- The surprising U.S. election outcome has led to considerable uncertainty over how President-elect Trump will prioritize his policy agenda, the likelihood of its implementation, and a wider set of possible outcomes for the financial markets.
- We expect the Trump Administration to review the major regulatory initiatives that were finalized under the Obama Administration.
- Trump’s proposed deregulation policies and potential new legislation, if enacted, could benefit energy and financial stocks.
- Trump’s proposed tax reform, which will require bipartisan Congressional support, would be generally positive for corporate profit margins.
- Inflation expectations have risen since the election, and coupled with already increasing wage inflation could lead to further Federal Reserve interest rate hikes in 2017.
- Proposed increases in defense spending could benefit defense companies; more infrastructure spending may benefit the machinery, engineering construction, building products, construction materials, and steel industries.
On November 8, 2016, Republican Party nominee Donald J. Trump was elected President of the United States, and the Republican Party maintained a majority in both the Senate and the House of Representatives. As the transition to a new presidential administration begins, we gathered a cross-section of Fidelity leaders to discuss President-elect Trump’s policy agenda, and to put the election outcome into perspective.
Brian Leite (Moderator): Let’s begin by setting some political context on the outcome of the election. Shahira, could you recap how the election played out?
Shahira Knight (Fidelity Government Relations): Sure. Trump’s victory was definitely a big surprise, especially to anybody who trusted the polls. I think that is something that will be examined in the wake of the election—how the polls got it so wrong. Were there secret Trump voters or was it inaccurate voter turnout? Trump was able to do something that no other Republican has been able to do for a long time, which is to break through the “blue wall” of the Electoral College and win some of the traditionally Democratic states, such as Wisconsin and Pennsylvania.
Republicans did better than expected in Congress as well. They kept control of the House, albeit with a bit of a smaller majority. So far, it looks like Republicans have netted only a six-seat loss. They have 238 seats right now. Democrats have 193, and there are about four races right now that are still too close to call. The Senate was considered a pure toss-up and a lot of the models had predicted that Democrats were going to win the Senate. However at this point, it looks like Democrats have netted only one new seat in the Senate, Illinois. So right now, Republicans have retained control with 51 seats. Democrats have 47. There are still two outstanding races: one in New Hampshire, which is too close to call; and the second in Louisiana, which is going into a runoff in December.
Leite: Much of what Mr. Trump was campaigning on doesn’t necessarily align with traditional Republican orthodoxy. So do you think that the President-elect is going to be able to achieve most of his policy agenda, and how do you see that playing out with Congress?
Knight: Good point. It is really difficult to look into the policy crystal ball right now. There is so much detail that’s not known about his policy positions, and there’s a lot of uncertainty about how he would work with Congressional Republicans—and with Democrats for that matter. We don’t know what a Trump administration will look like, and how he would govern and function over the next few years.
But there are a few things to keep in mind. There are definitely divisions in the Republican Party right now. Not all Republicans are aligned with all aspects of Trump’s policy agenda, so that may hinder his ability to get things done. Also, and importantly, remember that it does take 60 votes to pass most legislation in the Senate. There are procedural things that you can do to avoid the 60-vote hurdle. But, for the most part, you need 60 votes to pass legislation. And Republicans are going to end up with somewhere between 51 to 53 votes when all the ballots are counted. So Republicans can’t just ram through anything they want. Legislation will need some bipartisan support to advance.
Leite: Do you have any thoughts or expectations about what policy issues might be prioritized within a Trump administration?
Knight: He covered a lot of ground in his policy platform, ranging from immigration to trade to health care to infrastructure spending. It’s difficult right now to know what issues he will prioritize and where he will be able to reach a consensus with Congress. We also don’t know where he’s going to be able to do things unilaterally without Congressional approval. But one area where we know Trump is aligned, with most Congressional Republicans at least, is tax reform. Tax reform is a big priority for a lot of Republicans in Congress and it was a major theme of Trump’s platform. It’s also an area where Trump’s policy actually has some similarities to what House Republicans have laid out. So we do expect to see a lot of discussion over tax reform next year.
