Investing in the Trump Era

The main body of the book discussed a diverse array of policies that affect prospects for the overall economy and key sectors such as healthcare, financial services and international trade. In assessing these policies, it is useful to categorize them as to whether they primarily influence the demand side of the economy and have a short-term impact, or whether they are geared to the supply side, which shapes long-term growth.

During the worst of the GFC in 2008 and the first half of 2009, policymakers sought to counter declines in household and business spending, deleveraging of balance sheets and heightened demand for liquidity. The Bush administration lobbied Congress to pass the TARP program, where the proceeds eventually were used to recapitalize financial institutions, and the Obama administration followed with an $800 billion stimulus package. Meanwhile, the Federal Reserve lowered short-term interest rates to zero, and pursued quantitative easing to inject liquidity into the financial system.

These programs succeeded in stabilizing financial markets by the spring of 2009, and the economy began to recover by the middle of the year. Although the pace of economic growth was well below the average for other recoveries in the post-war era, the unemployment rate fell steadily in ensuing years, as the Fed continued its program of purchasing financial assets to encourage greater risk taking by investors.

As the recovery spread, economists debated the desirability of pursuing fiscal and monetary stimulus in the wake of a ballooning federal budget deficit that reached 10% of GDP in 2009, and concerns that the Fed’s unorthodox policies were distorting capital markets. Keynesian-oriented economists such as Larry Summers and Paul Krugman favored large, permanent increases in government spending to bolster aggregate demand, as well as low or negative real interest rates to spur business investment. However, as the problem lingered for nearly a decade, many economists questioned whether demand-oriented policies would be effective in promoting long-term growth. Market-oriented economists such as John Taylor, Glen Hubbard and Larry Lindsay argue that these policies added to investor uncertainty and thereby inhibited economic growth.

The dog that didn’t bark: Trade wars

While risks assets were supported by the prospect of tax cuts and deregulation in 2017, market participants were also relieved that President Trump did not follow through on his campaign threat to impose across-the-board duties on China, Mexico and other countries. Early on, the President recognized that China could play an important role in pressuring the government of North Korea to negotiate a settlement over nuclear weapons with the United States, and he backed off from imposing trade sanctions. He also agreed to renegotiate the NAFTA treaty with Mexico and Canada, rather than abrogating it. Meanwhile, there were ongoing negotiations with various countries to reduce the bilateral US trade imbalances that included discussions of areas in which US businesses claimed they received unfair treatment.

Still, there is a distinct possibility the President will pursue a more aggressive stance on trade issues, especially if he believes trading partners are not cooperating. Indeed, one area in which the President has been remarkably consistent over several decades is his view that bilateral US trade deficits are a sign of weakness.

During the first quarter of 2018, the White House boosted tariffs on aluminum, steel, solar panels and washing machines, and also on Chinese imports of $50 billion. These actions fueled concerns about a possible trade war and resulted in heightened market volatility. Moreover, some observers are concerned the President could decide to allow NAFTA and the Korea–US trade agreement to lapse, which could unsettle financial markets further.

One of the messages of this book, however, is that trade imbalances are the result of macro forces that influence saving-investment decisions both at home and abroad. During the 1980s and early 1990s, the most important factor contributing to enlarged US trade deficits was the expansion in US budget deficits. Beginning with the turn of the century, however, enlarged US trade deficits increasingly were associated with rising surpluses in China and other Asian economies, which acquired massive holdings of US dollar-denominated reserves. It was also during the decade of the 2000s that job losses in manufacturing became more prevalent. Accordingly, there are valid reasons for the US government to take a tougher stance with China and other Asian countries to limit the size of their trade surpluses and their holdings of foreign exchange reserves.

That said, the US government must also be cognizant that threats to impose trade sanctions would inevitably invite retaliation. If so, it could result in a decline in the volume of world trade that would be very harmful to the world economy. Indeed, one of the important lessons from the market developments during 2017 is the crucial role that international economies played in boosting global growth and corporate profitability.

How long will markets stay calm?

This issue became increasingly prevalent in 2017, as the stock market experienced one of the longest stretches of gains in history without even a minor pullback. It was especially surprising considering the political mayhem in Washington, DC, and heightened tensions with North Korea at the time.

The prevailing view among investors throughout 2017 was that risks of recession or inflation were both low, and the Federal Reserve would proceed very gradually in normalizing monetary policy. With interest rates at low levels, the strategy many investors pursued was to grab yield wherever they could find it, while underweighting bonds relative to stocks. Indeed, this strategy has been the key to outperforming markets since the economy stabilized from the GFC in the first half of 2009. Looking ahead, the relevant issue is whether investors should continue to bank on the trend being their friend, or begin to position portfolios defensively.

We have had ongoing debates about this issue at my firm, Fort Washington Investment Advisors. Our conclusion is that it is prudent to pare back holdings of risks assets when valuations become stretched, but as 2018 began we did not believe it was the time to shift portfolios into safe assets such as Treasuries and cash. The main reason was the near-term economic outlook was positive.

There was a possibility the US economy could have a breakout year, in which real GDP growth approached the 3% threshold for the first time since the 2008 financial crisis. That said, we made some tactical changes such as lightening holdings of high-yield bonds when credit spreads versus treasuries have narrowed below historic norms.

The more formidable issue is how to view the valuation of the stock market.

Using traditional P/E ratios, the market appears expensive relative to long-term norms. However, as Jeremy Grantham has pointed out, the average ratio for the past 20 years is considerably above that for the pre-1997 period.

Furthermore, this shift coincides with a jump in US corporate profits as a percent of GDP, as well as with a decline in real bond yields. At the start of 2018, equity strategists were revising upward their projections for 2018 earnings in the wake of the tax legislation, with the consensus calling for profit growth in the low double digits. Therefore, it is not obvious that the stock market is grossly mispriced, despite its remarkable run since March 2009. Accordingly, our firm has been neutral on the market since mid-2015, after having overweighted it beginning in the first half of 2009.

At the beginning of 2018, I felt that the stock market was overdue for a correction.

Therefore, I was cautious about increasing exposure to US equities at the time. But I did not favor large-scale reductions in equity holdings, because the likelihood of an asset bubble appeared low. Typically, they occur when there is rapid credit expansion, the property sector becomes frothy and financial institutions are overexposed to the sector. But those conditions have not been evident for the past decade. Also, despite the market’s huge run-up since 2009, investor sentiment did not appear euphoric. According to Cornerstone Macro, for example, many investors are cognizant that the investment cycle is in its later stages, and they have been gravitating to defensive plays such as large cap stocks with franchise value rather than more speculative small cap names.

Read more articles by Nicholas P. Sargen