U.S. Stocks Mostly Rose in the Aftermath Of Donald Trump’s Election. Our Response Is to Lean Against the Wind.
In his 1936 book The General Theory of Employment, Interest and Money, John Maynard Keynes used the term “animal spirits” to describe the instincts, proclivities and emotions—rather than rational thoughts—that influence human behavior in the economy and financial markets.
While I believe that acting based on rational thoughts is the best way for investors to achieve their long-term goals, I agree with Keynes that animal spirits often rule the day in the short term. Moreover, I note that even though animal spirits are generally associated with euphoria, these spirits can turn sour and drive asset prices lower.
Benjamin Graham, a pioneer in fundamental investing, put it another way: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Here, Graham was saying that a voting machine measures the fickle attitudes of investors—while a weighing machine measures the cold, hard facts.
Beyond these metaphors, we just witnessed the surprising verdict of our own real-life “voting machine.” Most investment analysts didn’t predict that Donald Trump would be elected president. And if they had, very few would have anticipated the post-election rally in U.S. stocks that actually occurred.
I believe this rally was the result of animal spirits based on the notion that Trump’s pro-growth policies will support the economy. At the same time, many investors assume that growth in the economy will lead to upticks in inflation and interest rates, which—along with lighter regulations—are perceived as positive for business.
In general, the rally since the election didn’t play to the strengths of our high-quality, non-index-like focus at Wasatch Funds. Although many of our funds moved up during the post-election period, we lagged our benchmarks in most cases.
At the same time that U.S. stocks benefited from animal spirits in the aftermath of Trump’s election, other markets were subjected to losses. For example, long-term Treasury bonds suffered particularly large declines, while intermediate-term bonds and even short-term bonds also fell. These losses primarily resulted from the widespread belief that interest rates have embarked on a path of continual increases, as highlighted by the Federal Reserve’s December move to hike the federal-funds target rate and by the signal that three more rate hikes are likely in 2017. Elsewhere, emerging-market stocks weren’t immune to losses either.
So, how should investors respond to the current environment? Should they chase the recent winners in the financial markets? Our approach at Wasatch is to lean against the wind. In other words, we’re sticking with our process and we’re maintaining a skeptical view of investments that may have gotten ahead of themselves.
Prior to the U.S. election, I suggested that the next president would matter less than many voters had hoped or feared. My reasoning was that bureaucracy and political checks and balances cause most new policies to be implemented slowly and incrementally. Moreover, as I discussed in a previous “Message to Shareholders,” a new administration is a relatively small force compared to the massive effects of global disinflationary pressures, aging demographics and declining productivity growth.
Since the election, contrary to my own view, the prevailing view in the financial markets has been that big changes are in store for the U.S. economy. So, let’s start by considering several conditions that I believe aren’t likely to be altered much by a Trump presidency.
First, there’s the employment situation. The jobless rate is already down to 4.6%, which is the lowest since August 2007 and is at a level most economists consider indicative of “full employment.” While government stimulus under a Trump administration could bring some job rotation and better pay to those currently employed, such gains might be offset by higher wage costs for businesses.
Second, the U.S. government faces a heavy debt burden, which has risen to a level that can no longer be ignored. This burden would likely be exacerbated by Trump’s proposed tax cuts and spending increases.
Third, in most developed countries, including the United States, older citizens comprise an increasing proportion of the population. And since many of these citizens are unprepared for retirement, they’re likely to prioritize saving over spending—a situation that doesn’t support strong economic growth, no matter who’s president. Moreover, older Americans are likely to resist any inflationary policies put forth by a Trump administration because inflation is harmful to people such as retirees living on fixed incomes.
Fourth, there’s been speculation that interest rates will rise meaningfully under a Trump presidency. But given the global savings glut, rate increases in the U.S. would likely boost the value of the dollar and draw in foreign capital seeking higher returns. Such a situation would probably not be sustainable because a strong dollar is already hurting the competitiveness of U.S. exports, and because a flood of foreign capital would drive interest rates back down.
Fifth, many conservatives believe Republican control of the White House and both branches of Congress will lead to smooth sailing in Washington, D.C. Let’s not forget, however, the dashed hopes of many liberals who were similarly optimistic when President Barack Obama took office with a perceived overwhelming mandate. In addition, we need to remember that Hillary Clinton did, in fact, win the popular vote. And her supporters aren’t likely to fold under Republican pressure.
Another disconnect regarding the supposed unity among Republicans is that many of Donald Trump’s campaign promises run counter to party orthodoxy. Take international trade, for example. Some of his positions sound a lot more like those of Bernie Sanders than of Ronald Reagan.
Now, let’s consider the conditions that I believe will experience more significant changes after Trump’s inauguration. And while the following changes could be meaningful, I still don’t think they’ll leave the country in a vastly improved situation once the dust settles. This is because the U.S. economy has already performed reasonably well compared to most other developed countries. During the third quarter, for example, U.S. gross domestic product expanded at a real, seasonally adjusted rate of 3.5%—which was the strongest growth rate in two years.
Perhaps Trump’s number one change will be to deal with the large amount of corporate capital stashed overseas. Many American corporations are reluctant to repatriate that capital to the United States because it would face additional taxes. Lowering or temporarily eliminating the taxes on repatriated capital seems likely, as such a move has support on both sides of the aisle. Having said that, repatriated capital won’t necessarily have a dramatic impact on domestic business activity because a lack of capital hasn’t been the main reason for corporations’ reluctance to spend. In fact, many companies have been using the capital they already have to repurchase shares rather than make new investments.
Number two—the incoming administration is likely to make some progress on rolling back regulations. But Trump ran on a populist agenda, and I think many of his supporters will have little sympathy for the likes of “fat cat” bankers and “big pharma” executives looking to save money through regulatory reforms.
Number three—Trump will probably feel compelled to deliver on infrastructure projects. And the Democrats will likely go along because infrastructure spending has been on their agenda since the end of the global financial crisis. The scope of the spending, however, could be limited by the country’s budget deficit and mounting national debt—as well as by environmental considerations, which are often influenced more by “not in my backyard” attitudes than by political-party affiliations.