The consensus going into the US election was that a Donald Trump victory would result in considerable market turmoil. This was a pretty reasonable argument, given that Trump’s anti-establishment campaign almost by definition would be expected to generate far more uncertainty than Hillary Clinton.
Yet the sell-off never happened, and markets have instead rallied on the back of the apparent growth-boosting aspects of Trump’s policies. However, looking longer term we think many investors have underappreciated the conflict between policies which the market likes – such as tax relief and deregulation – and those it does not – such as tougher stances on immigration and trade, which are broadly viewed as hurting economic growth. As a result, we fear that the rush out of long-term Treasury bonds and into financial and industrial stocks might have gone too far.
We focus here on what may be the growth-hurting aspects of his agenda, including his potentially inflationary fiscal stimulus and protectionism. Meanwhile worries over the US equity market sit alongside the biggest risk to global economic growth in 2017: political crisis in Europe. A rolling calendar of political events poses a significant threat to the EU’s economic stability. We anticipate that this will be a difficult environment to navigate: our priority is to provide downside protection for our clients’ portfolios.
Deficit spending
For us, the most striking aspect of Trump’s agenda is his promise of a very large fiscal stimulus, including aggressive tax cuts and sharp increases in government spending. Whilst we still await the details of his plans, markets have clearly viewed them as bullish for growth – banking stocks and the dollar have rallied, whilst Treasuries have suffered rather a dramatic sell-off.
Fiscal easing of this kind, alongside full employment and accommodative monetary conditions, has not happened since the 1980s under Ronald Reagan, who presided over one of America’s largest peacetime increases in budget deficits and debt. However, Reagan’s starting-point was a federal debt-to-GDP ratio of 26 per cent: Trump’s is at 74 per cent before he has even taken office. The full implementation of Trump’s campaign platform would probably push the federal debt-to-GDP ratio towards 100 per cent. Clearly a surge in US Treasury issuance could have a much greater impact on inflation, heralding the end of the recent period of ultra-low interest rates.
Protectionism
We think the inflationary aspects of Trump’s policies are not restricted to his planned deficit spending. The president-elect’s protectionist instincts could also have an inflationary impact. Protectionist policies could drive up import prices, whilst his anti-immigration policies could boost domestic wages. Investors are starting to price in the potential inflationary implications of President Trump, with rising breakeven rates in the US now spreading to Europe and Japan.
Our short- to medium-term view on the US is, however, positive. Trump’s unfolding agenda is like to provide a steady stream of good news for stock market investors in coming weeks: lower taxes could boost earnings at a time they have been in decline, whilst cutting the effective tax rate of S&P 500 companies could double the 2017 earnings growth rate. We think an interesting means of exposure to the US is through First Trust’s US Large Cap Core Alphadex fund, which is a good value way of exposure to the large cap index, but with the use of fundamental growth and value factors.
Performance of First Trust US Large Cap Core Alphadex ETF vs S&P 500 YTD
Source: FE Analytics
Yet we are nervous about the longer-term impact on stock markets of Trump’s policies – in particular the risk that interest rates will go up faster than anticipated as inflation feeds into the system.
Political crisis in Europe
Our concern is not restricted to President Trump’s policies. The next twelve-month period is essentially a rolling calendar of potential shocks to the market – primarily populist uprisings in Europe – starting off very shortly with Italy’s constitutional referendum, and moving swiftly towards elections in France, Germany, Austria and the Netherlands. Alongside potential political shocks are the risks of banking crises in both Italy and Germany, all set against the backdrop of the UK’s exit negotiations. It is difficult to conclude that Trump’s populist victory in America will do anything other than encourage the ongoing rise of anti-establishment populists. In our view, the political risks to Europe have now substantially increased and the EU’s future looks bleaker today than at any point in the last forty years.
A shock event in one of Europe’s major economies could kick off a chain of events resulting in potential banking crises in Italy and Germany, or the structural problems afflicting the eurozone once again coming to the fore. Even if none of these fears actually comes to pass, undoubtedly there will be nervousness (and consequent volatility) in the market in the run-up to many of these events.
Understanding risk
We would argue that downside protection during market sell-offs is critical to delivering healthier long-term returns. As part of our approach to managing risk, we are increasingly using defensive structured products, including those developed in-house at Walker Crips, in order to mitigate some of that volatility. We believe that, barring a very large fall in equity markets, the prospect of a defined level of return will smooth out some of the peaks and troughs we expect in coming months.
In this 'new normal' environment of rolling potential shocks to the system, we think it is absolutely essential that an investment process has risk management at its core. Our commitment to the constant stress-testing of client portfolios, for example, ensuring the risks that we are taking with client money are deliberate and diversified, remains central to what we do. Given the potentially bumpy ride ahead, and given our clients’ priority to downside protection, an effective understanding of the risks we are taking in portfolios is as important today as it has ever been.
Andrew Morgan is an Alpha r:² portfolio manager at Walker Crips. The views expressed above are his own and should not be taken as investment advice.