January 2017 – Monthly Commentary
The election of Donald Trump to President of the United States continues to pose challenges to forecasting and investing in the capital markets. Arguably, the world order has been turned on its head in ways that could not have been predicted. The prevailing view prior to the election was that the European economy was to be forever mired in economic malaise; the U.S. economy was growing, albeit at a less than spectacular sub-2% annual pace; equity valuations, as measured by the price/earnings ratio were expensive; and the Republican Party had lost its way and had no clear leadership. None those assumptions have held true. The Trump win in conjunction with the Republican control of both houses of Congress has left the Democratic Party in disarray, with that party’s most senior leaders at a loss for how to counter the new President.
The biggest surprise, aside from Trump’s victory, has been the revival of the European economy. Manufacturing in Europe, as measured by the Purchasing Managers Index is at the highest level since the index was launched two years ago and stands at a very healthy 56.1 level. Similarly, the Euro Stoxx index of 50 blue chip European stocks has rallied 20% from the low touched last summer. That’s not to say that it’s smooth sailing for all members of the Euro. Significant structural hurdles remain and the popularity of French Presidential candidate Marine Le Pen is worrisome.
The forecasts for economic armageddon that followed the United Kingdom’s vote to exit the European Union have not come to pass either. In fact, the roughly 17% devaluation of the British Pound witnessed since the vote has given U.K. exporters an unexpected competitive advantage versus their trading partners. However, despite the vote, the English government has not yet formally pulled the trigger to begin the process of severing ties with Europe. Assuming they ultimately will, they will need to renegotiate trade agreements with a European Union (EU) that has said that they don’t want to make it easy on the English. Conventional wisdom holds that the EU wants to ensure that no other members are tempted to follow the U.K. Indeed, were it not for the great unknown of Brexit, the Bank of England would have likely raised overnight interest rates by now.
Domestically, investors have given Trump a resounding “thumbs up” vote of approval, as evident by the rally in stock prices. The chief beneficiaries have been manufacturing and infrastructure companies. The investment thesis of the bulls, as we discussed last month, is that Trump will be successful in implementing his infrastructure spending plan and that will percolate through the broader economy, boosting economic growth above the elusive 3% annual rate. Another equity sector that has rallied is bank and finance. Trump’s intention to roll back Dodd-Frank regulations would reduce costs at financial firms, boosting profits. Goldman Sachs CEO Lloyd Blankfein said on a Bloomberg television interview when asked about the possibility for changes that “he’d like to hold less reserves” on his balance sheet. All things being equal, less reserves equals more leverage. Certainly, government oversight of banking has proved onerous to the management of financial services firms. oweveH However, given the severity of the financial crisis, we do not think reducing bank leverage ratios is in the best interest of anyone.
Given the improved growth prospects and the rally of stock prices to new all-time highs, one could expect that the Federal Reserve would feel more comfortable in lifting interest rates. That doesn’t seem to be the case. Comments following the February meeting were not much different than the December narrative in which they describe risks as balanced and failed to give an indication of when we can expect the next move. With the continued strong employment sector and rising average hourly earnings, the Federal Reserve under Alan Greenspan would have likely raised rates several times by now. But the Yellen Fed seems much more willing to allow the economy to run hot. Our guess is that the committee is worried that Trump’s trade bravado could back fire and harm the economy. That’s certainly a distinct possibility.