On the regulatory front, I think we are definitely expecting to see a lot of change. We’ve had a really active regulatory agenda during the past four years, and we do expect some regulatory relief as we move forward. This has been another major part of Trump’s platform. His belief is that regulation is stifling job creation and economic growth.
Leite: In what areas might we see regulatory relief?
Knight: Trump has said that on day one, when he takes office, he is going to reverse President Obama’s executive orders—all the things he did unilaterally. In addition, his transition team is dedicated to looking at the major regulatory initiatives that were finalized under Obama, with an eye toward either changing those regulations or reversing them altogether. He’s also said that he’s going to impose a moratorium on new regulations that didn’t specifically come from Congressional authority. Republicans in Congress have been looking to reform the regulatory process for a long time now, so there could be changes there. In particular, Republicans have been looking to give Congress more oversight over the regulatory process, and to put a heavier emphasis on cost-benefit analysis.
Leite: Thank you Shahira. Let’s turn to the U.S. economy. Dirk, what are your initial thoughts on what a Trump presidency might mean for the U.S. economy and investors in the near term?
Dirk Hofschire (Asset Allocation Research): We can be fairly confident that uncertainty is going up across the board. The range of outcomes now is clearly a lot wider than it would have been under alternative outcome scenarios from last night’s election. But it’s important to consider where the economy is today. We’ve been characterizing the current business cycle state as a mix of mid- and late-cycle dynamics for a while. We think we are headed toward the late-cycle phase. What that really means is that growth will still be reasonably solid. There are low odds of recession. And inflationary pressures are likely to pick up. We’re already seeing it in U.S. wages, and that uptick in wages puts some pressure on corporate profit margins. In recent months, we’ve seen some stabilization in the global economy, which raises commodity inflation pressures. Now the question becomes: how is that current status likely to change based on what may happen in Washington? It’s difficult right now to have a lot of conviction on that front.
Leite: Can you walk us through a scenario or two and let us know how you are thinking about it?
Hofschire: Sure. If you think about the areas Shahira mentioned where there is agreement between the Republican Congress and Trump—tax reform, tax relief, and a lighter touch on regulation—those policies are generally positive for corporations, for profit margins, and even potentially for growth.
Then you have topics outside of that where they differ. On trade policy, the GOP generally is much more pro-free trade. Trump has been very protectionist in his rhetoric. Does he prioritize triggering some sort of trade confrontation with China or Mexico? That protectionism would work negatively toward economic growth, and would push up inflation. In terms of fiscal policy, Trump has proposed a lot of stimulus toward infrastructure. Traditionally, Republicans have been less excited about that. So it remains to be seen how much potential fiscal stimulus he could get done.
So for the economy, it will come down to the impact of any policy changes on growth and inflation. Whether it’s good or bad will depend upon the weighting of these policies. More deregulation and tax reform would be better for growth. More protectionism would be worse for growth. The one thing we have some conviction on is that inflation upside risk has risen, because almost every one of these policies is directionally and incrementally more inflationary.
Leite: What are the longer-term implications beyond the business cycle?
Hofschire: The populism movement is a longer-term theme in politics in developed markets. It’s a reaction to two or three decades of globalization policies and rising inequality. There’s a growing anti-establishment, anti-incumbent, anti-elite populism movement, and you can see it on the right and on the left in the U.S., and in many European countries as well. It’s a longer-term theme and it’s probably not going away, regardless of near-term policymaking in D.C. And what that means is more political uncertainty, and perhaps higher risk premiums for certain assets. We will need to think about politics and political risk more than we probably have had to in most of our adult lives up to this point.
Leite: So could that mean a more normalized inflationary environment relative to history or something else?
Hofschire: Our base-case scenario for the long term is we expect to have less inflation than if you just looked at a historical average level of inflation. That’s because we expect slower global growth, weaker demographics, and a lot of other factors. But I think politics are definitely putting that thesis at risk. So there is again upside inflation risk to our long-term thesis. When you think about asset allocation, upside inflation risk has gotten priced out of markets during the past two or three years, as rates have fallen and the valuations of assets that are beneficiaries of deflation have risen. It’s not necessarily a normalized inflation environment, because there are potential inflation upsides as we go forward. We’ll see what happens.
