In a pre-election, Aug. 9 interview with Fox News Channel, Trump said: “If rates go up, you’re going to see something that’s not pretty. It’s all a big bubble.” Fast forward to six days after his inauguration, and he tweeted the following:
Which Trump can we trust? With the stock market hitting record highs should we proceed with caution or buy into the excitement? We first need to understand what caused the current market rally, how Trump’s aggressive policies will affect the future market, and only then can we draw a conclusion on the actions investors should take.
Current US bull market: what caused it?
Conventional wisdom dictates that all good things eventually do come to an end, but eight years in, the bull market rallies on yet. Granted, the markets have taken a slight dip lately with major indexes S&P 500, DJIA and Nasdaq all sliding a full percentage point last Tuesday (March 21), logging their worst results since Trump’s inauguration. Focusing on that alone however would be to detract the impressive gains made by the market since its inception on March 9, 2009. Going by the textbook definition of a bull market – a period in which market indexes log an increase of at least 20%, and subsequently not declining by 20% of its highest value – the current bull market is the second longest in modern history. The S&P 500 index has rallied by approximately 250%, courted at every turn by naysayers. In this regard, it’s not hard to wonder where the skepticism is arising from: anemic global growth and the many unfortunate instances of social and political unrest have made for a dangerous concoction that, in theory, ought to have snuffed out the vitality in the markets long ago.
Source: Campos, R., & Mikolajczak, C. (2017). No matador in sight as bull market in U.S. stocks turns eight. Reuters. Retrieved 24 March 2017, from http://www.reuters.com/article/us-usa-stocks-bullmarket-idUSKBN16G0E7
To single out with any degree of certainty what exactly factors into the longevity of the existing bull market would be all but impossible. Nevertheless, markets generally abide by trends, that in turn rise and fall to the tune of several market indicators including corporate profits, investor and consumer sentiment, and economic stability (“Marketwatch,” 2017). The key word here is stability, and one only has to look towards the recent Brexit referendum to see how stocks prices unfailingly plummet in times of uncertainty (“Independent,” 2017). Over the past few years, America’s ever-growing budget deficit has spurred growing fears of yet another US fiscal cliff, and it’s hard not to flip through the newspapers without stumbling upon an article that paints America as a nation on the brink of an economic crisis. Of course, while fears regarding US’s chronic overspending cannot, and should not, be reduced to mere worry-mongering, it has depicted a situation far more dire than reality (Jackson, 2017). The US Federal Reserve’s decision to push up interest rates by 25 basis points again this month only serves to reinforce the strength of the economy. Furthermore, while annual GDP growth in the US may have fallen over the past few years, averaging 1.2% under Obama’s tenure, this is characteristic of a developed nation where the era of gains from industrialization and the normalization of women in the workforce are long over (Moon, 2017).
Source: United States GDP Annual Growth Rate | 2007-2017 | Data | Chart | Calendar. (n.d.). Retrieved March 20, 2017, from http://www.tradingeconomics.com/united-states/gdp-growth-annual.
Of course, the recent presidential elections also had a part to play in the surprise resurgence of the bull market. After a brief pre-election day fall, stock markets have managed to rise to new heights, the DJIA clocking in at 21000 for its first time. A flip through the annals of history indicates that the earlier part of a presidential cycle is usually mired in bear markets and recessions (Smith, 2016). This time round, however, the increasingly hefty price tag on shares seems to indicate that most investors are banking on Trump’s ability to deliver on his election campaign promises. Politics aside, the Republican party has long been touted as the business-friendlier of the two and Trump’s plans for large-scale tax cuts under a “five parts tax plan” in addition to proposed deregulation of the financial markets is reflective of this. The banking, pharmaceuticals, for-profit education and private prison industries are expected to make substantial gains; with its ties to a few key personnel within Trump’s administration, Goldman Sach’s alone has been responsible for at least a third of the increase in the banking sector (Kiersz, 2017). Consequently, the pressing question now is truly how realistic Trump’s proposed economic reforms are and how they will possibly translate into reality. A closer examination on Trump’s election promises might be able to shed more light in this regard.
Trump’s grand plans: How will his policies interact with the current economy?
It’s easy to confuse the strength of the economy with confidence in the markets. For us to paint an accurate picture of Trump’s interaction with both, we first need to analyze their underlying conditions more carefully.
“The Federal Reserve hiked interest rates on Wednesday, raising its target federal funds rate by 25 basis points to a range of 0.75% to 1.0%.” (Perumal, 2017). Perumal (2017) also stated that the rate hike was seen as a vote of confidence. According to Peter Schiff of Euro Pacific Capital (2017), the federal reserve is faking confidence. He noted that during Janet Yellen most recent testimony, when asked about reducing the balance sheet, she said that the Fed would need to see “normalization of interest rates” before they could begin. The catch? She was unable to define what this meant. Her lack of ability to explain this, according to Schiff, alludes to the fact that they have no real plans to raise rates in the future and therefore have no real confidence in the economy. Quarter one’s GDP estimates and missed inflation targets could explain the Fed’s lack of confidence. The Federal Reserve Bank of Atlanta’s most recent quarter one GDP forecast is 0.9 percent, revised down from a high of almost 3.5 percent in early February (“GDP Now”, 2017). The Fed’s target inflation rate of 2 percent is well known, but recent statistics state that the 12-month inflation rate is 2.5 percent – much higher than comfort for the Fed (“Inflation Rate”, 2017). Are quarter-point rate hikes enough to stop rising inflation? Or will the Fed fall behind the curve?
