With just a couple weeks left to the year, we naturally ponder the main events of 2016 and how they might shape 2017. We try to abstain from political commentary and limit our opinions (here anyway!) to potential investment consequences from policy decisions. Although we don’t always succeed, we make every effort not to color our statements with our own political beliefs.
This year, it is admittedly hard to ignore the elephant in the room: Donald Trump’s election has so far been a game changer at many levels, political, diplomatic, etc. It has also had a dramatic impact on markets around the world: currencies, commodities, bonds and equity securities have all been affected.
The dollar rose to its highest level in 13 years, rates on the 10-year treasury note rose by more than 0.5% to 2.39% at the end of November, and crude oil prices went over $50. The chart below from the Economist illustrates what happened to US stocks since the election with the dramatic outperformance of small companies’ shares (as represented by the Russell 2000) and Financial stocks compared to the broad market (the S&P 500). Small Cap value funds did even better: They were up more than 21% for the year as of December 1st, with half that return coming since the election.
Is the positive stock market reaction warranted? It is too early to tell. If we take Trump’s policy proposals at face value, the overall picture emerging from the developing cabinet nominations is that of a pro-growth, pro-business agenda, not unlike the one implemented by the Reagan administration in the early 80s. Looking at key posts, the nominees favor cutting corporate taxes, rolling back environmental and labor regulations, and increasing investment and infrastructure spending. While longer-term, many will worry about the impact of these policies on the deficit, the national debt, inflation and interest rates; in the short-term, the initial reaction suggests that market participants believe that such supply-side policies will further lift investors’ animal spirits and provide a backdrop for increased business profits and stock prices. Trump will begin his presidency, though, with stocks trading at historically high valuations, in stark contrast to the historically low valuations when Presidents Reagan (and Obama) took office.
Rightly or wrongly, investors have so far concluded that small companies are more likely to benefit from Trump’s policies, particularly his proposal to cut the corporate tax rate and his threats to raise import tariffs. This thesis makes sense to us: small companies typically don’t have foreign subsidiaries that they can use to shield profits from US taxes, a strategy widely implemented by much larger companies with sizable intellectual property, mainly in the technology and pharmaceutical industries. Small companies also tend to export less and are more impacted by overseas’ competition. Punitive import tariffs would disproportionately advantage them, as they need not worry about reciprocal actions from foreign countries.
Financial companies and banks will probably benefit too. Congress’ reaction to the financial crisis was to increase oversight and capital requirements, thereby pressuring profitability. Relaxation of these rules should be a tailwind going forward. Banks and insurance companies should also benefit from higher rates in the US as their assets start yielding more.
Should we make changes to your portfolio and prepare for the Trump economy? Not in our opinion. First, although investors are optimistic today, the reality of intended and unintended consequences will eventually set in. Not all policy intentions will translate into laws. Even when they do, only the future will tell if the results match the expectations. As we mentioned in a prior commentary, this election caught a lot of pundits flat-footed. As an example, investors who sold banks in expectation of a Clinton victory and continued regulatory pressure from Senator Warren left a lot of money on the table. Making big portfolio decisions by speculating on political outcomes is a recipe for disaster.
Second, none of this should much affect long-term investors like us. We will integrate the impact of actual(rather than speculative) policy decisions in our equity valuation and asset allocation models. But, unless your own circumstances change, we are very unlikely to implement dramatic changes to your portfolio. We recommend that you do not heed such calls either. Regardless of who is president, we remain optimistic about the future of this country; an optimism that is grounded in its constitutional checks and balances, its institutions, and its people.
Warm Wishes for the Holidays and for a Happy and Healthy New Year from all of us at Bristlecone.