Leite: From an asset allocation perspective, what are some potential “winners” and “losers” under these scenarios?
Hofschire: If we enter a more mature, later phase of the business cycle, investors should consider moving back closer to their portfolio’s long-term, strategic weightings in equities, bonds, and other assets. The late-cycle phase isn’t necessarily when you want to take a huge amount of risk or big cyclical bets. This is a phase of the business cycle when you want to have some inflation resistance in your portfolio—assets such as commodities, commodity-producing equities such as energy and materials, Treasury Inflation-Protected Securities, and shorter-duration bonds. These assets historically have offered a bit of resistance against an uptick in inflation. Our research group doesn’t recommend changing that positioning, but instead gets even more conviction about it based on the outcome of the election.
Leite: Let’s now take more of an asset class view and switch gears to fixed income. Bill, we’ve certainly seen some initial movement in terms of a steepening of the yield curve. How do you interpret that, and how might the election results and Trump’s policy agenda influence the direction of interest rates or the shape of the curve?
Bill Irving (Investment-Grade Bonds): Interest rates have been volatile since the election outcome was confirmed, and longer-dated U.S. Treasury bonds have moved quite a bit higher in a short-term period. The biggest component of those moves has been the inflation component, based on how TIPS have traded, and breakeven rates. So inflation expectations have risen.
I would attribute that to three main factors. First, the market is pricing in more fiscal stimulus to the extent that we get near-term infrastructure spending without offsets. That would be positive for inflation in the coming years as the government boosts demand. A second factor would be trade protectionism. Our developed economy has generally benefitted from globalization, and the ability to import cheap goods by tapping cheaper goods from foreign markets. If that trend starts to reverse, then it’s just another inflationary input in terms of goods being more expensive. Third, stricter immigration policies could also push inflation higher. Reduced immigration, all else being equal, would lead to a tighter domestic labor market, which is supportive of inflation.
Leite: Are there any potential policy outcomes that are deflationary?
Irving: Yes. Some longer-term policy factors could lead to a stronger dollar versus other developed-market currencies, and a stronger dollar would be a disinflationary force. One of those factors would be Federal Reserve (Fed) interest rate hikes. More fiscal stimulus might compel the Fed to hike more rapidly. That would put upward pressure on the dollar, which would be a disinflationary force. Another potential factor would be if part of tax reform involved repatriation of dollars—all of the corporate dollars that are trapped overseas. That would be positive for the dollar and a disinflationary force.
Leite: What’s your outlook on monetary policy?
Irving: I still expect another Fed rate hike in December, as is priced into the market. The economy is nearing full employment, wage growth is accelerating, and consumer inflation is moving towards target. The outlook for rate hikes next year is much less clear. The market is priced for only a single additional hike, but as Dirk pointed out, there is a tremendous amount of uncertainty in terms of what we will get for fiscal, trade, regulatory, and foreign policy—all of which will affect the financial conditions, the economy, and thus monetary policy. If Trump and Congress do deliver more stimulative fiscal policy (in the form of either tax cuts or increases in infrastructure and defense spending), then I would not be surprised to see two or three rate hikes next year. Even longer term, I think that the biggest monetary-policy challenge facing the Fed is how to counter the next recession, especially with interest rates still so low.
Leite: Let’s talk a little bit about the equity markets now, focusing on some of the key equity market sectors that might be impacted as a result of a Trump presidency. Tobias, how do you feel a Trump presidency might influence the dynamics within the industrials and materials sectors?
Tobias Welo (Industrials and Materials): Most of Trump’s major policy plans affect the industrials and materials sectors, and are quite positive. Let me highlight a couple. He’s been very vocal on his support for defense, where the backdrop has already been pretty good and improving. I believe Trump is looking to support larger defense programs, for the development of ships and military fighters, which are important contracts for several defense companies. He has also said one of his first moves would be to eliminate sequestration, a law that reduced the amount that could be spent on defense. Trump has also been vocal about boosting infrastructure spending, which is positive for machinery, engineering construction, building products, construction materials, and the steel industry. It’s important to keep in mind that this spending is largely going to be structured with multiyear contracts, which is very positive, as it provides multiyear visibility to the earnings of these companies. Any increased spending will require Congressional support, however, so we’ll have to watch the dynamics at the Congressional level as well.