Current market conditions are equally as important to analyze. According to David Collum of Cornell University (2017), with help of the graph below, “a number of valuation indicators pointing to a +40% correction simply to regress to the mean.”
Source: Average of the Four Valuation Indicators – dshort – Advisor Perspectives. (n.d.). Retrieved March 20, 2017
Markets are potentially propped up on false confidence -end of the year stock buybacks, Trump confidence, and low-interest rates may be enough to keep the markets floating for now, but the short-term future is uncertain. After analyzing the current economy and market conditions in more depth, we can now discuss the changes that will be caused by Trump’s economic agenda.
Trump’s most ambitious proposal yet – a $1 trillion stimulus plan to rebuild decaying infrastructure (Bender, 2017). The Dow rally surged on as investors waited with open arms for less government intervention, allowing the free markets to prosper for the coming years, but a $1 trillion government spending program isn’t a free market solution. At 12:57 AM on Saturday, March 25th, the US national debt is $19.85 trillion (“US Debt Clock”, 2017). With talk of significant tax cuts for both individuals and corporations, how will the government pay for this? Their only option is to increase national debt significantly. With interest rates expected to rise, servicing this debt will not be plausible. If this leads to creditors losing confidence in repayment, the US dollar could significantly weaken. The infrastructure plan will have to be completed and approved by Congress before any effects take place, with a Republican controlled congress it is easier said than done. While this is Trump’s policy that is the least likely to come to fruition, this policy would cause the greatest change in the economy and markets.
Border Adjusted Tax
Another one of Trump’s radical proposals is a border-adjusted tax. What is a border-adjusted tax? Information from NPR podcast ‘Planet Money’ explain: Trump stated, “Well, we’re working on a tax reform bill that will reduce our trade deficits, increase American exports and will generate revenue from Mexico that will pay for the wall if we decide to go that route.” (Smith, 2017). Peter Schiff (2017) explained that with this policy, there would be an initial increase in the value of the dollar as the trade deficit also initially decrease. In other words, the short-term goals would be met. However, he also produced three arguments against this policy. The first – he argued that the US does not have the domestic good production capacity for Americans to stop buying imported goods. Moreover, he stated that the US does not have the infrastructure to start producing local products which raise the question whether businesses are willing to invest in infrastructure when Trump’s term is only a four-year promise. The second, Schiff does not believe the tax will be substantial enough to offset the demand for cheap imported goods. Finally, he argued that this policy will hurt the markets – when the US economy spends less money on foreign goods, foreign businesses will have less money to invest in the US financial system. As there is then less supply of funds, interest rates will rise which the US economy may not be ready. It is also important to note that this tax will only affect American retailers who have domestic workers and American made goods, not online stores that ship direct to consumer – overall hurting the US economy through rising unemployment and rising prices of domestically produced goods.
Middle-Class Tax Relief
Trump stated that the US government would provide massive tax relief for the middle class. According to Forbes magazine, massive, in this context, is defined as, “the middle class, on average, will have an extra $1,500 or so to spend each year should the President’s plan, as proposed, come to fruition.” (Nitti, 2017). Individually this is not a large amount, but across the board, it will be a significant decline in government revenue. The middle-class taxpayer can use these additional funds for two things – saving or spending. As approximately 62% of Americans have less than $1,000 in savings (Fottrell, 2015), these funds will be used on spending. With the border adjusted tax on the way, this money won’t be used to buy domestic goods; it will be to pay off debt or buy more imported goods instead. Regardless, the tax cut will not lead to the growth that the US economy needs.
Drastic plans can have drastic results. Effects will not be felt immediately, but with grand plans to drastically alter the structure of the US economy, they will be prevalent in the future. In the short term, rising prices and expenses for retailers. In the long term, rising interest rates and increased national debt – something every investor should worry.
Ultimately, however, prices are driven by none other than the collective will of the traders themselves, be they big-shot investment bankers or simply the average salaryman with some additional savings. The election of President Trump has created favorable market conditions with allusions to lower corporate tax rates and more liberal regulations, and undoubtedly some investors are fully confident on the economic advantages of the new policies and the administration’s ability to implement them. However, many are wreathed by uncertainty arising from a manner of the presidency previously unobserved.
Most investors are more prudent than one might expect. Who would, with clear rationality, not be wary of growth rooted in the expectation of reforms which have not even begun to be enacted (Hube, 2017) and which are heralded by a man with a history of grandiose proclamations? (“PolitiFact,” 2017) Yet, we are humans before investors, burdened by the dual vices of greed and fear. We cannot escape the temptation of profits, especially after such a long stretch of economic weakness. To compound the issue, the human mind cannot help but be terrified of missing out on ‘obvious’ opportunities. Just like a group of boys who understand their mischief is wrong but still continues with it for fear of becoming outcasts, what choice does a trader have other than to dive headlong into the market? Doing anything else at all, even daring to mention ‘protection against risk,’ now seems to be abandoning free money.
