald Trump will finally recognize he has been wrong about China’s currency.  It is overvalued, not undervalued, and the proof is that the country’s foreign currency reserves have been drawn down in defending its value.  Last year the renminbi dropped from six to the dollar to almost seven (one of my 2016 Surprises that I got right).  This year I expect a further drop to eight to the dollar.  China’s economy depends on a trade surplus and a weak currency will help exports.  This Surprise is consistent with my general view that the dollar will continue to be strong against most of the world’s currencies.  I also think China will be reluctant to draw down its foreign currency reserves much further to defend the renminbi.

I am seeing stronger economic data out of Japan and I believe this will continue.  Because I believe the yen will weaken to 130 against the dollar, I expect exports to be improving there as well.  Japan is a high cost producer in a low labor cost region and that is a weakness, but the quality and innovation of its products coupled with a weak currency should enable it to do well.  The country has been in a deflationary recession for most of the past two decades, but I have projected growth this year at 2%, which should result in a strong equity market.  This is the ninth Surprise.  The price-earnings ratio of Japanese equities is at a discount to the United States and Japan is under-weighted in most institutional portfolios.

My tenth Surprise is that we finally have a lasting ceasefire in Syria brokered by the United States and Russia.  An agreement will be reached that leaves Bashar al-Assad in power.  A step-up in force by Russia and the U.S. will result in neutralizing ISIS in the region.  The use of American troops is justified by the recognition that ISIS represents a breeding ground for terrorists whose efforts have been seen in Europe and the U.S., and this expansion must be stopped.  The military people in the new administration are strongly in support of this hawkish shift.

Every year I always have a few “Also Rans” that do not make the basic list because either they are not as important as the ten I picked or I cannot bring myself to the point where I believe they are probable events.

The first Also Ran is that Donald Trump prefers to sleep in a bed in one of his households in New York or Palm Beach rather than the White House.  His wife and young son are planning to remain in New York and he will not want to be away from them all week, every week.  He will spend time in Washington for important diplomatic and legislative activities but for a good part of April to December he will be in the New York area, and in Palm Beach during the winter months. 

The twelfth Surprise is ironic.  Prior to the election, when Hillary Clinton looked be the winner, pundits were talking and writing about how the Republicans would have to regroup and figure out a way for them to pull away from the extreme positions of Trump’s campaign.  Now, with Trump victorious, the Democrats are the ones who are going to have to rethink their strategy.  Bernie Sanders and Elizabeth Warren will be attempting to pull the party to the liberal left and Chuck Schumer and others will be trying to keep them near the center.  We will see who will hold sway.

I believe Donald Trump’s intimidation tactics will be effective in keeping American companies from moving manufacturing overseas, but he will have more difficulty bringing those who have already moved back to this country.  This is the thirteenth Surprise.  A border tax on imported goods and tax relief for exporters may be helpful here, but I think bringing a large number of manufacturing jobs back will be hard.  The U.S. has lost more than five million jobs in the new millennium, but not all of those jobs were nbbb lost to foreign workers.  Many were lost to robots and will never be done by humans again anywhere.  The failure to bring back jobs will be the biggest disappointment of Trump’s first term.

In the fourteenth Surprise Trump’s first international confrontation is with North Korea, and it is already happening.  Kim Jong-un is threatening to test a ballistic missile in the Pacific, and Trump has said that there is “no way” he will be permitted to do this.  The only restraining geopolitical force with any influence on North Korea is China, and getting Kim to back down will be a big challenge to Trump’s negotiating skills.

I continue to believe that there is money to be made in the Indian equity market and that is the fifteenth Surprise.  The country is growing at 7%.  Prime Minister Modi’s reform program is slowly being implemented and very few institutional portfolios own Indian stocks.  I think India will be one of the best performers among the emerging markets but I am generally not bullish on the sector.

In the sixteenth and final Surprise, Trump attempts to dismantle the Iran agreement to suspend the production of nuclear weapons material, which he believes was one of the worst deals into which the U.S. has ever entered.  I think the other participants to this agreement are reasonably satisfied that Iran is adhering to it and will encourage the U.S. to remain a participant.  The Trump administration will take some time to determine whether Iran is complying with the agreement’s provisions, so any action is likely to be taken later in the year if at all.

So I have tried to provide further detail on the thinking behind The Ten Surprises and the six Also Rans.  Now let’s see how the year plays out.  Something I already know from talking to clients is that they expect 2017 to be full of surprises with Donald Trump in the White House (or wherever he may be).

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