One of the very possible outcomes, in addition to tax reform, is cash repatriation. Cash repatriation has been discussed as something that might be allowed if used to fund infrastructure spending. Since infrastructure spending has been historically supported by Democrats and cash repatriation has been supported by Republicans and the business community, this appears to be a policy that could garner support from all parties.
Leite: Are there any other policies that could affect other areas of the two sectors?
Welo: Protectionist policy benefits the U.S. steel industry. The stocks of steel companies rallied after the election. They have faced pricing pressure from some foreign Asian imports. Outside of steel, many global U.S. companies have a regional manufacturing footprint, so they aren’t overly impacted by U.S. protectionism. Global multinational companies can be very flexible and have been quick to adapt and move their facilities around. Could there be some slight wage pressure? Yes. But some of these other policies we’ve discussed can lead to higher U.S. industrial production, which would definitely more than offset potential issues related to trade and wages. There are certain companies which have more exposure to a geographic region, such as Mexico, and more restrictive trade policy could be a headwind for them. But in general, those are exceptions, not the rule.
Leite: Chris, financials has been an area that’s generally been under pressure the past couple of years. It’s also been a sector that’s reacted very positively immediately after the election. What do you read into that?
Chris Lee (Financials): Yes, financial stocks have reacted well to a Trump presidency, and I think that is largely a reaction to his pro-growth campaign policy rhetoric. Financial services stocks are ultimately driven by underlying GDP growth. A large part of the sector is sensitive to spread-based income streams and therefore interest rates—including banks and insurance companies. So, the immediate uptick in yields has been a welcomed development. As a result, stocks reacted positively. One risk to consider is that we’re seven or eight years into an economic recovery, and it’s likely going to go down as one of the longest in history. Is the current recovery much more sustainable, and can these intermediate-term policies extend this expansion?
Leite: Is Trump’s promise to reduce regulation likely to influence the financial sector?
Lee: It’s one of the biggest potential positives. We’ve recently seen an unprecedented period of regulation within the financial services industry. But I think it is a bit of a nuanced discussion because if you really examine the platform on which Trump was elected, it was a somewhat populist platform. So there is a real tug of war between populism and pragmatism here. That said, he has addressed some of the areas that have really weighed on the financial sector, such as repealing certain aspects of Dodd-Frank [Wall Street Reform and Consumer Protection Act]. Any relief in those areas would be a net positive for many companies in the financial sector.
Leite: Do you have a sense as to what is going to matter most to a Trump Administration?
Lee: For financial stocks to outperform the market, there has to be an accelerating growth backdrop. In talking with some of our companies today, the simple matter of rolling back regulation doesn’t undo a lot of the expenses that they have incurred over the past couple of years. Many of these processes are now well engrained and they have made the investment. So any rollback is a little bit of a pyrrhic victory to some extent, because you know the money has been spent. Going forward, understanding the economy’s growth trajectory, both domestically and globally, is going to determine the outlook for financial companies.
Leite: John, what are your thoughts on the potential impact of the election for energy stocks?
John Dowd (Energy): The biggest news is that we are not likely to see increased regulations. The energy sector has been in the crosshairs of our heightened regulatory environment during the past eight years. Some of the challenges for companies are increased ethanol mandates, challenges to building interstate pipelines, alternative energy subsidies, restrictions to drilling on federal lands, and an environmental crackdown on the coal industry. Trump has made the case for less regulation going forward, and I believe the absence of a negative is a positive. That alone is a big deal. The market has been concerned with the sustainability of fracking [i.e., shale oil drilling technology], and particularly to what extent it might have been regulated into obscurity by a different election outcome.