Once Again, a Bubble?
A significant market downturn is unlikely for now if the current condition is not disturbed, even though all signs point to an imminent crash. With the VIX volatility index near all-time lows (“CBOE,” 2017), one might expect the progression of equities to be placid. However, what we see is only an illusion of a calm ocean, utterly unaware of the roiling undercurrents beneath. Paradoxically, uncertainty does not give birth to volatility; rather, when the public holds firm conviction (whether justified or not) that prices will swing one way or another, such as the bull market before 2008 and the subsequent disappointment, wild fluctuations are at their greatest.
Source: CBOE. (2017). VIX (CBOE MARKET VOLATILITY). Retrieved 25 March 2017, from http://www.cboe.com/delayedquote/advanced-charts?ticker=VIX
2017 has been characterized until now by a record 109-day streak without a 1% decline in the S&P 500 index, a turn of events which some even describe as ‘boring.’ A particularly wise analyst might be sitting uneasily at his desk, burdened by a hunch, an instinct that something is wrong. Wherever light shines, a shadow is cast. Even following the collapse of Lehman Brothers in 2008 where 5% intraday movements in the S&P 500 became the norm, the market nonetheless experienced resurrections of over 10% scattered amongst the carnage. By contrast, the election of President Trump – plunging the US into several years where experience becomes meaningless – has shone forth the proverbial light without the shadow which must accompany it. Investors may even be comforted by a drop. After all, it is only natural to see minor pullbacks interlaced within a larger uptrend. A lack thereof conjures a sense of paranoia and trepidation among traders, a forced ‘wait-and-see’ attitude which precludes next recession if the status quo persists, but is fragile beyond measure if disturbed.
Looking into the future
It is still too early in Trump’s presidency to predict the direction of the market, but already analysts have identified numerous areas of potential concerns with the new administration. Incidentally, these concerns are partially factored into equity prices by now, and if none of them come to pass, the continuation of the bull market in the medium term is all but guaranteed.
One of the primary risk is the fact that the current inflated levels are firmly planted in the expectation of favorable policy from the Republican party, but what will result if the GOP is no longer in a position to dictate law? While the tripartite Republican control of the American government is reassuring right now, the outcome of the 2018 midterm elections is less than indisputable, especially given Trump’s 42.2% approval rating (“FiveThirtyEight,” 2017) which seems unlikely to change in the near term. Without support from Congress, further policy advantageous to the market can plausibly and easily be delayed. Also, bookmakers give odds of more than 50% that Trump himself will be removed from office (Ladbrokes, 2017), impeached or otherwise, before the conclusion of his first term. Such an outcome, if stocks revert anywhere close to pre-election prices, will be disastrous for global equities, regardless of anyone’s concern for morality or social justice.
Even if Republicans can remain seated in both Presidency and Congress, doubts have arisen on whether they can successfully enact laws in the wake of the failed attempt at healthcare reform. Proposed tax cuts and deregulation are meaningless if not made into policy, and markets will take such a disappointment harshly. The effectiveness and efficiency of the administration will be tested in the coming weeks.
One number unexplained by the reasonable uncertainties hitherto presented is the US Consumer Sentiment Index, tracking public confidence, which currently lingers around extreme highs at 97.6 (“University of Michigan,” 2017). It must be noted that those who are uncertain tend not to give their opinion as an average of plausible options; they tend not to deliver an opinion at all. Thus, among the duel between optimists and naysayers, it seems the former has attained victory since November 2016. However, to account for the remainder of the rise in the index, one should acknowledge that humans are not rational. Once large institutions begin to rejoice at proposed reforms by President Trump, their enthusiasm infects the overly impulsive buyers, then spreads to the ordinary trader until even the most conservative investor is all but compelled to abandon his hedge for fear of a stupendous market uprising. Perhaps, forced into buying, false hope is consolidated by speculation into solid foundations, and perhaps speculation is enough to keep indices growing for all of the foreseeable future.
All the short-term risks, the ample quantity of speculation right now, and the unreliability of the current administration in their delivery of promises cannot be overlooked. Equities, since the birth of capitalism and for all the days to come, will forever be a celebration of human ingenuity and human innovation. They are the materialization of an entrepreneurial spirit which alone will propel markets past any storm of hardship. Humanity’s inborn hope will undoubtedly carry us along lofty peaks, but hope burns more candidly in our dark valleys. Never forget discretion, yet, neither forget Warren Buffett’s prophecy that stocks are ‘virtually certain to be worth far more in the years ahead.’
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
Master of International Business student in Melbourne Business School. Prior to his time in the MBS, he was working at the Institute of Social and Economic Research-Universitas Indonesia and has published several working papers on the implication of economic and social developments toward the perceived level of corruption in both developing and developed countries.
This author has not left any details