Going forward, a more benign regulatory environment is healthy for many energy industries. In addition to the Trump win, we did see some votes take place in Colorado that made it more difficult to amend the state constitution to inhibit fracking in the state. That has been a major deal for the exploration and production companies operating there. It’s a step forward. Meanwhile, there is potential for a rollback of some regulations. For example, I think a more rational implementation of ethanol mandates would be extremely important for certain refiners. The pipeline industry also stands to benefit. There has been a lot of news over the past several years about pipelines to and from Canada to export crude oil. To the extent that those get built, it would reduce price differentials between the United States and Canada, and boost the economics of drilling there.
Leite: What do you see as the major investment opportunities in the sector?
Dowd: What we have been seeing is disruptive technology in the form of shale drilling, which has enabled the U.S. oil industry to move down the global cost curve. This has been a stock picker’s dream. We’ve seen U.S.-focused small-cap companies aggressively using this new drilling technology to lower their production costs at the expense of the bigger integrated oil companies, which invest more broadly across the world. This has been happening amid a challenging regulatory environment, and been a boon for the earnings and stocks of certain domestic energy and production companies, refiners, pipeline companies, and drillers. This increased production of domestic oil at lower costs is not necessarily good for the international competitors in the country. Lower production costs are deflationary for oil prices, and that could lead to more instability in the Middle East or elsewhere. But if you are the company that owns the disruptive technology, I think you stand to benefit.
Leite: What other knock-on effects have occurred as a result of this deflationary dynamic?
Dowd: We’ve seen many companies around the world trying to adjust to this environment. Russian oil companies immediately reduced their cost structure when they devalued their currency. That made them more competitive on a global scale. Several weeks ago, Saudi Arabia reduced the pay of all state employees by 20%. Integrated oil companies cut their capital spending budgets in half. Oil services companies reduced their employee base by anywhere from 40% to 100%. And about 10% of the companies in the energy index went bankrupt last year. So what we have now is basically a race down the global cost curve.
In the U.S., we’ve seen more supply growth than we were used to. For the previous two decades, non-OPEC supplies basically did not grow. With the advent of shale drilling technology, we saw U.S. production growth accelerate, which depressed commodity prices, and the industry has really been trying to adjust. We’ve seen the same technology increase supply and lower prices for natural gas. Natural gas prices are down two-thirds from a cyclical peak, yet the stocks of companies operating with this technology in the Marcellus basin (Appalachian Region) are up about 350%. Oil prices are down a third, but the stocks of the shale oil companies that were driving shale production growth and pushing down the commodity price are up roughly 150% over the past decade. So the dynamics in the sector are different. I don’t believe the “winners” of the past 20 years are necessarily going to be the “winners” of the next 20 years.
Leite: Trump has brought a lot of attention to the coal industry. Do you anticipate any changes with his Administration taking office?
Dowd: From my perspective, the future of the coal industry is facing a very difficult challenge due to the oversupply of domestic natural gas, and lower natural gas prices. It is going to be very difficult for the coal industry to compete with that going forward. The coal industry also has suffered from increased regulation, another challenge.
Leite: Dirk, looking abroad to international markets, could you provide some perspective on the language Trump has used toward China and Mexico, and how those views might play out?
Hofschire: During the course of this year, for the first time in several years, our research team has generally become much more positive on the underlying cyclical momentum in emerging markets. In China, we’ve seen a significant amount of fiscal stimulus and a prioritization on economic stability by policymakers. Trump’s rhetoric throws some uncertainty into that view. If, in his first 100 days, there’s an effort to try to renegotiate or repeal NAFTA [North American Free Trade Agreement] or start slapping tariffs on China right away, then that’s going to be difficult for the emerging markets in general, even though those actions may be directed only at China and Mexico.
If, however, Trump places more priority on some of the business-friendly tax and deregulatory policies, then the backdrop—late-cycle environment with the potential pickup in growth due to stimulus—is not a bad one for emerging markets. Longer term, we’re pretty favorably disposed towards emerging markets as a global equity category, due primarily to its long-term growth prospects and favorable demographics.
Leite: Thank you all for sharing your perspectives today.